Select Comfort Corporation Form 10-Q for period ended September 30, 2006

Table of Contents

 

 

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 September 30, 2006

 

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x   

Accelerated filer  o   

Non-accelerated filer  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 20, 2006, 52,672,000 shares of Common Stock of the Registrant were outstanding.

 




 

 

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

 

INDEX

 

PART I: FINANCIAL INFORMATION

 

 

 

Item 1.

Financial Statements

Page

 

 

 

 

Consolidated Balance Sheets

 

 

September 30, 2006 and December 31, 2005

3

 

 

 

 

Consolidated Statements of Operations

 

 

for the Three and Nine Months ended

 

 

September 30, 2006 and October 1, 2005

4

 

 

 

 

Consolidated Statements of Cash Flows

 

 

for the Nine Months ended

 

 

September 30, 2006 and October 1, 2005

5

 

 

 

 

Notes to Consolidated Financial Statements

6

 

 

 

Item 2.

Management’s Discussion and Analysis of

 

 

Financial Condition and Results of Operations

13

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

21

 

 

 

Item 4.

Controls and Procedures

21

 

 

 

PART II: OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

22

 

 

 

Item 1A.

Risk Factors

22

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

23

 

 

 

Item 3.

Defaults upon Senior Securities

23

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

24

 

 

 

Item 5.

Other Information

24

 

 

 

Item 6.

Exhibits

24




Table of Contents

 

 

PART I: FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

SELECT COMFORT CORPORATION AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands, except per share amounts)

 

 

 

(Unaudited)

September 30,

2006

 

December 31,

2005

 

Assets

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

26,029

 

$

32,863

 

Marketable securities – current

 

 

35,994

 

 

24,122

 

Accounts receivable, net of allowance for doubtful accounts of
$521 and $552, respectively

 

 

17,120

 

 

10,109

 

Inventories

 

 

26,030

 

 

21,982

 

Prepaid expenses

 

 

9,658

 

 

9,841

 

Deferred income taxes

 

 

6,641

 

 

6,139

 

Total current assets

 

 

121,472

 

 

105,056

 

 

Marketable securities – non-current

 

 

50,699

 

 

55,102

 

Property and equipment, net

 

 

58,778

 

 

53,866

 

Deferred income taxes

 

 

15,551

 

 

11,256

 

Other assets

 

 

3,533

 

 

3,554

 

Total assets

 

$

250,033

 

$

228,834

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

47,225

 

$

31,655

 

Consumer prepayments

 

 

10,489

 

 

14,718

 

Accruals:

 

 

 

 

 

 

 

Sales returns

 

 

4,168

 

 

5,403

 

Compensation and benefits

 

 

24,814

 

 

24,839

 

Taxes and withholding

 

 

8,273

 

 

9,624

 

Other

 

 

10,912

 

 

8,659

 

Total current liabilities

 

 

105,881

 

 

94,898

 

 

 

 

 

 

 

 

 

Other long-term accrued liabilities

 

 

15,132

 

 

12,589

 

Total liabilities

 

 

121,013

 

 

107,487

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

Undesignated preferred stock; 7,500 shares authorized, no shares issued and
outstanding

 

 

 

 

 

Common stock, $.01 par value; 142,500 shares authorized, 52,680 and 53,598
shares issued and outstanding, respectively

 

 

527

 

 

536

 

Additional paid-in capital

 

 

28,120

 

 

56,854

 

Retained earnings

 

 

100,373

 

 

63,957

 

Total shareholders’ equity

 

 

129,020

 

 

121,347

 

Total liabilities and shareholders’ equity

 

$

250,033

 

$

228,834

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

SELECT COMFORT CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations

(unaudited – in thousands, except per share amounts)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

2006

 

October 1,

2005

 

September 30,

2006

 

October 1,

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

208,314

 

$

175,833

 

$

609,685

 

$

503,185

 

Cost of sales

 

 

78,610

 

 

71,041

 

 

235,763

 

 

206,806

 

Gross profit

 

 

129,704

 

 

104,792

 

 

373,922

 

 

296,379

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

87,708

 

 

72,704

 

 

257,848

 

 

211,777

 

General and administrative

 

 

18,327

 

 

13,791

 

 

57,638

 

 

40,476

 

Asset impairment charges

 

 

1,763

 

 

162

 

 

1,763

 

 

162

 

Operating income

 

 

21,906

 

 

18,135

 

 

56,673

 

 

43,964

 

Other income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

618

 

 

405

 

 

2,248

 

 

1,543

 

Income before income taxes

 

 

22,524

 

 

18,540

 

 

58,921

 

 

45,507

 

Income tax expense

 

 

8,583

 

 

7,094

 

 

22,505

 

 

17,557

 

Net income

 

$

13,941

 

$

11,446

 

$

36,416

 

$

27,950

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income per share – basic

 

$

0.26

 

$

0.21

 

$

0.68

 

$

0.52

 

Weighted average shares – basic

 

 

52,766

 

 

53,457

 

 

53,201

 

 

53,631

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income per share – diluted

 

$

0.25

 

$

0.20

 

$

0.65

 

$

0.48

 

Weighted average shares – diluted

 

 

55,304

 

 

57,492

 

 

56,068

 

 

58,223

 

 

See accompanying notes to consolidated financial statements.

 

 

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Table of Contents

 

 

SELECT COMFORT CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited – in thousands)

 

 

 

Nine Months Ended

 

 

 

September 30,

2006

 

October 1,

2005

 

 

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income

 

$

36,416

 

$

27,950

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

14,261

 

 

11,586

 

Share-based compensation

 

 

6,115

 

 

549

 

Loss on disposal and impairment of assets

 

 

1,806

 

 

165

 

Excess income tax benefits from stock option exercises

 

 

 

 

2,391

 

Changes in deferred income taxes

 

 

(4,797

)

 

(3,010

)

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

 

(7,011

)

 

(2,110

)

Inventories

 

 

(4,048

)

 

(1,542

)

Prepaid expenses and other assets

 

 

178

 

 

(2,629

)

Accounts payable

 

 

15,570

 

 

2,809

 

Consumer prepayments

 

 

(4,229

)

 

3,920

 

Accrued sales returns

 

 

(1,235

)

 

210

 

Accrued compensation and benefits

 

 

(25

)

 

8,421

 

Accrued taxes and withholding

 

 

(1,351

)

 

2,096

 

Other accruals and liabilities

 

 

4,796

 

 

5,014

 

Net cash provided by operating activities

 

 

56,446

 

 

55,820

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(20,953

)

 

(19,860

)

Investments in marketable securities

 

 

(28,369

)

 

(22,615

)

Proceeds from maturity of marketable securities

 

 

20,900

 

 

27,125

 

Net cash used in investing activities

 

 

(28,422

)

 

(15,350

)

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Repurchase of common stock

 

 

(49,512

)

 

(46,201

)

Proceeds from issuance of common stock

 

 

7,163

 

 

6,887

 

Excess income tax benefits from stock option exercises

 

 

7,491

 

 

 

Net cash used in financing activities

 

 

(34,858

)

 

(39,314

)

 

 

 

 

 

 

 

 

(Decrease) increase in cash and cash equivalents

 

 

(6,834

)

 

1,156

 

Cash and cash equivalents, at beginning of period

 

 

32,863

 

 

15,066

 

Cash and cash equivalents, at end of period

 

$

26,029

 

$

16,222

 

 

 

 

 

 

 

 

 

Supplemental Disclosure of Cash Flow Information

 

 

 

 

 

 

 

Cash paid during the year for –

 

 

 

 

 

 

 

Income taxes

 

$

22,175

 

$

16,764

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

 

SELECT COMFORT CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

 

 

1. Basis of Financial Statement Presentation

 

The consolidated financial statements as of and for the three and nine months ended September 30, 2006 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 September 30, 2006 and December 31, 2005 and the results of operations and cash flows for the periods presented. Our historical results of operations may not be indicative of the results that may be achieved for any future period.

 

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 on Form 10-K for the fiscal year ended December 31, 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.

 

On May 9, 2006, our Board of Directors approved a three-for-two stock split. Shareholders of record as of May 25, 2006, received one additional share for every two shares owned, with fractional shares being redeemed for cash. The additional shares were distributed on June 8, 2006. All share and per share information herein reflects this stock split.

 

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates. Critical accounting policies consist of stock-based compensation, revenue recognition, store closing and long-lived asset impairment expenses, accrued warranty costs and accrued sales returns.

 

In June 2006, the Financial Accounting Standards Board (“FASB”) ratified the consensuses of Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (“EITF 06-3”). EITF 06-3 indicates that the income statement presentation on either a gross basis or a net basis of the taxes within the scope of the Issue is an accounting policy decision. Our accounting policy is to present the taxes on a net basis. The adoption of EITF 06-3 in the first quarter of 2007 will not result in a change to our accounting policy and, accordingly, will not have a material effect on our consolidated financial statements.

 

In June 2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. We have not completed our evaluation, but do not expect the Interpretation to have a material impact on our consolidated financial statements.

 

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Table of Contents

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for our fiscal year beginning December 30, 2007, with early adoption permitted. We have not completed our evaluation, but do not expect SFAS 157 to have a material impact on our consolidated financial statements.

 

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ending December 30, 2006, with early application encouraged. We do not expect SAB 108 to have a material impact on our consolidated financial statements.

 

Other than our adoption of the accounting standard requiring the expensing of stock options (see Note 5), there were no additional new accounting pronouncements 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 U.S. government and related agencies, municipalities and corporations with investment grade ratings.

 

Our investments have an original maturity of up to 36 months with a weighted-average time to maturity of 11 months as of September 30, 2006. 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 September 30, 2006 carried an amortized cost of $86.7 million and a fair value of $86.3 million.

 

3. Inventories

 

Inventories consist of the following (in thousands):

 

 

 

September 30,

2006

 

December 31,

2005

 

 

 

 

 

 

 

 

 

Raw materials

 

$

7,409

 

$

6,549

 

Work in progress

 

 

321

 

 

226

 

Finished goods

 

 

18,300

 

 

15,207

 

 

 

$

26,030

 

$

21,982

 

 

4. Credit Agreement

 

In June 2006, we entered into a five-year Syndicated Credit Agreement (the “Credit Agreement”). The Credit Agreement provides for a $100 million senior unsecured revolving credit facility available to be used by us for general corporate purposes. Borrowings available under the credit facility can be increased by an additional amount up to $75 million.

 

Borrowings under the credit facility bear interest at a floating rate and may be maintained as base rate loans (tied to the prime rate or the federal funds rate plus 0.5%) or as Eurocurrency rate loans tied to LIBOR, plus a margin up to 1.0% depending on our leverage ratio, as defined.

 

We are subject to certain financial covenants under the agreement principally consisting of maximum leverage and minimum interest coverage ratios. We have remained in full compliance with all covenants from the time of the agreement through September 30, 2006. There have been no borrowings against the credit facility.

 

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Table of Contents

 

5. Stock-Based Compensation

 

Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123R (“SFAS 123R”), “Share-Based Payment,” which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values. SFAS 123R supersedes the Company’s previous accounting methodology using the intrinsic value method under Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the intrinsic value method, no share-based compensation expense related to stock option awards granted to employees had been recognized in our Consolidated Statements of Operations, since all stock option awards granted under the plans had an exercise price equal to or greater than the market value of the common stock on the date of the grant.

 

We adopted SFAS 123R using the modified prospective transition method. Under this transition method, compensation expense recognized during the three and nine months ended September 30, 2006 included: (a) compensation expense for all share-based awards granted prior to, but not yet vested, as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In accordance with the modified prospective transition method, the consolidated financial statements for prior periods have not been restated to reflect the impact of SFAS 123R.

 

Current Period Impact of Adopting SFAS 123R

 

The following table shows the impact of adopting SFAS 123R on selected reported items (“As Reported”) as compared with previous reporting permitted by APB 25 (“Pro Forma”):

 

 

 

 

Three Months Ended September 30, 2006

(in thousands, except per share amounts)

 

As Reported

 

Pro Forma

 

Increase

(Decrease)

 

 

 

 

 

 

 

 

 

Operating income

 

$

21,906

 

$

23,639

 

 

(1,733

)

Income before income taxes

 

 

22,524

 

 

24,257

 

 

(1,733

)

Net income

 

 

13,941

 

 

15,137

 

 

(1,196

)

Net cash provided by (used in):

 

 

 

 

 

 

 

 

 

 

Operating activities

 

 

50,730

 

 

50,509

 

 

221

 

Financing activities

 

 

(25,288

)

 

(25,067

)

 

(221

)

Earnings per share:

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.26

 

$

0.29

 

$

(0.03

)

Diluted

 

 

0.25

 

 

0.27

 

 

(0.02

)

 

 

 

 

 

Nine Months Ended September 30, 2006

(in thousands, except per share amounts)

 

As Reported

 

Pro Forma

 

Increase

(Decrease)

 

 

 

 

 

 

 

 

 

Operating income

 

$

56,673

 

$

61,582

 

 

(4,909

)

Income before income taxes

 

 

58,921

 

 

63,830

 

 

(4,909

)

Net income

 

 

36,416

 

 

39,875

 

 

(3,459

)

Net cash provided by (used in):

 

 

 

 

 

 

 

 

 

 

Operating activities

 

 

56,448

 

 

63,939

 

 

(7,491

)

Financing activities

 

 

(34,858

)

 

(42,349

)

 

7,491

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.68

 

$

0.75

 

$

(0.07

)

Diluted

 

 

0.65

 

 

0.71

 

 

(0.06

)

 

 

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Table of Contents

Prior Period Pro Forma

 

Results of operations for fiscal year 2005 and prior periods have not been restated to reflect recognition of stock-based compensation expense. If compensation expense for employee stock-based compensation had been determined based on the fair value at the grant dates consistent with the methods provided in SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net income and net income per share for the three and nine months ended October 1, 2005 would have been as follows (in thousands, except per share amounts):

 

 

 

Three Months

Ended

October 1,

2005

 

Nine Months

Ended

October 1,

2005

 

 

 

 

 

 

 

 

 

Net income, as reported

 

$

11,446

 

$

27,950

 

Stock-based compensation cost, net of tax, included in net income

 

 

155

 

 

338

 

Stock-based compensation cost, net of tax, if fair value
method had been applied

 

 

(1,039

)

 

(2,823

)

Pro forma net income

 

$

10,562

 

$

25,465

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

Basic – as reported

 

$

0.21

 

$

0.52

 

Basic – pro forma

 

 

0.20

 

 

0.47

 

 

 

 

 

 

 

 

 

Diluted – as reported

 

$

0.20

 

$

0.48

 

Diluted – pro forma

 

 

0.18

 

 

0.44

 

 

Stock-Based Compensation Plans

 

The Company compensates officers, directors, and key employees with stock-based compensation under three stock plans approved by the Company’s shareholders in 1990, 1997 and 2004 and administered under the supervision of the Company’s Board of Directors. At September 30, 2006, a total of 2,002,000 shares were available for future grant under the stock plans. Stock option awards are granted at exercise prices equal to the average of the high and low prices of the Company’s stock on the date of grant. Generally, options vest proportionally over periods of three to four years from the dates of the grant and expire after ten years. Compensation expense is recognized ratably over the vesting period.

 

Stock option activity was as follows for the nine months ended September 30, 2006 (in thousands, except per share amounts and years):

 

 

 

Shares

 

Weighted

Average

Exercise Price

 

Weighted

Average

Remaining

Contractual

Term (years)

 

Aggregate

Intrinsic

Value *

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

6,067

 

$

7.42

 

 

 

 

 

 

Granted

 

1,110

 

 

24.53

 

 

 

 

 

 

Exercised

 

(1,134

)

 

5.42

 

 

 

 

 

 

Canceled

 

(111

)

 

16.08

 

 

 

 

 

 

Outstanding at September 30, 2006

 

5,932

 

 

10.84

 

6.08

 

$

65,441

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercisable at September 30, 2006

 

4,087

 

 

6.59

 

4.78

 

$

62,449

 

 

* Aggregate intrinsic value includes only those options where the exercise price is below the market value

 

 

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Table of Contents

Other information pertaining to options for the periods ended September 30, 2006 and October 1, 2005 was as follows (in thousands, except per share amounts):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

2006

 

October 1,

2005

 

September 30,

2006

 

October 1,

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average grant date fair value of stock options granted

 

$

10.79

 

$

7.52

 

$

12.76

 

$

7.44

 

Total intrinsic value (at exercise) of stock options exercised

 

$

678

 

$

2,666

 

$

21,281

 

$

11,017

 

Cash received from the exercise of stock options

 

$

695

 

$

892

 

$

7,163

 

$

6,887

 

Excess income tax benefit from exercise of stock options

 

$

(221

)

$

526

 

$

7,491

 

$

2,391

 

 

There were 1,110,000 options granted in the nine months ended September 30, 2006, and 936,000 options granted in the nine months ended October 1, 2005. At September 30, 2006, there was $15.3 million of total stock option compensation expense related to non-vested awards not yet recognized, which is expected to be recognized over a weighted average period of 3.4 years.

 

Determining Fair Value

 

We estimate the fair value of stock options granted using the Black-Scholes-Merton option-pricing formula and a single option award approach. A description of significant assumptions used to estimate term, volatility, and risk-free interest rate follows.

 

Expected Term – Expected term represents the period that our stock-based awards are expected to be outstanding and was determined based on historical experience and anticipated future exercise patterns, giving consideration to the contractual terms of unexercised stock-based awards.

 

Expected Volatility – Expected volatility is determined based on implied volatility of our traded options and historical volatility of our stock price.

 

Risk-Free Interest Rate – The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with a term equal to the expected term.

 

The table below provides the weighted average assumptions used to calculate the fair value of awards granted during 2006 and 2005:

 

 

Three Months Ended

September 30,

2006

 

Three Months Ended

October 1,

2005

 

Nine Months Ended

September 30,

2006

 

Nine Months Ended

October 1,

2005

 

 

 

 

 

 

 

 

 

 

 

 

Expected dividend yield

0

%

 

0

%

 

0

%

 

0

%

Expected volatility

50

%

 

60

%

 

50

%

 

60

%

Risk-free interest rate

4.7

%

 

4.0

%

 

4.7

%

 

4.0

%

Expected term (in years)

5.2

 

 

5.0

 

 

5.6

 

 

4.9

 

 

 

10




Table of Contents

Restricted and Performance Stock

 

The Company issues restricted and performance stock awards to certain employees in conjunction with its share-based compensation plan. The awards cliff-vest at four, five or ten years of service based on continued employment. Compensation expense related to stock awards is charged to earnings on a straight-line basis over the vesting period. Total compensation expense related to restricted and performance stock was $410,000 and $251,000 for the three months ended September 30, 2006 and October 1, 2005, respectively. Total compensation expense related to restricted and performance stock was $1,206,000 and $551,000 for the nine months ended September 30, 2006 and October 1, 2005, respectively. All outstanding restricted and performance stock awards were unvested at September 30, 2006 and December 31, 2005. Restricted and performance stock activity was as follows for the nine months ended September 30, 2006 (in thousands, except per share amounts):

 

 

Restricted

Stock

 

Weighted-Average

Grant Date Fair Value

 

Performance Stock

 

Weighted-Average Grant Date Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

318

 

 

$ 11.78

 

 

68

 

 

$ 18.23

 

Granted

104

 

 

23.64

 

 

89

 

 

24.65

 

Canceled

(43

)

 

16.06

 

 

(8

)

 

20.92

 

Outstanding at September 30, 2006

379

 

 

14.53

 

 

149

 

 

21.92

 

 

At September 30, 2006, there was $6.3 million of unrecognized compensation expense related to non-vested restricted and performance share awards not yet recognized, which is expected to be recognized over a weighted average period of 3.2 years.

 

Employee Stock Purchase Plan

 

Employees are eligible to participate in the Company’s Employee Stock Purchase Plan (“ESPP”), which was approved by the Company’s shareholders in fiscal year 1999. Purchases are funded by payroll deductions over calendar quarter offering periods. The purchase price is 95% of the average of the high and low market price of the Company’s common stock on the last day of the offering period.

 

6. Asset Impairment Charges

 

During the three months ended September 30, 2006, we determined that certain software that we had been developing would not be installed in its current configuration and would be abandoned. As a result, we recognized an impairment charge of $1,248,000. We also determined during the three months ended September 30, 2006 that certain store assets were impaired and recognized an impairment charge for the difference between fair value and net book value of $515,000.

 

7. 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

 

 

 

September 30,

2006

 

October 1,

2005

 

September 30,

2006

 

October 1,

2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

13,941

 

$

11,446

 

$

36,416

 

$

27,950

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reconciliation of weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average shares outstanding

 

 

52,766

 

 

53,457

 

 

53,201

 

 

53,631

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Options

 

 

2,350

 

 

2,359

 

 

2,639

 

 

2,541

 

Warrants

 

 

3

 

 

1,363

 

 

35

 

 

1,760

 

Restricted shares

 

 

185

 

 

313

 

 

193

 

 

291

 

Diluted weighted average shares outstanding

 

 

55,304

 

 

57,492

 

 

56,068

 

 

58,223

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income per share – basic

 

$

0.26

 

$

0.21

 

$

0.68

 

$

0.52

 

Net income per share – diluted

 

 

0.25

 

 

0.20

 

 

0.65

 

 

0.48

 

 

 

11




Table of Contents

Additional potentially dilutive securities totaling 1,068,000 for the three and nine month periods ended September 30, 2006, and 1,119,000 and 1,016,000 for the three and nine month periods ended October 1, 2005, respectively, have been excluded from diluted net income per share because these securities’ exercise price was greater than the average market price of our common shares.

 

8. Litigation

 

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

 

12




Table of Contents

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 December 31, 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 stretch 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;

 

Our ability to maintain cost-effective sales, production and delivery of our products;

 

Our ability to secure adequate sources of supply, especially considering our dependence on single sources of supply for some components and our 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 dependence on third parties for certain services, including without limitation product delivery and assembly services and consumer credit options, and the vulnerability of such third parties to commodity shortages, inflationary pressures, labor negotiations, liquidity concerns or other factors;

 

The impact of litigation claims, including the potential impact of any adverse publicity;

 

The capability of our information systems to meet our growing and increasingly complex business requirements and our ability to continue to upgrade our systems on a cost-effective basis and without disruptions to our business;

 

Our ability to successfully implement systems and manufacturing process changes designed to enable us to comply with pending federal flammability standards on a cost-effective basis;

 

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.

 

13




Table of Contents

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 sales 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

 

September 30,

2006

 

October 1,

2005

 

September 30,

2006

 

October 1,

2005

 

 

 

 

 

 

 

 

 

 

 

 

The percentages of our total net sales, by dollar volume, from each of our channels are summarized as follows:

Percent of sales:

 

 

 

 

 

 

 

 

 

 

 

Retail

76

%

 

77

%

 

76

%

 

76

%

Direct

9

%

 

10

%

 

10

%

 

11

%

E-Commerce

5

%

 

5

%

 

5

%

 

5

%

Wholesale

10

%

 

8

%

 

9

%

 

8

%

Total

100

%

 

100

%

 

100

%

 

100

%

 

The components of sales growth, including comparable store sales increases, are as follows:

Sales growth:

Same-store(1) sales growth

7

%

 

15

%

 

13

%

 

14

%

New/closed stores, net

10

%

 

5

%

 

9

%

 

7

%

Retail total

17

%

 

20

%

 

22

%

 

21

%

Direct

4

%

 

10

%

 

3

%

 

17

%

E-Commerce

26

%

 

41

%

 

35

%

 

32

%

Wholesale

49

%

 

48

%

 

27

%

 

56

%

Total

18

%

 

22

%

 

21

%

 

23

%

 

 

 

 

 

 

 

 

 

 

 

 

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

412

 

 

369 

 

 

396 

 

 

370 

 

Opened

15

 

 

19 

 

 

33 

 

 

32 

 

Closed

(2

)

 

 

 

(4

)

 

(14

)

End of period

425

 

 

388 

 

 

425 

 

 

388 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retail partner stores

727 

 

 

264 

 

 

727 

 

 

264 

 

 

(1)

Stores enter the same-store calculation in the 13th full month of operation. Stores that have been remodeled or relocated within the same shopping center remain in the same-store base.

 

We anticipate increasing our store count by between 40 to 45 net new retail stores during 2006. We also plan to increase our retail partner store count during 2006 to 800 as we continue to partner with major mattress retailers and expand distribution to improve consumer convenience and leverage our growing brand awareness.

 

14




Table of Contents

Our growth plans are centered on increasing consumer awareness of our products and stores through expansion of media and promotion, 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 of products directly to consumers in the U.S. domestic market. We recently began selling in Canada through a major mattress retailer and believe that other 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. Generally in recent years, 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 general and administrative (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). During 2006 we expect our primary sources of leverage will be gross margin improvements (resulting from price increases implemented during the last half of 2005 and productivity improvements in manufacturing and logistics in excess of cost increases) and improved leverage of sales and marketing expenses. Although pricing actions have been taken, continued increases in commodity and fuel costs 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. We anticipate de-leverage in G&A expenses during 2006 primarily due to incentive compensation costs including the adoption of SFAS 123R. We estimate the full-year impact of expensing stock options will be $0.08 per diluted share.

 

Our long-term target is to sustain sales growth rates between 15% and 20% with same-store growth between 7% and 12%, and annual earnings growth rates between 20% and 25%. Our annual earnings growth rate target excludes the incremental effects on compensation expense within cost of sales and operating expenses resulting from our expensing of stock options during 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

 

 

 

September 30,
2006

 

October 1,
2005

 

September 30,
2006

 

October 1,
2005

 

Net sales

 

$

208.3

 

100.0

%

$

175.8

 

100.0

%

$

609.7

 

100.0

%

$

503.2

 

100.0

%

Cost of sales

 

 

78.6

 

37.7

%

 

71.0

 

40.4

%

 

235.8

 

38.7

%

 

206.8

 

41.1

%

Gross profit

 

 

129.7

 

62.3

%

 

104.8

 

59.6

%

 

373.9

 

61.3

%

 

296.4

 

58.9

%

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

87.7

 

42.1

%

 

72.7

 

41.3

%

 

257.8

 

42.3

%

 

211.8

 

42.1

%

General and administrative

 

 

18.3

 

8.8

%

 

13.8

 

7.8

%

 

57.6

 

9.5

%

 

40.5

 

8.0

%

Asset impairment charges

 

 

1.8

 

0.8

%

 

0.2

 

0.1

%

 

1.8

 

0.3

%

 

0.2

 

0.0

%

Total operating expenses

 

 

107.8

 

51.8

%

 

86.7

 

49.3

%

 

317.2

 

52.0

%

 

252.4

 

50.2

%

Operating income

 

 

21.9

 

10.5

%

 

18.1

 

10.3

%

 

56.7

 

9.3

%

 

44.0

 

8.7

%

Other income, net

 

 

0.6

 

0.3

%

 

0.4

 

0.2

%

 

2.2

 

0.4

%

 

1.5

 

0.3

%

Income before income taxes

 

 

22.5

 

10.8

%

 

18.5

 

10.5

%

 

58.9

 

9.7

%

 

45.5

 

9.0

%

Income tax expense

 

 

8.6

 

4.1

%

 

7.1

 

4.0

%

 

22.5

 

3.7

%

 

17.6

 

3.5

%

Net income

 

$

13.9

 

6.7

%

$

11.4

 

6.5

%

$

36.4

 

6.0

%

$

28.0

 

5.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

Basic

 

 

$ 0.26

 

 

$ 0.21

 

 

$ 0.68

 

 

$ 0.52

 

Diluted

 

 

0.25

 

 

0.20

 

 

0.65

 

 

0.48

 

Weighted-average number of common shares:

 

 

 

 

Basic

 

 

52.8

 

 

53.5

 

 

53.2

 

 

53.6

 

Diluted

 

 

55.3

 

 

57.5

 

 

56.1

 

 

58.2

 

 

 

15




Table of Contents

Net sales

We record sales 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 sales for products and home delivery services is recorded at the time the bed is delivered and set up in the home. Sales are recorded net of sales taxes. We reduce sales for estimated returns at the time revenue is recognized. This estimate is based on historical return rates, which have been reasonably consistent from period to period. If actual returns vary from expected rates, sales in future periods are 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 trends of warranty costs. Because our warranty obligations cover an extended period of time, a revision of estimated claim rates or the projected cost of materials and freight associated with sending replacement parts to customers 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 levels of 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, risk management and research and development. Costs include salaries, bonus, stock-based compensation expense and other benefits, information system hardware, software and maintenance, office facilities, insurance and other overhead. General and administrative expenses do not include stock option compensation expense in 2005 and prior periods.

 

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 generating negative cash flows. 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. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds its fair value. See Note 6 to the Consolidated Financial Statements.

 

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 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.

 

16




Table of Contents

Comparison of Three Months Ended September 30, 2006 with Three Months Ended October 1, 2005

 

Net sales

Net sales increased 18% to $208.3 million for the three months ended September 30, 2006 from $175.8 million for the three months ended October 1, 2005. Sales of mattress units increased 8% overall and the average selling price per bed (mattress sales divided by mattress units) in our company-controlled channels increased 6% to $1,712, while sales of other products and services increased by 25%.

 

The increase in net sales by sales channel was attributable to (i) a $22.7 million increase in sales from our retail stores, including an increase in comparable-store sales of $9.3 million and an increase of $13.4 million from new stores, net of stores closed, (ii) a $0.6 million increase in direct marketing sales, (iii) a $2.3 million increase in sales through our e-commerce channel and (iv) a $6.9 million increase in sales through our wholesale channel.

 

Gross profit

Gross profit increased to 62.3% for the three months ended September 30, 2006 from 59.6% for the three months ended October 1, 2005, primarily due to higher average selling prices, an increase in mattress unit sales and productivity improvements in manufacturing and logistics, partially offset by increased product and delivery costs resulting from rising commodity and fuel costs.

 

Sales and marketing expenses

Sales and marketing expenses increased 21% to $87.7 million for the three months ended September 30, 2006 from $72.7 million for the three months ended October 1, 2005 and increased as a percentage of net sales to 42.1% from 41.3%. The $15.0 million increase was primarily due to additional media investments, increased number of stores and variable costs due to higher sales. The increase as a percentage of net sales was comprised primarily of 0.8 percentage point (ppt) increase in media, and 0.5 ppt increase in promotional expenses, partially offset by 0.9 ppt leverage of sales compensation over higher sales. We generally expect sales and marketing expense growth rates to be lower than the rate of net sales growth due to leveraging the fixed component of sales and marketing expenses across a higher sales base, while reinvesting some of these leverage benefits into higher levels of media investments.

 

General and administrative expenses

General and administrative (G&A) expenses increased 33% to $18.3 million for the three months ended September 30, 2006 from $13.8 million for the three months ended October 1, 2005 and increased as a percentage of net sales to 8.8% from 7.8% for the prior-year period. The dollar and percentage increases in G&A were comprised primarily of increased compensation and benefits expenses related to additional headcount, the adoption of SFAS 123R requiring the expensing of stock option compensation 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 de-leverage in 2006 principally due to increased incentive compensation expense including the impact of SFAS 123R.

 

Other income

Other income increased $0.2 million to $0.6 million for the three months ended September 30, 2006 from $0.4 million for the three months ended October 1, 2005. The improvement is primarily due to higher interest income resulting from higher interest rates and higher average balances of invested cash.

 

Income tax expense

Income tax expense increased $1.5 million to $8.6 million for the three months ended September 30, 2006 from $7.1 million for the three months ended October 1, 2005. The effective tax rate was 38.1% in 2006 and 38.3% in 2005. The decrease in the effective tax rate was principally due to increased interest income from tax exempt securities.

 

17




Table of Contents

Comparison of Nine Months Ended September 30, 2006 with Nine Months Ended October 1, 2005

 

Net sales

Net sales increased 21% to $609.7 million for the nine months ended September 30, 2006 from $503.2 million for the nine months ended October 1, 2005. Sales of mattress units increased 9% overall and the average selling price per bed (mattress sales divided by mattress units) in our company-controlled channels increased 8% to $1,702, while sales of other products and services increased by 33%.

 

The increase in net sales by sales channel was attributable to (i) an $85.1 million increase in sales from our retail stores, including an increase in comparable store sales of $50.2 million and an increase of $34.9 million from new stores, net of stores closed, (ii) a $1.8 million increase in direct marketing sales, (iii) an $8.4 million increase in sales through our e-commerce channel and (iv) an $11.2 million increase in sales through our wholesale channel.

 

Gross profit

Gross profit increased to 61.3% for the nine months ended September 30, 2006 from 58.9% for the nine months ended October 1, 2005, primarily due to higher average selling prices, an increase in mattress unit sales and productivity improvements in manufacturing and logistics, partially offset by increased product and delivery costs resulting from rising commodity and fuel costs, and a correction in warranty accruals to include freight costs which had not been included in prior periods. This correction did not have a material impact on current or prior periods.

 

Sales and marketing expenses

Sales and marketing expenses increased 22% to $257.8 million for the nine months ended September 30, 2006 from $211.8 million for the nine months ended October 1, 2005 and increased as a percentage of net sales to 42.3% from 42.1%. The $46.1 million increase was primarily due to additional media investments, increased number of stores and variable costs due to higher sales. The increase as a percentage of net sales was comprised primarily of 0.3 ppt increase in advertising production costs associated with the launch of our new advertising campaign, 0.3 ppt increase in promotional expenses and 0.2 ppt increase in media, partially offset by 0.6 ppt leverage of sales compensation over higher sales. We generally expect sales and marketing expense growth rates to be lower than the rate of net sales growth due to leveraging the fixed component of sales and marketing expenses across a higher sales base, while reinvesting some of these leverage benefits into higher levels of media investments.

 

General and administrative expenses

General and administrative (G&A) expenses increased 42% to $57.6 million for the nine months ended September 30, 2006 from $40.5 million for the nine months ended October 1, 2005 and increased as a percentage of net sales to 9.5% from 8.0% for the prior-year period. The dollar and percentage increases in G&A were comprised primarily of increased compensation costs related to the adoption of SFAS 123R requiring the expensing of stock option compensation, increased compensation and benefits expenses related to additional headcount, higher professional fees and additional incentive compensation costs resulting from our performance. 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 de-leverage in 2006 principally due to increased incentive compensation expense including the impact of SFAS 123R.

 

Other income

Other income increased $0.7 million to $2.2 million for the nine months ended September 30, 2006 from $1.5 million for the nine months ended October 1, 2005. The improvement is primarily due to higher interest income resulting from higher interest rates and higher average balances of invested cash.

 

Income tax expense

Income tax expense increased $4.9 million to $22.5 million for the nine months ended September 30, 2006 from $17.6 million for the nine months ended October 1, 2005. The effective tax rate was 38.2% and 38.6% in 2006 and 2005, respectively. The decrease in the effective tax rate was principally due to increased interest income from tax exempt securities.

 

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Liquidity and Capital Resources

 

As of September 30, 2006, we had cash and marketable securities of $112.7 million, of which $62.0 million was classified as a current asset compared to $112.1 million of cash and marketable securities as of December 31, 2005, of which $57.0 million was classified as a current asset. The $0.6 million increase in cash and marketable securities was the result of generating $56.4 million of cash provided by operating activities, reduced by $21.0 million of capital expenditures and $34.9 million of cash used in financing activities (principally the $49.5 million repurchase of shares of our stock net of cash from stock option exercises and related tax benefits).

 

We generated cash from operations for the nine months ended September 30, 2006 of $56.4 million. Cash from operations for the nine months ended September 30, 2006 is comprised of net income of $36.4 million, plus net non-cash earnings charges of $17.4 million, and a decrease in non-cash working capital of $2.6 million, due primarily to increases in accounts payable offsetting increases in inventory and accounts receivable. Cash from operations for the comparable period of 2005 was $55.8 million, $0.6 million less than 2006. Cash from operations in 2005 is comprised of net income of $28.0 million, $8.4 million less than 2006; net non-cash earnings charges of $11.7 million, $5.7 million less than 2006 due primarily to the stock option expense under SFAS 123R adopted in 2006; and a decrease in non-cash working capital of $16.1 million primarily due to increases in accrued compensation and other current liabilities in excess of increases in current assets.

 

Net cash used in investing activities was $28.4 million and $15.4 million for the nine months ended September 30, 2006 and October 1, 2005, respectively. The increase in net cash used in investing activities was principally due to a net increase in investments in marketable securities in 2006 of $7.5 million as compared to a net reduction in investments in marketable securities in 2005 of $4.5 million. In both periods, our capital expenditures were approximately equal and related primarily to new and remodeled retail stores and investments in information technology. In the first nine months of 2006 we opened 33 and remodeled 20 retail stores, while in the first nine months of 2005 we opened 32 and remodeled 16 retail stores. We anticipate increasing our retail store count by 40 to 45 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 needs.

 

Net cash used in financing activities was $34.9 million for the nine months ended September 30, 2006, compared to $39.3 million for the nine months ended October 1, 2005. The $4.5 million decrease in cash used in financing activities resulted from the change in the classification of the excess tax benefit from stock option exercises of $7.5 million from operating to financing in accordance with SFAS 123R, partially offset by a $3.3 million increase in repurchases of common stock. The use of cash for financing activities in both 2006 and 2005 was principally due to repurchases of our common stock of $49.5 million in 2006 and $46.2 million in 2005. 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 September 30, 2006 was $118.9 million. We may terminate or limit the stock repurchase program at any time.

 

Cash and investments and 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 working capital to fund operations.

 

In June 2006, we obtained a $100 million bank revolving line of credit to provide additional financial flexibility for the Company to pursue its long-term growth strategies. The line of credit is a five-year senior unsecured revolving facility available to be used by the Company for general corporate purposes, including acquisitions. The Company has the ability to increase available borrowings under the credit facility by an additional amount up to $75 million.

 

Borrowings under the credit facility bear interest at a floating rate and may be maintained as base rate loans (tied to the prime rate or the federal funds rate plus 0.5%) or as Eurocurrency rate loans tied to LIBOR, plus a margin up to 1.0% depending on the Company’s leverage ratio, as defined. We are subject to certain financial covenants under the agreement, principally consisting of maximum leverage and minimum interest coverage ratios. We have remained, and expect to remain in the foreseeable future, in full compliance with all covenants. We currently have no borrowings outstanding under this credit agreement.

 

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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 revenue recognition, accrued sales returns, accrued warranty costs, stock-based compensation, and store closing and asset impairment expenses.

 

Revenue recognition

 

We record sales 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 sales are 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, sales in future periods are 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 trends of warranty claims. Because our warranty obligations cover an extended period of time, a revision of estimated claim rates or the projected cost of materials and freight associated with sending replacement parts to customers could have a material adverse effect on future results of operations.

 

Stock-based compensation

 

Effective January 1, 2006, we changed our accounting for stock options in accordance with SFAS 123R to the fair value method and now recognize stock option compensation expense in the consolidated financial statements. The valuation of stock options and resulting compensation expense is determined using the Black-Scholes-Merton single option pricing model with the most significant inputs into the model being exercise price, our estimate of expected stock price volatility and the weighted average expected life of the options. Previously, two alternative methods existed for accounting for stock options: the intrinsic value method and the fair value method. Prior to fiscal 2006, we used the intrinsic value method of accounting for stock options and accordingly, no compensation expense was recognized in the financial statements for options granted to employees, or for the discount feature of our employee stock purchase plan. This change in accounting policy has a material impact on our consolidated results of operations and earnings per share. See Notes 1 and 5 to the Consolidated Financial Statements.

 

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. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds its fair value. See Note 6 to the Consolidated Financial Statements.

 

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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.

 

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 September 30, 2006 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

 

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

 

ITEM 1A. RISK FACTORS

 

Our business, financial condition and operating results are subject to a number of risks and uncertainties, including both those that are specific to our business and others that affect all businesses operating in a global environment. Investors should carefully consider the information in this report under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and also the information under the heading “Risk Factors” in our most recent Annual Report on Form 10-K. The information provided below is intended to update the information included in our most recent Annual Report on Form 10-K.

 

We are currently evaluating the implementation of a new foundation for our enterprise-wide information systems architecture, which may result in increased costs in the near term and which could cause distraction of key personnel or disruptions to our business.

 

We depend upon our management information systems for many aspects of our business. Our current information systems architecture includes some off-the-shelf programs as well as some key software that has been developed by our own programmers, which is not easily modified or integrated with other software and systems and limits the flexibility and scalability of our information systems.

 

We believe that the performance, flexibility, scalability and cost-effectiveness of our information systems on a long-term basis could potentially be significantly enhanced through the implementation of a new foundation for our enterprise-wide management information systems, or “ERP Systems.” We have recently engaged in discussions with leading worldwide suppliers of ERP Systems with the objective of selecting a supplier and proceeding with implementation of a new ERP System by early 2008.

 

The implementation of a new ERP System may result in distraction of management and key personnel, and may involve implementation costs and acceleration of depreciation of portions of our existing systems, which could adversely impact our cost structure on a short-term basis. While we intend to exercise all reasonable precautions designed to ensure a smooth transition, the implementation of a new ERP System could cause disruptions that may materially and adversely impact our business and operating results.

 

All beds, including ours, will be subject to new federal flammability standards and related regulations beginning in July 2007, which may result in increased product costs, may require modifications to our systems and operations to ensure compliance and may increase the risk of disruption to our business due to regulatory inspections.

 

The federal Consumer Product Safety Commission has adopted a new flammability standard for mattresses and related regulations to be effective nationwide in July 2007. Compliance with these requirements may result in higher materials and manufacturing costs for our products, and may require modifications to our systems and operations, which may also increase our costs. To the extent we are unable to offset increased costs through value engineering and similar initiatives underway, or through price increases, our operating margins may be adversely impacted. If we choose to increase prices to preserve operating margins, our unit sales volumes could be adversely impacted.

 

Compliance may also require more complicated manufacturing processes, which may reduce our manufacturing capacity and require us to expand our manufacturing capacity sooner than otherwise anticipated. We may also face increased risks of disruptions to our business caused by regulatory inspections.

 

The risks described in this report and in our Annual Report on Form 10-K are not the only risks facing our company. Other factors may also exist that we cannot anticipate or that we may consider immaterial based on information currently available.

 

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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)

 

Fiscal 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

July 2006

268

$20.30

268

 

August 2006

652

19.14

652

 

September 2006

389

20.02

389

 

Total

1,309

19.68

1,309

$118,902

 

(1) The Finance Committee of the Board of Directors reviews, on a quarterly basis, the authority granted as well as any repurchases under this program. The repurchase authorization expires in 2008.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

Not applicable.

 

 

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

   None.

ITEM 5.   OTHER INFORMATION

   Not applicable.

ITEM 6.   EXHIBITS

Exhibit
Number
Description Method of Filing
 
10.1     Fifth Amendment to Lease dated August 28, 2006 between Cabot Industrial Properties L.P. and Select Comfort Direct Corporation.     Filed herewith    
10.2   Net Lease Agreement (Build-to-Suit) by and between Opus Northwest LLC, as Landlord, and Select Comfort Corporation, as Tenant, dated July 26, 2006.   Incorporated by reference to Exhibit 10.1 contained in Select Comfort’s Quarterly Report on Form 10-Q for the quarter ended July 1, 2006 (File No. 0-25121)
10.3   Profit Participation Agreement by and between Opus Northwest LLC and Select Comfort Corporation dated July 26, 2006.   Incorporated by reference to Exhibit 10.2 contained in Select Comfort’s Quarterly Report on Form 10-Q for the quarter ended July 1, 2006 (File No. 0-25121)
31.1   Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.   Filed herewith  
31.2   Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.   Filed herewith  
32.1   Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.   Filed herewith  
32.2   Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.   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.

 

SELECT COMFORT CORPORATION

 

 

 

 

 

 

 

/s/   William R. McLaughlin

October 27, 2006

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 Method of Filing
 
10.1     Fifth Amendment to Lease dated August 28, 2006 between Cabot Industrial Properties L.P. and Select Comfort Direct Corporation.     Filed herewith    
10.2   Net Lease Agreement (Build-to-Suit) by and between Opus Northwest LLC, as Landlord, and Select Comfort Corporation, as Tenant, dated July 26, 2006.   Incorporated by reference to Exhibit 10.1 contained in Select Comfort’s Quarterly Report on Form 10-Q for the quarter ended July 1, 2006 (File No. 0-25121)
10.3   Profit Participation Agreement by and between Opus Northwest LLC and Select Comfort Corporation dated July 26, 2006.   Incorporated by reference to Exhibit 10.2 contained in Select Comfort’s Quarterly Report on Form 10-Q for the quarter ended July 1, 2006 (File No. 0-25121)
31.1   Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.   Filed herewith  
31.2   Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.   Filed herewith  
32.1   Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.   Filed herewith  
32.2   Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.   Filed herewith  











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