Select Comfort Form 10-K for fiscal year ended December 30, 2006

Table of Contents

 
 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

_________________________

FORM 10-K

(Mark one)

x

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

 

For the Fiscal Year Ended December 30, 2006

 

o

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

 

For the transition period from                   to                  .

 

Commission File No. 0-25121

_________________________

SELECT COMFORT CORPORATION

(Exact name of registrant as specified in its charter)

MINNESOTA

 

41-1597886

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

6105 Trenton Lane North

 

 

Minneapolis, Minnesota

 

55442

(Address of principal executive offices)

 

(Zip code)

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

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

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $.01 per share

 

The NASDAQ Stock Market LLC
(NASDAQ Global Select Market)

Securities registered pursuant to Section 12(g) of the Act: None

_________________________

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act.

YES x   NO o

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

YES o   NO x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company. YES o   NO x

The aggregate market value of the common equity held by non-affiliates of the Registrant as of June 30, 2006, was $1,206,168,000 (based on the last reported sale price of the Registrant’s common stock on that date as reported by NASDAQ).

As of February 9, 2007, there were 49,971,760 shares of the Registrant’s common stock outstanding.


 
 


Table of Contents

DOCUMENTS INCORPORATED BY REFERENCE

 

The following table provides references to the location of information, required by Form 10-K, that is included in (a) the Registrant’s Annual Report to Shareholders for the year ended December 30, 2006 (the “Annual Report to Shareholders”) or (b) the Proxy Statement for the Registrant’s 2007 Annual Meeting of Shareholders to be held on May 15, 2007 (the “Proxy Statement”), a definitive copy of which will be filed within 120 days of Registrant’s 2006 fiscal year-end. All such information set forth under the heading “Reference” below is included herein or incorporated herein by reference.

 

 

 

ITEM IN FORM 10-K

 

REFERENCE

 

 

 

 

 

PART I

 

 

 

 

 

 

 

 

 

Item 1.

 

Business

 

Business, pages 2 – 11 of this document

 

 

 

 

 

Item 1A.

 

Risk Factors

 

Risk Factors, pages 12 – 22 of this document

 

 

 

 

 

Item 1B.

 

Unresolved Staff Comments

 

Unresolved Staff Comments, page 22 of this document

 

 

 

 

 

Item 2.

 

Properties

 

Properties, pages 23 – 24 of this document

 

 

 

 

 

Item 3.

 

Legal Proceedings

 

Legal Proceedings, page 24 of this document

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

Submission of Matters to a Vote of Security Holders, page 24 of this document

 

 

 

 

 

PART II

 

 

 

 

 

 

 

 

 

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Common Stock, Comparative Stock Performance and Equity Compensation Plan Information, pages 25 – 27 of this document

 

 

 

 

 

Item 6.

 

Selected Financial Data

 

Selected Consolidated Financial Data, page 28 of this document

 

 

 

 

 

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations, pages 29 – 37 of this document

 

 

 

 

 

Item 7A.

 

Quantitative and Qualitative Disclosures about Market Risk

 

Quantitative and Qualitative Disclosure about Market Risk, page 37 of this document

 

 

 

 

 

Item 8.

 

Financial Statements and Supplementary Data

 

Pages 38 – 60 of this document

 

 

 

 

 

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure, page 61 of this document

 

 

 

 

 

Item 9A.

 

Controls and Procedures

 

Controls and Procedures; Management’s Report on Internal Control over Financial Reporting set forth on page 61 of this document

 

 

 

 

 

Item 9B.

 

Other Information

 

Other Information, page 61 of this document

 

 

 

 

 

 

 

 

 

 

 

 

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Table of Contents

PART III

 

 

 

 

 

 

 

 

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

Election of Directors, Corporate Governance and Section 16(a) Beneficial Ownership Reporting Compliance in the Proxy Statement; Executive Officers of the Registrant, pages 10 – 11 of this document; Directors, Executive Officers and Corporate Governance, page 62 of this document

 

 

 

 

 

Item 11.

 

Executive Compensation

 

Executive Compensation in the Proxy Statement

 

 

 

 

 

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Security Ownership of Certain Beneficial Owners and Management in the Proxy Statement

 

 

 

 

 

Item 13.

 

Certain Relationships and Related Transactions and Director Independence

 

Certain Relationships and Related Transactions in the Proxy Statement

 

 

 

 

 

Item 14.

 

Principal Accountant Fees and Services

 

Approval of Selection of Independent Registered Public Accounting Firm in the Proxy Statement

 

 

 

 

 

PART IV

 

 

 

 

 

 

 

 

 

Item 15.

 

Exhibits, Financial Statement Schedules

 

Exhibits and Financial Statement Schedules, pages
63 – 64 of this document

 

As used in this Form 10-K, the terms “we,” “us,” “our,” the “company” and “Select Comfort” mean Select Comfort Corporation and its subsidiaries and the term “common stock” means our common stock, par value $0.01 per share.

 

As used in this Form 10-K, the term “bedding” includes mattresses, box springs and foundations and does not include bedding accessories, such as sheets, pillows, headboards, frames, mattress pads and related products.

 

Select Comfort®, Sleep Number®, Comfort Club®, Sleep Better on Air®, The Sleep Number Bed by Select Comfort (logo)®, Select Comfort( logo with double arrow design)®, Firmness Control System™, Precision Comfort®, Corner Lock™, Intralux®, Everybody has a Sleep Number™, Knowing your Sleep Number is the Key to a Perfect Night’s Sleep™, The Sleep Number Store by Select Comfort (logo)®, You can only find your Sleep Number on a Sleep Number Bed by Select Comfort™, Select Comfort Creator of the Sleep Number Bed®, What’s Your Sleep Number? ®, Grand King®, Sleep Number SofaBed™, Personalized Warmth Collection®, GridZone®, and our stylized logos are trademarks and/or service marks of Select Comfort. This Form 10-K may also contain trademarks, trade names and service marks that are owned by other persons or entities.

 

Our fiscal year ends on the Saturday closest to December 31, and, unless the context otherwise requires, all references to years in this Form 10-K refer to our fiscal years. Our fiscal year is based on a 52- or 53-week year. All years presented in this Form 10-K are 52 weeks, except for the 2003 fiscal year ended January 3, 2004, which is a 53-week year.

 

 

 

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TABLE OF CONTENTS

 

PART I

2

 

 

 

 

 

Item 1.

Business

2

 

 

 

 

 

Item 1A.

Risk Factors

12

 

 

 

 

 

Item 1B.

Unresolved Staff Comments

22

 

 

 

 

 

Item 2.

Properties

23

 

 

 

 

 

Item 3.

Legal Proceedings

24

 

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

24

 

 

 

 

PART II

25

 

 

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

25

 

 

 

 

 

Item 6.

Selected Financial Data

28

 

 

 

 

 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

29

 

 

 

 

 

Item 7A.

Quantitative and Qualitative Disclosure about Market Risk

37

 

 

 

 

 

Item 8.

Financial Statements and Supplementary Data

38

 

 

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

61

 

 

 

 

 

Item 9A.

Controls and Procedures

61

 

 

 

 

 

Item 9B.

Other Information

61

 

 

 

 

PART III

62

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

62

 

 

 

 

 

Item 11.

Executive Compensation

62

 

 

 

 

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

62

 

 

 

 

 

Item 13.

Certain Relationships and Related Transactions and Director Independence

62

 

 

 

 

 

Item 14.

Principal Accountant Fees and Services

62

 

 

 

 

PART IV

63

 

 

 

 

 

Item 15.

Exhibits, Financial Statement Schedules

63

 



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PART I

 

This Annual Report on Form 10-K contains or incorporates by reference certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. For this purpose, any statements contained in or incorporated by reference into this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements, including but not limited to projections of revenues, results of operations, financial condition or other financial items; any statements of plans, strategies and objectives of management for future operations; any statements regarding proposed new products, services or developments; any statements regarding future economic conditions, prospects or performance; statements of belief and any statement or assumptions underlying any of the foregoing. In addition, we or others on our behalf may make forward-looking statements from time to time in oral presentations, including telephone conferences and/or Web casts open to the public, in press releases or reports, on our Internet Web site or otherwise. We try to identify forward-looking statements in this report and elsewhere by using words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms.

 

Our forward-looking statements speak only as of the date made and by their nature involve substantial risks and uncertainties. Our actual results may differ materially depending on a variety of factors, including the items discussed in greater detail below under the caption “Risk Factors.” These risks and uncertainties are not exclusive and further information concerning the company and our business, including factors that potentially could materially affect our financial results or condition, may emerge from time to time, including factors that we may consider immaterial or do not anticipate at this time.

 

We wish to caution readers not to place undue reliance on any forward-looking statement and to recognize that forward-looking statements are predictions of future results, which may not occur as anticipated. We assume no obligation to update forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements. We advise you, however, to consult any further disclosures we make on related subjects in our quarterly reports on Form 10-Q and current reports on Form 8-K that we file with or furnish to the Securities and Exchange Commission.

 

ITEM 1. BUSINESS

 

Our Business

 

Overview

 

Select Comfort Corporation was founded as a Minnesota-based corporation in 1987 by an entrepreneur who developed and manufactured adjustable firmness mattresses after considering other alternatives such as innerspring and water. We have evolved from a specialty, niché direct marketer to a nationwide multi-channel business with fiscal 2006 net sales of $806 million.

 

Our principal business is to develop, manufacture, market and support premium quality, adjustable-firmness beds and other sleep-related accessory products. We have a mission-driven culture, with passionate employees and customers. Our mission is to improve people’s lives through better sleep. Our goal is to open a consumer’s mind to take control of their sleep naturally, with a bed that adjusts with comfort and support, rather than having the consumer adjust to the bed.

 

In 1998, Select Comfort became a publicly-traded company listed on The NASDAQ Stock Market LLC (NASDAQ Global Select Market) under the symbol “SCSS.” When used herein, the terms “Select Comfort,” “Company,” “we,” “us” and “our” refer to Select Comfort Corporation, including consolidated subsidiaries.

 

Competitive Strengths

 

Differentiated, Superior Product

 

Our proprietary Sleep Number® bed was designed through sleep research. Clinical research has shown that people who sleep on a Sleep Number bed fall asleep faster and experience deeper sleep with fewer disturbances than those sleeping on a traditional innerspring mattress. The proprietary air-chamber technology of our Sleep Number bed allows adjustable firmness of the mattress at the touch of a button, independently adjustable on either side to meet each partners’ individual preference. Our bed’s sleep surface provides better sleep quality and greater relief of back pain in comparison with traditional innerspring mattress products.

 

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Distinctive Brand

 

In 2001, we created the Sleep Number brand. This branding strategy allows our advertising and consumer communication to focus on our bed’s distinguishing and proprietary feature, adjustable firmness and support for personalized comfort, as represented by the digital Sleep Number display on the bed’s hand-held remote control, with a brand message hierarchy as follows:

 

A Sleep Number represents an ideal level of mattress comfort, firmness and support;

Everybody has a Sleep Number;

Knowing your Sleep Number is the Key to a Perfect Night’s Sleep; and

You can only find your Sleep Number on a Sleep Number Bed by Select Comfort.

 

Controlled Selling Environment

 

Over 90% of our sales are generated through our direct-to-consumer sales channels. Our nationwide chain of retail stores provides a unique mattress shopping experience and offer a relaxed environment designed to provide education on the importance of sleep and the products that best fit consumers’ needs. Controlling the selling process enables us to ensure that the unique benefits of our products are effectively communicated to consumers. Our multiple touch-points of service, including sales, delivery and post-sale service, provide several opportunities to communicate with our customers, reinforcing the sale and enabling us to understand and respond quickly to consumer trends and preferences.

 

Integrated Business Process

 

We are a vertically-integrated business from production through sales, delivery and customer service, which allows us to control quality, cost, price and presentation. The modular design of our Sleep Number bed allows a just-in-time, build-to-order system that enables our retail stores to be positioned as showrooms, requiring minimal inventory in our stores and in our plants enabling us to maximize cash flow and operate with a minimal working capital business model.

 

Growth Strategy

 

In 2005, we ranked as the 6th largest mattress manufacturer according to the June 19, 2006 edition of Furniture/Today, with a 5% market share of industry revenue and 2% market share of industry units. We ranked as the leading U.S. bedding retailer, according to the Top-25 Bedding Retailers report in the August 14, 2006 edition of Furniture/Today. Our vision is to be the leading brand in the bedding industry.

 

Building Brand Awareness

 

Our most significant growth driver has been building brand awareness. With approximately 16% unaided brand awareness in the U.S., we have significant opportunity for domestic growth through increasing awareness of the Sleep Number and Select Comfort brands.

 

The Sleep Number brand has been integrated into all of our sales channels and throughout our internal and external communication programs. We utilize a media mix that includes television, radio and print advertising in support of our Sleep Number marketing campaign with increasing use of Internet advertising and paid search in our media mix.

 

We also sell to commercial markets which increases the awareness of our brand through media exposure, trial, sales and word-of-mouth. These commercial markets include the QVC television shopping channel, the luxury motor home market and Radisson Hotels and Resorts® in the U.S., Canada and the Caribbean.

 

Expanding Distribution

 

Over the long-term, we expect to operate between 600 and 650 company-owned stores in the U.S. with annual square footage growth increasing by 7% to 10% per year. We supplement our company-controlled distribution channels with sales through a limited number of leading home furnishings and specialty bedding retailers. Our retail partner program is expected to grow to over 1,000 U.S. partner doors over a multi-year period. At that level of distribution, we expect our retail partner program to represent as much as 15% of our net sales mix.

 

 

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In 2005, we expanded our distribution network outside the U.S. with a retail partner relationship in Canada. In 2006, the Canadian retail partner relationship grew to 119 doors. We believe opportunities exist to expand our products and brands throughout the world and have built a team to begin pursuing international expansion.

 

Accelerating Innovation

 

Our goal is to continue to lead the industry in innovative sleep products. We have historically introduced new features and benefits to our Sleep Number beds every two to three years, through a pipeline of research and development (“R&D”) activities. In 2006, we ramped-up our investment in R&D with the goal of accelerating new and innovative product introductions. We plan to increase our research and development investment again in 2007 by approximately 50%. The introduction of new products and features is expected to benefit our results of operations beginning in 2008.

 

Leveraging our Infrastructure

 

We believe we are well positioned to sustain long-term profitable growth. Our vertically-integrated business model provides multiple sources for efficiency and leverage. Sustaining such performance over a multi-year period is based on expected scale efficiencies (fixed cost utilization) and cost containment initiatives. We also have an ongoing focus on productivity gains through a variety of programs, including the implementation of a new enterprise resource planning system in the first half of 2008, expansion of our pilot hub and spoke network, automation of home delivery services, marketing and sales initiatives, and a Six Sigma initiative to improve product and service quality.

 

Our Products

 

Mattress Sets

 

We offer five different Sleep Number bed models through our company-owned channels, including the Sleep Number 3000, 4000, 5000, 7000 and 9000. Each bed model comes in standard mattress sizes, ranging from twin to king, as well as some specialty mattress sizes. Our bed models vary in features, functionality and price. As you move up the product line, the Sleep Number bed models offer enhanced features and benefits, including higher-quality fabrics and cover filling, additional cushion and padding, higher overall mattress profiles, quieter Firmness Control Systems with additional functions, and wireless remote controls as a standard feature.

 

The contouring support of our Sleep Number beds are optimized when used with our specially designed, proprietary foundation. This durable foundation, used in place of a box spring, is a modular design that can be disassembled and easily moved through staircases, hallways and other tight spaces.

 

Our mattress price points range from approximately $900 for the entry-level Sleep Number 3000 queen-size set (mattress and foundation) to $4,000 for the luxurious Sleep Number 9000 queen-size set. Our most popular model is the 5000 queen-size set and sells for approximately $1,900. These prices are subject to periodic promotional offerings.

 

Our unique product design allows us to ship our beds in a modular format to customers throughout the U.S. by United Parcel Service (“UPS”). For an additional fee, customers can take advantage of our home delivery service, which includes bed assembly and optional mattress removal services.

 

We also manufacture our Sleep Number beds for distribution through our retail partners. Our retail partner beds have different model numbers or names, but have similar features and benefits, and sell for similar prices.

 

Each of our Sleep Number beds come with a 30 night in-home trial and better night’s sleep guarantee, which allows customers 30 nights at home to make sure they are 100% comfortable with the bed. The customer is responsible for the return shipping costs. Independent durability testing has shown our Sleep Number beds to withstand more than 20 years of simulated use, and each of our Sleep Number beds is backed by our 20-year limited warranty.

 

Accessories

 

In addition to our mattresses and foundations, we offer a line of accessory bedding products, including specialty pillows, mattress pads, comforters, sheets, bed foundations and leg options. The specialty pillows, available in a variety of sizes, materials and firmness levels, are designed to provide personalized comfort and better quality sleep for stomach, back or side sleepers. We also market our Personal Warmth Collection™, a group of comforters and blankets designed to be twice as warm on one half of the bed as the other, accommodating varying warmth preferences among couples.

 

 

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Other Products and Services

 

In 2003, we completed the roll-out of our Precision Comfort adjustable foundation to all of our company-owned retail stores. The adjustable foundation enables consumers to raise the head or foot of the bed, and to experience the comfort of massage, using a handheld remote control.

 

In 2004, we introduced the Sleep Number SofaBed line into a select number of our stores. The SofaBed is now available in 180 stores in 75 U.S. markets. The Sleep Number SofaBed features a queen-size Sleep Number mattress inside a beautifully appointed sofa surround, which is available in a variety of fabrics or leather options.

 

Sales Distribution

 

Unlike traditional bedding manufacturers, which primarily sell through third-party retailers, over 90% of our sales are through one of three company-controlled distribution channels – Retail, Direct Marketing and e-commerce. These channels enable us to control the selling process to ensure that the unique benefits of our products are effectively presented to consumers. Our direct-to-consumer business model enables us to understand and respond quickly to consumer trends and preferences.

 

Our retail stores accounted for 76% of our sales in 2006. Average net sales per company-owned store were $1,493,000 in 2006 versus $626,000 in 2001, with average sales per square foot of $1,244 in 2006 versus $666 in 2001. New stores are expected to average in excess of $900,000 in net sales in the first year of operations. In 2006, 81% of our stores generated net sales of over $1,000,000.

 

Our direct marketing call center and e-commerce Web site provide national sales coverage, including markets not yet served by one of our retail stores and accounted for 15% of our sales in 2006. In addition, these channels provide a cost-effective way to market our products, are a source of information on our products and refer customers to our stores if there is one near the customer.

 

Beginning in 2002, we supplemented our sales through semi-exclusive relationships with selected home furnishing retailers and specialty bedding retailers. Currently, this program includes 11 home furnishing retailers and specialty bedding retailers in the U.S. and Canada. In 2006, we aggressively expanded our retail partner program to 822 doors, up from 353 doors at the end of 2005. Each retail partner serves a unique geographic market, which enables us to increase sales and leverage our media spending to accelerate brand awareness.

 

Marketing and Advertising

 

Awareness among the broad consumer audience of our brand, product benefits and store locations has been our most significant opportunity for growth. The Sleep Number advertising campaign was introduced early in 2001 to support our retail stores in selected markets through our first comprehensive multi-media advertising campaign using prime-time TV, national cable television, infomercials, drive-time radio and newspaper advertisements. We have expanded the comprehensive local multi-media Sleep Number advertising campaign from the initial eight markets in 2001 to 37 markets in 2006. In addition, our successful radio personality endorsement advertising program now totals 145 radio personalities in approximately 126 retail store markets.

 

Since 2001, the Sleep Number brand positioning has been integrated into our marketing messages across all of our distribution channels, advertising vehicles and media types. We have increased our 1-800 advertising on national cable TV as an economical means of increasing brand awareness for our Sleep Number bed. Through our dedicated call center, we are able to provide the inquiring consumer more information or send a video and brochure. In 2006, our total media spending was approximately $105 million.

 

Owners of Sleep Number beds purchased through company-controlled channels are members of our Comfort Club, our customer loyalty program designed primarily to reward our owners for recommending our beds. Each time a referred customer purchases a bed, the referring Comfort Club member receives a $50 coupon for purchase of our products, with increasing benefits for multiple referrals. In 2006, approximately 45,000 new customers bought beds after receiving referrals from our Comfort Club members, and existing owners bought approximately 35,000 additional beds.

 

Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Money Bank. Approximately 40% of our net sales during 2006 were financed by GE Money Bank or its predecessor, Mill Creek Bank. In 2005, we entered into an amended and restated agreement with GE Money Bank that

 

 

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extends this consumer credit arrangement through February 15, 2011, subject to earlier termination upon certain events and subject to automatic extensions. Under the terms of our agreement, GE Money Bank sets the minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures, and is the owner of the accounts. In connection with all purchases financed under these arrangements, GE Money Bank pays us an amount equal to the total amount of such purchases, net of promotional related discounts, upon delivery to the customer. Consumers that do not qualify for credit under our agreement with GE Money Bank may apply for credit under a secondary program maintained by the company through another provider.

 

Operations

 

Manufacturing and Distribution

 

We have two manufacturing plants, one located in Irmo, South Carolina, and the other in Salt Lake City, Utah, which cost effectively distribute products in the U.S. and Canada. The manufacturing operations in South Carolina and Utah consist of quilting and sewing of the fabric covers for our beds and final assembly and packaging of mattresses and foundations. In addition, our electrical Firmness Control Systems are assembled in our Utah plant.

 

We manufacture beds on a just-in-time basis to fulfill orders rather than stocking inventory, which enables us to maintain lower levels of finished goods inventory and operate with limited regional warehousing. Orders are currently shipped from our manufacturing facilities via UPS or through our company-controlled home delivery, assembly and mattress removal service, typically within 48 hours following order receipt. Orders are usually received by the customer within five to 14 days from the date of order.

 

Suppliers

 

We obtain all of the raw materials and components used to produce our beds from outside sources. A number of components, including our proprietary air chambers, our proprietary blow-molded foundations, and various components for our Firmness Control Systems, as well as fabrics and zippers, are sourced from suppliers who serve as our sole source of supply for these components. Beginning in 2005, we initiated work on dual and alternate sourcing, successfully introducing a second source for printed circuit boards and certain foam and fiber components. We will continue working toward dual sourcing on targeted components.

 

Our proprietary air chambers are produced to our specifications by one Eastern European supplier, which has been our sole source of supply of air chambers since 1994. Our agreement with this supplier runs through September 2011 and is thereafter subject to automatic annual renewal unless either party gives 365 days’ notice of its intention not to renew the agreement. We expect to continue this supplier relationship for the foreseeable future.

 

Our proprietary blow-molded foundations are produced to our specifications by one domestic supplier under an agreement that expires in December 2009. We expect to continue this supplier relationship for the foreseeable future.

 

All of the suppliers that produce unique or proprietary products for us have in place either contingency or disaster recovery plans or redundant production capabilities in other locations in order to safeguard against any unforeseen disasters. We review these plans and sites on a regular basis to ensure the supplier’s ability to maintain uninterrupted supply of materials and components.

 

Home Delivery Service

 

Select Comfort’s home delivery, assembly and mattress removal service has contributed to improving the overall customer experience. Our home delivery technicians are Sleep Number bed owners who can articulate the benefits of the bed, reinforcing the sales process and ensuring satisfied customers. Approximately 60% of beds sold through our company-owned retail stores in 2006 were delivered by our full-service home delivery team.

 

In 2003, we expanded the availability of our company-controlled delivery, assembly and removal services to all of our retail markets. In 2006, we made investments in home delivery systems and personnel to enable continued improvement and efficiency in our home delivery service. We plan to continue those investments and improvements in 2007 to help meet our expanded sales goals.

 

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Customer Service

 

We maintain an in-house customer service department staffed by customer service representatives who receive extensive training in sleep technology and all aspects of our products and operations. Our customer service representatives field customer calls and also interact with each of our retail stores to address customer questions and concerns. Our customer service team is part of our total quality process, facilitating early identification of emerging trends or issues. They coordinate with engineering and manufacturing to implement immediate solutions and provide inputs for long-term improvements to product design.

 

Research and Development

 

Our research and development team continuously seeks to improve product performance and benefits based on sleep science. Through customer surveys and consumer focus groups, we seek feedback on a regular basis to help enhance our products. Since the introduction of our first bed, we have continued to improve and expand our product line, including a quieter Firmness Control System, remote controls with digital settings, more luxurious fabrics and covers, new generations of foams and foundation systems, and enhanced border walls. Our research and development expenses were $4.7 million in 2006, $2.2 million in 2005, and $1.9 million in 2004.

 

Information Systems

 

We use information technology systems to analyze and manage our business, to reduce operating costs and to enhance our customers’ experience. Our major systems include an in-store point of sale system, a retail portal system, in-bound and out-bound telecommunications systems for direct marketing and customer service, e-commerce systems, retail partner support systems, a data warehouse system and an enterprise resource planning system. These systems are comprised of both packaged applications licensed from market leaders and internally developed programs. Our production data center and e-commerce Web site are hosted at an outsourced facility that provides top-tier, fully-secured data center space. We maintain a disaster recovery plan that is tested annually.

 

We have recently undertaken plans to implement an integrated suite of SAP®-based applications, including enterprise resources planning, customer relationship management, supply chain management, product lifecycle management, supplier relationship management, human capital management, strategic enterprise management, business intelligence and enterprise portal systems to replace many of our current systems. We believe this SAP-based IT architecture, along with best-practices-based processes and greater utilization of off-the-shelf, packaged solutions, will provide greater flexibility and functionality for our growing and evolving business model and be less expensive to maintain over the long-term. We currently expect the SAP implementation to be completed in the first half of fiscal year 2008.

 

Intellectual Property

 

We hold various U.S. and foreign patents and patent applications regarding certain elements of the design and function of our products, including air control systems, remote control systems, air chamber features, border wall and corner piece systems, foundation systems, and features related to sofa sleepers with air mattresses, as well as other technology. We have 24 issued U.S. patents, expiring at various dates between December 2007 and June 2022, and five U.S. patent applications pending. We also hold 19 foreign patents and 10 foreign patent applications pending. Notwithstanding these patents and patent applications, we cannot ensure that these patent rights will provide substantial protection or that others will not be able to develop products that are similar to or competitive with our products. To our knowledge, no third party has asserted a claim against us alleging that any element of our product infringes or otherwise violates any intellectual property rights of any third party.

 

Select Comfort” and “Sleep Number” are trademarks registered with the U.S. Patent and Trademark Office. We have a number of other registered trademarks including our “Select Comfort” logo with the double arrow design, “Select Comfort Creator of the Sleep Number Bed,” “What’s Your Sleep Number?,” “Precision Comfort,” “The Sleep Number Bed by Select Comfort” (logo), “The Sleep Number Store by Select Comfort” (logo), “Comfort Club” and “Sleep Better on Air” and “LuxLayer.” U.S. applications are pending for a number of other marks. Several of these trademarks have been registered, or are the subject of pending applications, in various foreign countries. Each federally registered mark is renewable indefinitely as long as the mark remains in use. We are not aware of any material claims of infringement or other challenges asserted against our right to use these marks.

 

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Industry and Competition

 

The U.S. bedding manufacturing industry is a mature and stable industry. According to the 2005 Annual Report by the International Sleep Products Association (ISPA), industry wholesale shipments of mattresses and foundations were estimated to be $6.4 billion in 2005, compared to $5.8 billion in 2004. We estimate that traditional innerspring mattresses represent approximately 73% of total U.S. bedding sales.

 

The U.S. bedding retail industry is highly fragmented. According to the Top-25 Bedding Retailers report in the August 1, 2005 edition of Furniture/Today, the U.S. bedding retail industry was estimated to be $10.7 billion in 2004, with the top-25 retailers accounting for approximately 36% of total sales. We estimate that the U.S. bedding retail industry grew to nearly $12.0 billion in 2005 and more than $12.5 billion in 2006. Furniture/Today has ranked Select Comfort as the largest U.S. bedding retailer for six consecutive years.

 

Since 1984, the industry has consistently demonstrated growth on a dollar basis, with a 0.3% decline in 2001 being the only exception. Over the 5-year, 10-year and 20-year periods ended 2005, the value of U.S. wholesale bedding shipments increased at compound annual growth rates of 6.8%, 7.2% and 6.8%, respectively. We believe that industry unit growth has been primarily driven by population growth, and an increase in the number of homes (including secondary residences) and the increased size of homes. We believe growth in average wholesale prices resulted from a shift to both larger and higher quality beds, which are typically more expensive.

 

The bedding industry is highly competitive. Participants in the bedding industry compete primarily on price, quality, brand name recognition, product availability and product performance, including the perceived levels of comfort and support provided by a mattress. There is a high degree of concentration among the four largest manufacturers of innerspring bedding with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand name, Serta, Simmons and Spring Air. Numerous other manufacturers, primarily operating on a regional or niche basis, serve the balance of the bedding market. Simmons and Sealy, as well as a number of smaller manufacturers, have offered air-bed products in recent years. Tempur-Pedic International, Inc., and a number of other mattress manufacturers, offer foam mattress products.

 

Governmental Regulation and Environmental Matters

 

Our operations are subject to federal and local consumer protection and other regulations relating to the bedding industry. These regulations vary among the jurisdictions in which we do business. The regulations generally impose requirements as to the proper labeling of bedding merchandise, restrictions regarding the identification of merchandise as “new” or otherwise, controls as to hygiene and other aspects of product handling and sale, and penalties for violations. Our direct marketing and e-commerce operations are or may become subject to various adopted or proposed federal and state “do not call” and “do not mail” list requirements.

 

The federal Consumer Product Safety Commission and various other regulatory agencies have been considering new rules relating to fire retardancy standards for the bedding industry. Effective December 31, 2005, the State of California adopted a new fire retardancy standard applicable to bedding products sold in California for general consumer residential use. In February 2006, the Consumer Product Safety Commission announced the adoption of a federal open flame fire retardancy standard similar to the California standard, which will be effective nationwide in July 2007. We are developing product modifications to meet the new standard, which will add costs to the modified products and require more complicated manufacturing processes, potentially reducing our manufacturing capacity.

 

A portion of our net sales consists of refurbished products that are assembled in part from components returned to us from customers. These refurbished products must be properly labeled and marketed as refurbished products under applicable laws. Our sales of refurbished products are limited to approximately 24 states, as the balance of the states does not allow the sale of refurbished bedding products.

 

We are subject to national and local laws and regulations relating to occupational health and safety, pollution and environmental protection. We will also be subject to similar laws in foreign jurisdictions as we further expand distribution of our products internationally.

 

Our retail pricing policies and practices are subject to antitrust regulations in the U.S., Canada and other jurisdictions where we may sell our products in the future.

 

We believe we are in compliance in all material respects with each of these governmental regulations.

 

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We are not aware of any national or local provisions which have been enacted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, that have materially affected, or will materially affect our net income or competitive position, or will result in material capital expenditures. During fiscal 2006, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.

 

Customers

 

No single customer accounts for 10% or more of our total sales. Therefore, the loss of any one customer would not have a material impact on our business.

 

Seasonality

 

Our business is subject to some seasonal influences, with typically lower sales in the second quarter and higher sales during the fourth quarter holiday season due to greater mall traffic.

 

Working Capital

 

Our investment to open a new store is approximately $250,000, including inventory. We target new stores to be cash flow positive within 12 months with a payback of the initial cash investment in less than 24 months. Our stores break even on a four-wall cash flow basis with approximately $600,000 of annual net sales. Our four-wall cash flow is calculated as gross profit generated from store sales less store expenses, without deduction of depreciation expenses.

 

The component nature of our products allows our stores to serve as product showrooms for our Sleep Number beds. This aspect of our business model allows us to maintain low inventory levels which enables us to operate with minimal working capital. We have historically generated sufficient cash flows to self-fund our growth through an accelerated cash-conversion cycle. In addition, our $100 million bank revolving line of credit is available for additional working capital needs or investment opportunities.

 

Employees

 

At December 30, 2006, we employed 3,053 persons, including 1,601 retail sales and support employees, 199 direct marketing and customer service employees, 954 manufacturing and logistics employees, and 299 management and administrative employees. Approximately 200 of our employees were employed on a part-time basis at December 30, 2006. Except for managerial employees and professional support staff, all of our employees are paid on an hourly basis plus commissions for sales associates. None of our employees is represented by a labor union or covered by a collective bargaining agreement. We believe that our relations with our employees are good.

 



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Executive Officers of the Registrant

 

William R. McLaughlin, 50, joined our company in March 2000 as President and Chief Executive Officer. In May 2004, Mr. McLaughlin was also elected to the position of Chairman of our Board of Directors. From December 1988 to March 2000, Mr. McLaughlin served as an executive of PepsiCo Foods International, Inc., a snack food company and subsidiary of PepsiCo, Inc., in various capacities, including from September 1996 to March 2000 as President of Frito-Lay Europe, Middle East and Africa, and from June 1993 to June 1996 as President of Grupo Gamesa, S.A. de C.V., a cookie and flour company based in Mexico.

 

J. Douglas Collier, 40, joined our company as Chief Marketing Officer and Senior Vice President, Marketing in July 2005. From 2002 to June 2005, Mr. Collier held leadership positions with La-Z-Boy Incorporated, most recently as Chief Marketing Officer and Vice President, Marketing and Furniture Galleries Development. From 2000 to 2001, Mr. Collier was the Senior Vice President, Marketing and Product Management for Iomega Corporation. From 1996 to 2000, he held various positions with NIBCO, Inc., including General Manager and Director of eBusiness and Marketing. From 1992 to 1996, Mr. Collier served in several capacities for Whirlpool Corporation, including as a Product Director for Whirlpool Europe and Director of Business Development and Process Improvement for Whirlpool North America. Prior to 1992, he held several positions with GE Canada (CAMCO).

 

Mark A. Kimball, 48, has served as Senior Vice President, Legal, General Counsel and Secretary since August 2003. From July 2000 to August 2003, Mr. Kimball served as Senior Vice President, Human Resources and Legal, General Counsel and Secretary. From May 1999 to July 2000, Mr. Kimball served as our Senior Vice President, Chief Administrative Officer, General Counsel and Secretary. For more than five years prior to joining us, Mr. Kimball was a partner in the law firm of Oppenheimer Wolff & Donnelly LLP practicing in the area of corporate finance.

 

Ernest Park, 54, joined our company as Senior Vice President and Chief Information Officer in May 2006. From November 2000 through March 2006, he served as Senior Vice President and Chief Information Officer at Maytag Corporation. Mr. Park previously managed the global information technology function as Vice President and Chief Information Officer of a shared services organization at AlliedSignal, and later with Honeywell International, following AlliedSignal’s acquisition of Honeywell in 1999. He also served in various leadership capacities at Avnet Inc. from March 1980 through November 1996, culminating in his role as Corporate Vice President, Information Services Division.

 

Scott F. Peterson, 47, has served as Senior Vice President, Human Resources since August 2003. From January 2002 to August 2003, Mr. Peterson served as Senior Vice President, Human Resources, for LifeTime Fitness, a proprietor of health and fitness clubs. From March 2000 through November 2001, he served as Chief People Officer for SimonDelivers.com, an internet-based grocery sales and delivery company. From 1990 through 2000, he served in a variety of capacities with The Pillsbury Company, a food manufacturer, most recently as Vice President, Human Resources, for the Bakeries and Foodservice Division.

 

James C. Raabe, 46, has served as Senior Vice President and Chief Financial Officer since April 1999. From September 1997 to April 1999, Mr. Raabe served as our Controller. From May 1992 to September 1997, he served as Vice President – Finance of ValueRx, Inc., a pharmacy benefit management provider. Mr. Raabe held various positions with KPMG LLP from August 1982 to May 1992.

 

Kathryn V. Roedel, 46, joined our company as Senior Vice President, Global Supply Chain in April 2005. From 1983 to 2005, she held leadership positions within two divisions of General Electric Company, in Sourcing, Manufacturing, Quality and Service. From 2003 to March 2005, Ms. Roedel served as the General Manager, Global Supply Chain Strategy for GE Medical Systems. Other key positions included General Manager, Global Quality and Six Sigma; Vice President – Technical Operations and Director/Vice President – Quality Programs for GE Clinical Services, a division of GE Medical Systems.

 

Wendy L. Schoppert, 40, joined our company as Senior Vice President and General Manager – New Channel Development & Strategy in April 2005 and effective January 2007, became our Senior Vice President – International. From 2002 to March 2005, Ms. Schoppert led various departments within U.S. Bancorp Asset Management, most recently serving as Head of Private Asset Management and Marketing. From 1996 to 2000, she held several positions with America West Holdings Corporation, including Vice President of America West Vacations and head of the airline’s Reservations division. Prior to 1996, Ms. Schoppert held various finance-related positions at both Northwest Airlines and American Airlines.

 


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Keith C. Spurgeon, 52, joined our company as Senior Vice President, Sales in February 2002. From September 2000 to February 2002, Mr. Spurgeon served as an independent business consultant. From 1996 to September 2000 he was Chairman of the Board and Chief Executive Officer of Zany Brainy, Inc., a retailer of educational toys and books for children. Zany Brainy filed for Chapter 11 bankruptcy protection in May 2001. He served as Vice President-Asia/Australia at Toys “R” Us, Inc. from 1991 to 1996 after holding various management positions from 1986 to 1991. Mr. Spurgeon began his career at Jewel Food Stores.

 

Available Information

 

We are subject to the reporting requirements of the Exchange Act and its rules and regulations. The Exchange Act requires us to file reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Copies of our reports, proxy statements and other information can be read and copied at:

 

SEC Public Reference Room

100 F Street NE

Washington, D.C. 20549

 

Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a Web site that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC’s home page at http://www.sec.gov.

 

Our corporate Internet Web site is http://www.selectcomfort.com. Through a link to a third-party content provider, our corporate Web site provides free access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after electronic filing with the SEC. These documents are posted on our Web site at www.selectcomfort.com — select the “About Select Comfort” link and then the “Investor Relations” link. The information contained on our Web site or connected to our Web site is not incorporated by reference into this Form 10-K and should not be considered part of this report.

 

We also make available, free of charge on our Web site, the charters of the Audit Committee, Management Development and Compensation Committee, Corporate Governance and Nominating Committee and Finance Committee as well as our Code of Business Conduct (including any amendment to, or waiver from, a provision of our Code of Business Conduct) adopted by our Board. These documents are posted on our Web site — select the “Investor Relations” link and then the “Corporate Governance” link.

 

Copies of any of the above referenced information will also be made available, free of charge, upon written request to:

 

Select Comfort Corporation

Investor Relations Department

6105 Trenton Lane North

Minneapolis, MN 55442

 




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ITEM 1A. RISK FACTORS

 

We may not be able to sustain growth or profitability.

 

Our net sales have grown in each of the last five fiscal years after two consecutive years of declining net sales. Our 22 most recent quarters have been profitable after eight consecutive quarters of losses. We may not be able to sustain growth or profitability on a quarterly or annual basis in future periods. Our future growth and profitability will depend upon a number of factors, including but not limited to:

Our ability to manage growth in the size and complexity of our business, which has placed, and will continue to place, significant strains on our management, operations, information systems and other resources;

The level of competition in the mattress industry and our ability to successfully identify and respond to emerging and competitive trends in the mattress industry;

The level of consumer acceptance of our products, new product offerings and brand image;

Our ability to continuously improve our products to offer new and enhanced consumer benefits, better quality and reduced costs;

The effectiveness of our marketing messages and the efficiency of our advertising expenditures and other marketing programs in building product and brand awareness, driving traffic to our points of sale and increasing sales;

Our ability to execute our retail store distribution strategy, including increasing sales and profitability through our existing stores, securing suitable and cost-effective locations for additional retail stores and cost-effectively closing under-performing store locations;

Our ability to hire, train, motivate and retain qualified retail store management and sales professionals;

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 cost-effectively expand our distribution internationally;

Our ability to cost-effectively implement information systems changes, product design changes, manufacturing and procurement processes and document retention processes to comply with new federal flame retardancy standards applicable to mattresses and mattress and foundation sets effective as of July 1, 2007;

Our ability to secure adequate sources of supply at reasonable cost, especially considering our single sources of supply for some components and just-in-time manufacturing processes, 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 of which could increase product and service costs;

Our ability to cost-effectively offer consumer credit options through third party credit providers;

The capability of our management information systems to continue to meet the requirements of our business and our ability to successfully implement our planned SAP-based enterprise-wide information technology architecture;

General economic conditions and consumer confidence; and

Global events, such as terrorist attacks or a pandemic outbreak, or the threat of such events.

 

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We may not be successful in executing our growth strategy or in sustaining profitable growth. Failure to successfully execute any material part of our strategic plan or growth strategy could significantly harm our business, operating results and financial condition.

The mattress industry is highly competitive. Our business could be significantly harmed by existing competitive pressures or from one or more new entrants into the market.

Our Sleep Number beds compete with a number of different types of mattress alternatives, including standard innerspring mattresses, foam mattresses, waterbeds, futons and other air-supported mattress products sold through a variety of channels, including home furnishings stores, specialty mattress stores, department stores, mass merchants, wholesale clubs, telemarketing programs, television infomercials and catalogs. The mattress industry is characterized by a high degree of concentration among the four largest manufacturers of innerspring mattresses with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand, Serta, Simmons and Spring Air. Numerous other manufacturers, primarily operating on a regional or niche basis, serve the balance of the mattress market. Tempur-Pedic International, Inc. and other companies compete in the mattress industry with foam mattress products. A number of mattress manufacturers, including Sealy and Simmons, as well as a number of smaller manufacturers, including low-cost foreign manufacturers, have offered air beds that compete with our products.

We believe that many of our competitors, including in particular the four largest mattress manufacturers, have greater financial, marketing and manufacturing resources and better brand name recognition than we do and sell products through broader and more established distribution channels. Our stores and other company-owned distribution channels compete with other retailers who often provide a wider selection of mattress alternatives than we offer through our channels of distribution, which may place our channels of distribution at a competitive disadvantage. These manufacturing and retailing competitors, or new entrants into the market, may compete aggressively and gain market share with existing and new mattress products, and may pursue or expand their presence in the air bed segment of the market. Some competitors may engage in aggressive advertising strategies that may include false or misleading claims about competitive products and/or our products. Any such competition could inhibit our ability to retain or increase market share, inhibit our ability to maintain or increase prices and reduce our margins, which could significantly harm our business.

Our products represent a significant departure from traditional innerspring mattresses and the failure of our products to achieve market acceptance would significantly harm our business, operating results and financial condition.

We estimate that innerspring mattress sales represent approximately 73% of all mattress sales. Our air chamber technology represents a significant departure from traditional innerspring mattresses. Because no established market for adjustable firmness mattress products existed prior to the introduction of our products in 1988, we faced the challenge of establishing the viability of this market, as well as gaining widespread acceptance of our products. The market for adjustable firmness mattresses is now evolving and our future success will depend upon both the continued growth of this market and increased consumer acceptance of our products. The failure of our products to achieve greater consumer acceptance for any reason would significantly harm our business, operating results and financial condition.

If we are unable to enhance our existing products and develop and market new products that respond to customer needs and achieve market acceptance, we may not be able to sustain our growth or profitability.

One of our growth strategies is to continue to lead our industry in product innovation and sleep expertise by enhancing existing products and by developing and marketing new products that deliver personalized comfort and better sleep. We may not be successful in developing or marketing enhanced or new products that will receive acceptance in the marketplace. Further, the resulting level of sales from any of our enhanced or new products may not justify the costs associated with the development and marketing. Any failure to continue to develop and market enhanced or new products in a cost-effective manner could harm our ability to sustain our growth or profitability.

Our future growth and profitability will depend in large part upon the effectiveness of our marketing messages and the efficiency of our advertising expenditures and other marketing programs in generating consumer awareness and sales of our products.

We are highly dependent on the effectiveness of our marketing messages and the efficiency of our advertising expenditures (which were approximately $105 million in 2006, $90 million in 2005, $79 million in 2004, $60 million in 2003, $40 million in 2002 and $30 million in 2001) in generating consumer awareness and sales of our products. If our marketing messages are ineffective or our advertising expenditures and other marketing programs are inefficient in creating greater awareness of our

 

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products and brand name, driving consumer traffic to our points of distribution and motivating consumers to purchase our products, our operating results and financial condition may be significantly and adversely impacted.

Our integrated marketing program depends in part on national radio personalities and spokespersons, including Paul Harvey, Rush Limbaugh and Lindsay Wagner and other nationally known personalities. The loss of these endorsements, or any reduction in the effectiveness of these endorsements, or our inability to obtain additional effective endorsements, could adversely affect our net sales and profitability.

Our future growth and profitability will depend in part upon the effectiveness and efficiency of our internet-based advertising programs and upon the prominence of our Web site URLs on internet search engine results.

We believe that consumers are increasingly using the internet as a part of their shopping experience, both to conduct pre-purchase research, particularly with respect to high end consumer durables, as well as to purchase products. Consumers will typically use one of a small number of internet search engines to research products. These search engines may provide both natural search results and purchased listings for particular key words. In some cases, it may be difficult or impossible to determine how these search engines work, particularly in the area of natural search, and therefore how to optimize placement on those search engines for our Web site URLs and other positive sites for consumers who may be searching for our products or for mattress products or retailers generally. Some of these search engines may permit competitors to bid on our trademarks to obtain high placement in search results when consumers use our trademarks to seek information regarding our products, which may cause confusion among consumers and adversely impact our sales. In addition, some of our competitors may use our trademarks and/or publish false or misleading information on the internet regarding our products or their own products, which may also cause confusion among consumers and adversely impact our sales.

As a result, our future growth and profitability will depend in part upon the effectiveness and efficiency of our on-line advertising and search optimization programs in generating consumer awareness and sales of our products, and upon our ability to prevent competitors from misusing or infringing our trademarks or publishing false or misleading information regarding our products or their own products. If we are not successful in these efforts, our business, reputation, operating results and financial condition may be significantly and adversely impacted.

In addition, if our Web site becomes unavailable for a significant period of time due to failure of our information technology systems or the Internet, our net sales could be materially and adversely affected.

Our comparable-store sales or other operating results may fluctuate significantly. An unanticipated decline in comparable-store sales or other operating results may disappoint investors and result in a decline in our stock price.

Our comparable-store sales and other operating results have fluctuated significantly in the past. For example, from 1998 through 2006, our quarterly comparable-store sales results ranged from a decrease of 9% to an increase of 38%. These past results may not be a meaningful indicator of future performance. Our comparable-store sales and other operating results may fluctuate or decline significantly in the future. Many factors affect our comparable-store sales and other operating results and may contribute to fluctuations or declines in these results in the future, including but not limited to:

The effectiveness of our marketing messages and the efficiency of our advertising expenditures and other marketing programs in building awareness of our products, brand and store locations, driving traffic to our store locations and increasing sales;

Levels of consumer acceptance of our existing products, new product offerings and brand image;

Consumer shopping trends, including traffic trends in shopping malls and lifestyle centers and internet shopping trends;

Higher levels of sales in the first year of operations as each successive class of new stores is opened;

Comparable-store sales performance in prior periods;

The continuing maturation of our store base with increasing levels of average sales per store;

Our ability to adequately hire, train, motivate and retain sales professionals and store-level managers;

 

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The level of competitive activity;

The growth of our other distribution channels, including in particular the wholesale distribution of our products through home furnishings and specialty mattress retailers into markets with existing company-owned retail stores;

General economic conditions and consumer confidence; and

Global events, such as terrorist attacks or a pandemic outbreak, or the threat of such events.

Future fluctuations or decreases in our comparable-store sales or other operating results could significantly harm our business, operating results and financial condition. In addition, an unanticipated decline in comparable-store sales or other operating results may disappoint securities analysts or investors and result in a decline in our stock price.

Our business is subject to seasonal influences and a substantial portion of our net sales is often realized in the last month or last few weeks of a quarter, due in part to our promotional schedule and commission structure. As our marketing expenditures are largely based on our expectations of future customer inquiries and net sales, and cannot be adjusted quickly, a failure to meet these expectations may harm our profitability.

Our business is subject to some seasonal influences, with typically lower sales in the second quarter and higher sales during the fourth quarter holiday season due to greater mall traffic. Furthermore, a substantial portion of our sales is often realized in the last month or last few weeks of a quarter, due in part to our promotional schedule and commission structure. The level of our sales and marketing expenses and new store opening costs is based, in significant part, on our expectations of future customer inquiries and net sales and cannot be adjusted quickly. If there is a shortfall in expected net sales or in the conversion rate of customer inquiries, we may be unable to adjust our spending in a timely manner and our profitability may be significantly harmed.

Significant and unexpected return rates under our 30-night trial period and warranty claims under our 20-year limited warranty on our beds, in excess of our returns and warranty reserves, could significantly harm our business, operating results and financial condition.

Part of our marketing and advertising strategy focuses on providing a 30-night trial in which customers may return their beds and obtain a refund of the purchase price if they are not fully satisfied with our product. As we expand our sales, return rates may not remain within acceptable levels. A significant and unexpected increase in return rates could significantly harm our business, operating results and financial condition. We also provide our customers with a 20-year limited warranty on our beds. However, since we have only been selling beds in significant quantities since 1992, we may receive significant and unexpected claims under these warranty obligations that could exceed our warranty reserves. Significant warranty claims in excess of our warranty reserves could significantly harm our business, operating results and financial condition.

Our plan to pursue additional and maintain existing wholesale relationships with home furnishings retailers, specialty mattress retailers and the QVC shopping channel may not yield the benefits we expect and may involve other risks that may harm our business.

An important element of our growth strategy is to expand profitable distribution by increasing sales through our existing channels and by increasing opportunities for consumers to become aware of, and to purchase, our products through additional points of distribution, such as home furnishings retailers and specialty mattress retailers. We have only recently established a limited number of wholesale relationships with home furnishings retailers, specialty mattress retailers and the QVC shopping channel and therefore have limited wholesale experience. Our wholesale relationships may not result in the intended benefits of leveraging our advertising spending and increasing our brand awareness, sales and overall market acceptance of our products. Our wholesale distribution may also adversely impact sales through our company-controlled distribution channels. We also expect the gross margin from wholesale sales to be less than the gross margin we generate in our company-controlled channels. The success of our wholesale strategy will depend upon numerous factors, including but not limited to the following:

Our ability to analyze and identify suitable wholesale distribution partners and markets in which our retail presence is under-represented;

Our ability to negotiate favorable distribution terms with our wholesale distribution partners;

 

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Our ability and the ability of our wholesale distribution partners to adequately train, motivate and retain sales professionals who are selling our products;

Our ability to adapt our distribution and other operational and management systems to an expanded network of points of sale;

Our ability and the ability of our wholesale distribution partners to attract customers and generate sales sufficient to justify the expense of establishing the wholesale distribution relationship; and

Our ability to maintain sales growth in our company-controlled retail stores in markets in which wholesale distribution partners are added.

We have established relationships with a limited number of home furnishings retailers and specialty mattress retailers over the last several years. The loss of one or more of these accounts could have a material adverse affect upon our wholesale distribution strategy and could adversely impact our ability to achieve our overall sales growth and profitability objectives. Any failure to achieve the objectives of our wholesale distribution strategy may significantly harm our operating results and financial condition.

Our program to place beds in Radisson Hotels and Resorts may fail to achieve planned objectives, which may harm our business and adversely impact our operating results and financial condition.

An important element of our growth strategy is to expand consumer awareness of our products and brand. In May 2004, we established a relationship with Radisson Hotels and Resorts with plans to replace a majority of the beds in Radisson Hotels and Resorts in the United States, Canada and the Caribbean with Sleep Number beds over several years. This program is designed in part to drive consumer awareness of our products and brand among the guests of Radisson Hotels and Resorts. The success of this strategy will depend upon numerous factors, including but not limited to levels of acceptance of our products among Radisson Hotels and Resorts franchisees, the execution of marketing programs in connection with this relationship, and the quality of guests’ experiences on our beds at the Radisson Hotels and Resorts. Any material failure to achieve the objectives of this program with Radisson Hotels and Resorts may significantly harm our operating results and financial condition.

We have plans to expand our distribution internationally, which presents some additional risks to our business.

To date, the vast majority of our sales have been made in the U.S. and we have sold only very minimal quantities of products in foreign jurisdictions. In late 2005, we began to distribute our products in Canada through a Canadian-based bedding retailer and we have begun to pursue plans to enable distribution of our products in some other foreign countries. Expansion of our distribution to foreign jurisdictions, and our lack of experience in international distribution, present some risks to our business, including without limitation the need to build awareness of our products and brand in new markets, the need to gain market acceptance for new products that represent a significant departure from traditional bedding products, logistical and systems complexities, different levels of protection of our intellectual property, language and cultural differences, the need to comply with additional and different regulatory requirements, foreign currency exchange risks and political instability.

Although several members of our senior management team have significant experience in international distribution of consumer goods, as a company our experience in this area is limited. We plan to invest in our international infrastructure in advance of sales in international jurisdictions which may adversely impact our overall profitability. If we are unable to achieve consumer awareness and market acceptance for our products in foreign jurisdictions, we may not be able to achieve sufficient sales and profitability in our international operations to justify the investment.

We utilize “just-in-time” manufacturing processes with minimal levels of raw materials, work in process and finished goods inventories, which could leave us vulnerable to shortages of supply of key components. Any such shortage could result in our inability to satisfy consumer demand for our products in a timely manner and lost sales, which could significantly harm our business, operating results and financial condition.

We generally assemble our products after we receive orders from customers utilizing “just-in-time” manufacturing processes. Lead times for ordered components may vary significantly and depend upon a variety of factors, such as the location of the supplier, the complexity in manufacturing the component and general demand for the component. Some of our components, including our air chambers, have relatively longer lead times. We generally maintain minimal levels of raw materials, work in process and finished goods inventories, except for our air chambers, of which we generally carry approximately six weeks of inventory. As a result, an unexpected shortage of supply of key components used to manufacture our products, or an

 

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unexpected and significant increase in the demand for our products, could lead to inadequate inventory and delays in shipping our beds to customers. Any such delays could result in lost sales, which could significantly harm our business, operating results and financial condition.

 

Damage to either of our manufacturing facilities could increase our costs of doing business or lead to delays in shipping our beds, which could result in increased returns and adversely affect future sales.

We have two manufacturing plants, which are located in Irmo, South Carolina and in Salt Lake City, Utah. Unlike other mattress manufacturers, we manufacture beds to fulfill orders rather than stocking finished goods inventory. Therefore, the destruction or shutting down of either of our manufacturing facilities for a significant period of time as a result of fire, explosion, act of war or terrorism, flood, hurricane, tornado, earthquake, lightning or other natural disaster could increase our costs of doing business and lead to delays in shipping our beds to customers. Such delays could result in increased returns and adversely affect future sales. Due to our make-to-order business model, these adverse consequences to our business may be greater for our company than with other mattress manufacturers.

We rely upon several key suppliers that are, in some instances, our sole source of supply. The failure of one or more of these suppliers or our other key suppliers to supply components for our products on a timely basis, or a material change in the purchase terms for our components, could significantly harm our business, operating results and financial condition.

We currently obtain all of the materials and components used to produce our beds from outside sources. A number of components, including our proprietary air chambers, our proprietary blow-molded foundations, various components for our Firmness Control Systems, as well as fabrics and zippers, are sourced from suppliers who serve as our sole source of supply for these components. We also obtain the wood foundations to support our wholesale and hospitality channels businesses and our adjustable foundations from sole sources of supply.

We have a supply agreement with the supplier of our air chambers that expires in September 2011, subject to automatic annual renewal thereafter unless either party gives 365 days’ notice of non-renewal. We have a supply agreement with the supplier of our blow-molded foundations that expires in December 2009. We have a supply agreement with the supplier of our foam that expires in June 2008 with an option to renew the agreement for one year thereafter. If our relationship with either the supplier of our air chambers or the supplier of our blow-molded foundations is terminated, we could have difficulty in replacing these sources since there are relatively few other suppliers capable of manufacturing these components.

We generally purchase many of our other components and raw materials centrally to obtain volume discounts and achieve economies of scale. We therefore obtain a large percentage of our components and raw materials from a small number of suppliers. We purchase most of our components and raw materials through purchase orders and do not have any long-term purchase agreements with, or other contractual assurances of continued supply, pricing or access from, any of our suppliers, except for air chambers, blow-molded foundations, foam, fiber and circuit boards.

If prices for our key components increase and we are unable to achieve offsetting savings through value engineering or increased productivity or we are unable to increase prices to our customers, our operating results and financial condition may be significantly harmed. The loss of one or more of our key suppliers, the failure of one or more of our key suppliers to supply components to our products on a timely basis, or a material change in the purchase terms for our components could significantly harm our business, operating results and financial condition.

The foreign manufacturing of our air chambers and some of our other components involves risks that could increase our costs, lead to inadequate inventory levels or delays in shipping beds to our customers, which could substantially harm our business, operating results and financial condition.

Since our air chambers and some of our other components are manufactured outside the United States, our operations could be significantly harmed by the risks associated with foreign sourcing of materials, including but not limited to:

Political instability resulting in disruption of trade;

Existing or potential duties, tariffs or quotas that may limit the quantity of certain types of goods that may be imported into the United States or increase the cost of such goods;

 

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Disruptions in transportation that could be caused by a variety of factors including acts of terrorism, shipping delays, foreign or domestic dock strikes, customs inspections or other factors;

Any significant fluctuation in the value of the U.S. dollar against foreign currencies; and

Economic uncertainties, including inflation.

These factors could increase our costs of doing business with foreign suppliers, lead to inadequate inventory levels or delays in shipping beds to our customers, which could substantially harm our business, operating results and financial condition. If any of these or other factors were to render the conduct of any of our foreign suppliers’ businesses more difficult or impractical, we may have difficulty sourcing key components of our products, which could materially and adversely affect our operating results and financial condition.

Increases in commodity prices, component costs and/or delivery costs could harm our profitability.

Recently there have been significant increases or volatility in the prices of certain commodities, including but not limited to fuel, oil, natural gas, rubber, cotton, plastic resin, steel and chemical ingredients used to produce foam. Increases in prices of these commodities may result in significant cost increases for our raw materials and product components, as well as increases in the cost of delivering our products to our customers. These increases in costs may require us to increase our prices, potentially adversely impacting our unit sales volumes, and may increase our costs of doing business, potentially adversely impacting our operating results and financial condition.

We depend upon UPS and other carriers to deliver some of our products to customers on a timely and cost-effective basis. Any significant delay in deliveries to our customers could lead to increased returns and cause us to lose future sales. Any increase in freight charges could increase our costs of doing business and harm our profitability.

Historically, we have relied to a significant extent on UPS for delivery of our products to customers. For a significant portion of the third quarter of 1997, UPS was unable to deliver our products within acceptable time periods due to a labor strike, causing delays in deliveries to customers and requiring us to use alternative carriers. UPS may not be able to avert labor difficulties in the future or may otherwise experience difficulties in meeting our requirements in the future. From 2000 to 2003, we demonstrated an ability to shift a portion of our product delivery business to FedEx, as necessary. In addition, we either provide directly, or contract with a third party to provide, in-home delivery, assembly and mattress removal services, and in 2003 expanded the availability of this service to all of our retail stores across the country. Despite these alternative carriers, if UPS were to experience difficulties in meeting our requirements we may not be able to deliver products to all of our customers on a timely or cost-effective basis through any one or more of these or other alternative carriers. Any significant delay in deliveries to our customers could lead to increased returns and cause us to lose future sales. Any increase in freight charges could increase our costs of doing business and harm our profitability.

More than one-third of our net sales are financed by a third party. The termination of our agreement with this third party, any material change to the terms of our agreement with this third party or in the availability or terms of credit offered to our customers by this third party, or any delay in securing replacement credit sources, could harm our business, operating results and financial condition.

Our qualified customers are offered a revolving credit arrangement to finance purchases from us through a private label consumer credit facility provided by GE Money Bank. In December 2005 we entered into an amended and restated agreement with GE Money Bank that extends this consumer credit arrangement through February 15, 2011, subject to earlier termination upon certain events and subject to automatic extensions.

Under this agreement, GE Money Bank sets the minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures, and is the owner of the accounts. In connection with all purchases financed under these arrangements, GE Money Bank pays us an amount equal to the total amount of such purchases, net of promotional related discounts. Any increase by GE Money Bank in the minimum customer credit ratings necessary to qualify for credit could adversely impact our sales by decreasing the number of customers who can finance purchases. We are liable to GE Money Bank for charge-backs arising out of (i) breach of our warranties relating to the underlying sale transaction, (ii) defective products or (iii) our failure to comply with applicable operating procedures under the facility. We are not liable to GE Money Bank for losses arising out of our customers’ credit defaults.

 

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We have the right to terminate the agreement in order to manage this consumer credit program internally at any time after 2008. Upon the termination of the agreement, we have the right, but not the obligation, to purchase GE Money Bank’s portfolio of customer accounts.

Approximately 40% of our net sales during 2006 were financed by GE Money Bank or its predecessor, Mill Creek Bank. Consumers that do not qualify for credit under our agreement with GE Money Bank may apply for credit under a secondary program maintained by the company through another provider.

Termination of our agreement with GE Money Bank or with our secondary provider, any material change to the terms of our agreement with either of these providers, or in the availability or terms of credit for our customers from these providers, or any delay in securing replacement credit sources, could harm our business, operating results and financial condition.

Our current management information systems may not be adequate to support our growth strategy. We have recently undertaken plans to implement an SAP-based enterprise-wide information technology architecture. We currently expect this project to be completed in the first half of 2008 and we expect to incur significant increases in expenses and capital expenditures in 2007 and the remainder of the implementation phase to complete this project. This project may take longer and may require more resources to implement than anticipated, may cause distraction of key personnel, may cause disruptions to our business, and may not ultimately provide the benefits we anticipate. Any of these outcomes could impair our ability to achieve critical strategic initiatives and could significantly harm our business, operating results and financial condition.

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. Our business will be materially and adversely affected if our management information systems are disrupted or if we are unable to improve, upgrade, integrate or expand our systems as we execute our growth strategy. In addition, any failure of our systems and processes to adequately protect customer information from theft or loss could materially and adversely impact our business, our reputation and our operating results.

We have recently undertaken plans to implement an integrated suite of SAP-based applications, including enterprise resources planning, customer relationship management, supply chain management, product lifecycle management, supplier relationship management, human capital management, strategic enterprise management, business intelligence and enterprise portal systems to replace many of our current systems. We believe this SAP-based IT architecture, along with best-practices-based processes and higher concentrations of off-the-shelf, packaged solutions, will provide greater flexibility and functionality for our growing and evolving business model and be less expensive to maintain over the long-term.

This project may take longer and may require more resources to implement than anticipated, may cause distraction of key personnel, may cause disruptions to our business, and may not ultimately provide the benefits we anticipate. Any of these outcomes could impair our ability to achieve critical strategic initiatives and could significantly harm our business, operating results and financial condition.

We are subject to a wide variety of government regulations. Any failure to comply with any of these regulations could be very damaging to our business, reputation and operating results. We may be required to incur significant expenses or to modify our operations in order to ensure compliance with these regulations.

We are subject to a wide variety of government regulations relating to the bedding industry or to various aspects of our business and operations, including without limitation:

Regulations relating to the proper labeling of bedding merchandise and other aspects of product handling and sale;

State regulations related to the proper labeling and sale of bedding products produced in part from refurbished components;

Federal and state flammability standards applicable generally to mattresses and mattress and foundation sets, described in greater detail below;

Environmental regulations;

 

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Consumer protection and data privacy regulations;

Regulations related to marketing and advertising claims;

Various federal and state “do not call” or “do not mail” list requirements;

Federal, state and foreign labor laws, including but not limited to laws relating to occupational health and safety, employee privacy, wages and hours, overtime pay, harassment and discrimination, equal opportunity, and employee leaves and benefits;

Antitrust regulations in the United States and other jurisdictions where we may sell our products in the future;

Import and export regulations;

Federal and state tax laws; and

Federal and state securities laws;

Although we believe that we are in compliance in all material respects with these regulations and have implemented a variety of measures to promote continuing compliance, regulations may change over time and we may be required to incur expenses and/or to modify our operations in order to ensure compliance with these regulations, which could harm our operating results. If we are found to be in violation of any of the foregoing laws or regulations, we could become subject to fines, penalties, damages or other sanctions, as well as potential adverse public relations, which could materially and adversely impact our business, our reputation and our operating results.

All mattresses and mattress and foundation sets, including ours, will be subject to new federal flammability standards and related regulations beginning in July 2007. Compliance with these regulations may result in increased product costs, may require modifications to our systems and operations and may increase the risk of disruptions to our business due to ongoing testing to assure compliance or regulatory inspections.

The federal Consumer Product Safety Commission has adopted a new flammability standard and related regulations to be effective nationwide in July 2007 for mattresses and mattress and foundation sets. Compliance with these requirements may result in higher materials and manufacturing costs for our products, and will require modifications to our information systems and business 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.

The new regulations require manufacturers to implement quality assurance programs to ensure compliance and encourage manufacturers to conduct random testing of products. The new regulations also require maintenance and retention of compliance documentation. These quality assurance and documentation requirements will be costly to implement and maintain. If any product testing yields results indicating that any of our products may not meet the flammability standard, or if we obtain test results or other evidence that any of our products may fail to meet the standard or that a material or process used in manufacturing could affect the test performance of our product, we may be required to temporarily cease production and distribution and/or to recall products from the field, and we may be subject to fines or penalties, any of which outcomes could substantially harm our business, reputation, operating results and financial condition. We may also face increased risks of disruptions to our business caused by regulatory inspections.

We may face exposure to product liability claims.

We face an inherent business risk of exposure to product liability claims in the event that the use of any of our products is alleged to have resulted in personal injury or property damage. In the event that any of our products proves to be defective, we may be required to recall or redesign such products. In 2004, we experienced increased returns and adverse impacts on sales as a result of media reports related to the alleged propensity of our products to develop mold. We may experience material increases in returns and material adverse impacts on sales in the event any similar media reports were to occur in the future. We maintain insurance against product liability claims, but such coverage may not continue to be available on terms

 

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acceptable to us and may not be adequate for liabilities actually incurred. A successful claim brought against us in excess of available insurance coverage, or any claim or product recall that results in significant adverse publicity against us, may have a material adverse effect on our business.

If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology in competitive products.

We own various U.S. and foreign patents and patent applications related to certain elements of the design and function of our beds and related products. We also own several registered and unregistered trademarks and trademark applications, including in particular our Select Comfort and Sleep Number trademarks, which we believe have significant value and are important to the marketing of our products to customers. In addition to patents and trademarks, we rely upon copyrights, trade secrets and other intellectual property rights and we have implemented several measures to protect our intellectual property and confidential information contained in our products, such as entering into assignment of invention and nondisclosure agreements with certain of our employees. Our ability to compete effectively with other companies depends, to a significant extent, upon our ability to maintain the proprietary nature of our owned intellectual property and confidential information. Our intellectual property rights may not provide substantial protection against infringement or piracy and may be circumvented by our competitors. Our protective measures may not protect our intellectual property rights or confidential information or prevent our competitors from developing and marketing products that are similar to or competitive with our beds or other products. In addition, the laws of some foreign countries may not protect our intellectual property rights and confidential information to the same extent as the laws of the United States. If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology or trademarks in connection with competitive products, which could adversely affect our sales or require us to decrease our prices.

Intellectual property litigation, which could result in substantial costs to us and the diversion of significant time and effort by our executive management, may be necessary to enforce our patents and trademarks and to protect our trade secrets and proprietary technology. We may not have the financial resources necessary to enforce or defend our intellectual property rights.

We are not aware of any material intellectual property infringement or invalidity claims that may be asserted against us, however, it is possible that third parties, including competitors, may successfully assert such claims. The cost of defending such claims, or any resulting liability, or any failure to obtain necessary licenses on reasonable terms, may adversely impact our operating results and financial condition.

The loss of the services of any members of our executive management team could materially and adversely impact our ability to execute our business strategy and growth initiatives and could significantly harm our business.

We are currently dependent upon the continued services, ability and experience of our executive management team, particularly William R. McLaughlin, our Chairman and Chief Executive Officer. The loss of the services of Mr. McLaughlin or any other member of our executive management team could have a material adverse effect on our ability to execute our business strategy and growth initiatives and on our results of operation and financial condition. We do not maintain any key person life insurance on any members of our executive management team. Our future growth and success will also depend upon our ability to attract, retain and motivate other qualified personnel.

Additional terrorist attacks in the United States or against U.S. targets or actual or threats of war or the escalation of current hostilities involving the United States or its allies could significantly impact our business, financial condition, operating results or stock price in unpredictable ways.

Additional terrorist attacks in the United States or against U.S. targets, or threats of war or the escalation of current hostilities involving the United States or its allies, or military or trade disruptions impacting our domestic or foreign suppliers of components of our products, may impact our operations, including, but not limited to, causing delays or losses in the delivery of merchandise to us and decreased sales of our products. These events could cause an increase in oil or other commodity prices, which could adversely affect our materials or transportation costs, including delivery of our products to customers. More generally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the U.S. and worldwide financial markets. These events also could cause an economic recession in the United States or abroad. Any of these occurrences could have a significant impact on our business, operating results and financial condition and may result in volatility of our stock price.

 

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An outbreak of Avian Flu or a pandemic, or the threat of a pandemic, may adversely impact our ability to produce and deliver our products or may adversely impact consumer demand.

Concern has grown recently over the possibility of a significant or global outbreak of avian flu or a similar pandemic. A significant outbreak of avian flu, or a similar pandemic, or even a perceived threat of such an outbreak, could cause significant disruptions to our supply chain, manufacturing capability and distribution system that could adversely impact our ability to produce and deliver products, which could result in a loss of sales and an adverse impact on our results of operations and financial condition. Similarly, such events could cause significant adverse impacts on consumer confidence and consumer demand generally, which could significantly and adversely impact our sales, results of operations and financial condition.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.









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Table of Contents

ITEM 2. PROPERTIES

Distribution Locations

We currently lease all of our existing retail store locations and expect that our policy of leasing, rather than owning stores, will continue as we expand our store base. Our store leases generally provide for an initial lease term of five to 10 years with a mutual termination option if we do not achieve certain minimum annual sales thresholds. Generally, the store leases require us to pay minimum rent plus percentage rent based on net sales in excess of certain thresholds, as well as certain operating expenses.

The following table summarizes the geographic location of our 442 company-owned stores and 822 retail partner doors as of December 30, 2006:

 

 

Company-

Retail

 

 

 

Company-

Retail

 

Owned

Partner

 

 

 

Owned

Partner

 

Stores

Doors

 

 

 

Stores

Doors

Alabama

3

-

 

 

Montana

2

2

Alaska

-

3

 

 

Nebraska

3

4

Arizona

8

34

 

 

Nevada

4

-

Arkansas

2

-

 

 

New Hampshire

5

-

California

51

132

 

 

New Jersey

14

24

Colorado

14

1

 

 

New Mexico

2

-

Connecticut

8

26

 

 

New York

17

105

Delaware

2

-

 

 

North Carolina

12

30

Florida

29

33

 

 

North Dakota

1

7

Georgia

14

27

 

 

Ohio

16

16

Hawaii

-

6

 

 

Oklahoma

3

5

Idaho

1

-

 

 

Oregon

5

-

Illinois

18

3

 

 

Pennsylvania

20

2

Indiana

10

8

 

 

Rhode Island

1

-

Iowa

6

13

 

 

South Carolina

5

3

Kansas

5

7

 

 

South Dakota

2

10

Kentucky

4

1

 

 

Tennessee

10

13

Louisiana

4

4

 

 

Texas

34

109

Maine

2

-

 

 

Utah

4

-

Maryland

10

6

 

 

Vermont

1

-

Massachusetts

11

7

 

 

Virginia

13

1

Michigan

13

-

 

 

Washington

13

-

Minnesota

16

33

 

 

West Virginia

1

-

Mississippi

-

-

 

 

Wisconsin

10

15

Missouri

13

13

 

 

Wyoming

-

-

 

 

 

 

 

Canada

-

119

 

 

 

 

 

Total

442

822

Manufacturing and Headquarters

We lease approximately 122,000 square feet in Minneapolis, Minnesota that includes our corporate headquarters, our direct marketing call center, our customer service group, our research and development department, and a distribution center that accepts returns and processes warranty claims. This lease expires in 2017 and contains one five-year renewal option. We sublease approximately 18,000 square feet in Minneapolis for a home delivery distribution center and a portion of our corporate headquarters staff. This sublease expires in December 2007 with no renewal option. We also sublease approximately 29,000 square feet in Minneapolis for our information technology department and a portion of our corporate headquarters staff. This sublease expires in February 2008 and contains one two-year renewal option.

To better meet our anticipated future space needs, we entered into a lease agreement with Opus Northwest, L.L.C. (“Opus”) in July 2006, pursuant to which Opus will build our new 160,000-square-foot corporate headquarters. The new facility is expected to be completed during the second half of 2007 at which time the lease will commence and run for an initial term of 10 years with two five-year renewal options. We plan to continue to use our existing headquarters facility for our direct marketing call center, our customer service call center, our research and development department, and for processing returns and warranty claims and accessories.

 

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We lease two manufacturing and distribution centers in Irmo, South Carolina and Salt Lake City, Utah of approximately 105,000 square feet and approximately 101,000 square feet, respectively. We lease the Irmo facility through February 2008, with a five-year renewal option thereafter, and the Salt Lake City facility through April 2009, with a five-year renewal option thereafter.

To support our program with Radisson Hotels and Resorts, we lease approximately 40,000 square feet in Omaha, Nebraska, through July 2007. This lease also has two one-year renewal options.

 

ITEM 3. LEGAL PROCEEDINGS

 

We are involved in various legal proceedings 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 provided for in our consolidated financial statements if the liability is probable and estimable in accordance with generally accepted accounting principles. The ultimate outcome of these matters are not expected to have a material effect on our consolidated results of operations or financial position.

 

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

 

Not applicable.

 

 








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Table of Contents

PART II

 

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Our common stock trades on The NASDAQ Stock Market LLC (NASDAQ Global Select Market) under the symbol “SCSS.” As of February 9, 2007, there were approximately 187 holders of record of our common stock. The following table sets forth the quarterly high and low sales prices per share of our common stock as reported by NASDAQ for the two most recent fiscal years, adjusted for a three-for-two stock split that became effective on June 8, 2006. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.

 

 

 

Fourth Quarter

 

Third Quarter

 

Second Quarter

 

First Quarter

 

Fiscal 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High

 

$

25.25

 

 

$

24.28

 

 

$

28.52

 

 

$

27.50

 

 

Low

 

 

16.83

 

 

 

17.36

 

 

 

20.28

 

 

 

17.46

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High

 

$

19.17

 

 

$

15.04

 

 

$

16.49

 

 

$

15.17

 

 

Low

 

 

11.55

 

 

 

12.28

 

 

 

12.12

 

 

 

11.06

 

 

 

Select Comfort has not historically paid cash dividends on its common stock and has no current plans to pay cash dividends.

 

Information concerning stock repurchases completed during the fourth quarter of fiscal 2006 is set forth below:

 

Fiscal Period

 

Total Number of
Shares
Purchased (1)

 

Average Price
Paid per Share

 

Total Number of Shares
Purchased as Part of
Publicly Announced Plans
or Programs (2)

 

Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs

 

October 2006

 

72,873

 

$

21.69

 

 

72,873

 

 

 

 

 

November 2006

 

675,000

 

 

20.80

 

 

675,000

 

 

 

 

 

December 2006

 

824,518

 

 

17.71

 

 

824,518

 

$

88,674,000

 

 

Total

 

1,572,391

 

 

19.22

 

 

1,572,391

 

 

 

 

 

 

___________________________

(1)

Includes 79 shares acquired in open market transactions by the administrator of the Company’s non-qualified deferred compensation plan in order to accommodate investment elections of plan participants.


(2)

On May 15, 2006, the Company announced that the Board of Directors approved a $150 million share repurchase program. The Finance Committee of the Board of Directors reviews repurchases under this program on a quarterly basis. The repurchase authorization expires at the end of 2008. As of February 9, 2007, the total outstanding authorization was $59.4 million.


 

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Comparative Stock Performance

 

The graph below compares the total cumulative shareholder return on our common stock over the last five years to the total cumulative return on the Standard and Poor’s (“S&P”) 400 Specialty Stores Index and The NASDAQ Stock Market (U.S.) Index assuming a $100 investment made on December 29, 2001. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance. This graph is being “furnished” and not “filed.”

 

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN

AMONG SELECT COMFORT CORPORATION, S&P 400 SPECIALTY STORES INDEX,

AND THE NASDAQ STOCK MARKET (U.S.) INDEX


 

 

 

 

12/29/2001

 

12/28/2002

 

1/3/2004

 

1/1/2005

 

12/31/2005

 

12/30/2006

 

Select Comfort Corporation

 

$

100

 

$

446

 

$

1,217

 

$

884

 

$

1,347

 

$

1,285

 

S&P 400 Specialty Stores Index

 

 

100

 

 

85

 

 

116

 

 

136

 

 

143

 

 

161

 

The NASDAQ Stock Market (U.S.) Index

 

 

100

 

 

68

 

 

102

 

 

110

 

 

113

 

 

124

 

 

 

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Securities Authorized for Issuance under Equity Compensation Plans

 

The following table summarizes information about our equity compensation plans as of December 30, 2006:

 

EQUITY COMPENSATION PLAN INFORMATION

 

Plan Category

 

Number of securities to be issued upon exercise of outstanding options, warrants and rights

 

Weighted-average exercise price of outstanding options, warrants and rights

 

Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in the first column)

 

Equity compensation plans approved by security holders (1)

 

5,540,000

 

$11.43

 

1,964,000

 

 

 

 

 

 

 

 

 

Equity compensation plans not approved by security holders

 

None

 

Not applicable

 

None

 

 

 

 

 

 

 

 

 

Total

 

5,540,000

 

$11.43

 

1,964,000

 

 

________________________

(1)

Includes the Select Comfort Corporation 1990 Omnibus Stock Option Plan, the Select Comfort Corporation 1997 Stock Incentive Plan and the Select Comfort Corporation 2004 Stock Incentive Plan, as adjusted for our 2006 stock split.

 

 




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Table of Contents

ITEM 6. SELECTED FINANCIAL DATA

(in thousands, except per share and selected operating data, unless otherwise indicated)

 

The Consolidated Statements of Operations Data and Consolidated Balance Sheet Data presented below have been derived from our Consolidated Financial Statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and Notes thereto included in this Annual Report.

 

Certain reclassifications were made to prior period consolidated statements of operations and consolidated statements of financial position data in order to conform to the current-year presentation. These reclassifications had no impact on consolidated net income or retained earnings as previously reported. For additional information regarding these reclassifications, see Note 1 of the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.

 

 

 

Year

 

 

 

2006 (1)

 

2005

 

2004

 

2003 (2)

 

2002

 

2001

 

Consolidated Statements of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

806,038

 

$

689,548

 

$

557,639

 

$

458,489

 

$

335,795

 

$

261,687

 

Gross profit

 

 

490,508

 

 

406,476

 

 

339,838

 

 

285,324

 

 

208,663

 

 

154,180

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

341,630

 

 

286,206

 

 

250,628

 

 

207,400

 

 

156,307

 

 

138,496

 

General and administrative

 

 

65,401

 

 

49,300

 

 

37,826

 

 

33,974

 

 

30,123

 

 

23,834

 

Research and development

 

 

4,687

 

 

2,219

 

 

1,853

 

 

1,295

 

 

936

 

 

1,086

 

Asset impairment charges

 

 

5,980

 

 

162

 

 

 

 

71

 

 

233

 

 

1,366

 

Operating income (loss)

 

 

72,810

 

 

68,589

 

 

49,531

 

 

42,584

 

 

21,064

 

 

(10,602

)

Net income (loss)

 

$

47,183

 

$

43,767

 

$

31,555

 

$

27,102

 

$

37,466

 

$

(12,066

)

Net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.89

 

$

0.82

 

$

0.58

 

$

0.55

 

$

1.02

 

$

(0.44

)

Diluted

 

 

0.85

 

 

0.76

 

 

0.53

 

 

0.46

 

 

0.72

 

 

(0.44

)

Shares used in calculation of net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

52,837

 

 

53,357

 

 

54,015

 

 

49,157

 

 

36,824

 

 

27,236

 

Diluted

 

 

55,587

 

 

57,674

 

 

59,525

 

 

58,916

 

 

51,798

 

 

27,236

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and marketable securities

 

$

90,175

 

$

123,091

 

$

101,963

 

$

75,118

 

$

40,824

 

$

16,375

 

Working capital

 

 

5,637

 

 

10,158

 

 

23,479

 

 

53,972

 

 

27,064

 

 

(3,739

)

Total assets

 

 

228,961

 

 

239,838

 

 

202,033

 

 

153,506

 

 

108,633

 

 

67,436

 

Long-term debt, less current maturities

 

 

 

 

 

 

 

 

 

 

2,991

 

 

17,109

 

Total shareholders’ equity

 

 

115,694

 

 

121,347

 

 

114,344

 

 

92,201

 

 

54,024

 

 

5,937

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Operating Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stores open at period-end (3)

 

 

442

 

 

396

 

 

370

 

 

344

 

 

322

 

 

328

 

Stores opened during period

 

 

51

 

 

40

 

 

31

 

 

27

 

 

15

 

 

11

 

Stores closed during period

 

 

5

 

 

14

 

 

5

 

 

5

 

 

21

 

 

16

 

Retail partner doors

 

 

822

 

 

353

 

 

89

 

 

77

 

 

71

 

 

 

Average net sales per store (000’s) (4)

 

$

1,493

 

$

1,417

 

$

1,247

 

$

1,101

 

$

817

 

$

626

 

Percentage of stores with more than $1.0 million in net sales (4)

 

 

81

%

 

77

%

 

64

%

 

49

%

 

24

%

 

10

%

Comparable-store sales increase (decrease) (5)

 

 

7

%

 

15

%

 

16

%

 

31

%

 

27

%

 

(4

)%

Average square footage per store open during period (4)

 

 

1,200

 

 

1,121

 

 

1,032

 

 

990

 

 

972

 

 

941

 

Net sales per square foot (4)

 

$

1,244

 

$

1,264

 

$

1,208

 

$

1,113

 

$

841

 

$

666

 

Average store age (in months at period end)

 

 

81

 

 

79

 

 

75

 

 

70

 

 

61

 

 

51

 

 

 

(1)

In the first quarter of fiscal 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment,” requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected the modified prospective transition method as permitted by SFAS 123R and, accordingly, financial results for fiscal years prior to 2006 have not been restated. Stock-based compensation expense for fiscal 2006 was $8,325 ($5,687 net of tax). Prior to the adoption of SFAS 123R, the Company followed the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for its employee stock options and employee stock purchase plan. Accordingly, no compensation expense was recognized for share purchase rights granted in connection with the issuance of stock options under the Company’s employee stock option plan or employee stock purchase plan; however, compensation expense was recognized in connection with the issuance of restricted and performance shares granted. See Note 7 of the Notes to the Consolidated Financial Statements for additional information regarding stock-based compensation. Stock-based compensation expense (pre-tax) recognized in our financial results for years prior to fiscal 2006 were $793, $405, and $76 in 2005, 2004, 2003, respectively; and none in 2002 and 2001.

 

(2)

Fiscal year 2003 had 53 weeks. All other fiscal years presented had 52 weeks.

 

(3)

Includes stores operated in leased departments within other retail stores (none in 2006 and 2005; 13 in 2004, 2003 and 2002; and 22 in 2001).

 

(4)

For stores open during the entire period indicated.

 

(5)

Stores are included in the comparable-store calculation in the 13th full month of operation. Stores that have been remodeled or relocated within the same shopping center remain in the comparable-store base. The number of comparable-stores used to calculate such data was 391, 354, 339, 316, 307 and 317 for 2006, 2005, 2004, 2003, 2002 and 2001, respectively. Our 2004 and 2003 comparable-store sales increase reflects adjustments for an additional week of sales in 2003. Without adjusting for the additional week, comparable-store sales would have been 14% for 2004 and 34% for 2003.

 

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Table of Contents

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Forward-Looking Statements

 

The discussion in this Annual Report contains certain forward-looking statements that relate to future plans, events, financial results or performance. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. These risks and uncertainties include, among others, such factors as general and industry economic trends, uncertainties arising from global events, consumer confidence, effectiveness of our advertising and promotional efforts; our ability to secure suitable retail locations, our ability to attract and retain qualified sales professionals and other key employees; consumer acceptance of our products, product quality, innovation and brand image, our ability to continue to expand and improve our product line; industry competition; warranty expenses; the outcome of pending litigation, including consumer class action litigation; our dependence on significant suppliers, and the vulnerability of any suppliers to recessionary pressures, labor negotiations, liquidity concerns or other factors; rising commodity costs; and increasing government regulations, including new flammability standards for the bedding industry. Additional information concerning these and other risks and uncertainties is contained under the caption “Risk Factors” in this Annual Report on Form 10-K.

 

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 which focus on providing personalized comfort to complement the Sleep Number bed and 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®.

 

The proportion of our total net sales, by dollar volume, from each of our channels during the last three years is summarized as follows:

 

 

 

2006

 

2005

 

2004

 

Retail

 

76.2%

 

76.9%

 

78.0%

 

Direct

 

9.4%

 

10.8%

 

11.5%

 

E-commerce

 

5.6%

 

5.0%

 

4.6%

 

Wholesale

 

8.8%

 

7.3%

 

5.9%

 

Total

 

100.0%

 

100.0%

 

100.0%

 

 

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

 

 

 

2006

 

2005

 

2004

 

 

 

Channel
increase

 

Channel
increase

 

Channel
increase

 

Retail:

 

 

 

 

 

 

 

Comparable-store(1) sales

 

7%

 

15%

 

16%

 

New/closed stores, net

 

9%

 

7%

 

8%

 

Retail total

 

16%

 

22%

 

24%

 

 

 

 

 

 

 

 

 

Direct

 

1%

 

16%

 

10%

 

E-commerce

 

31%

 

34%

 

34%

 

Wholesale

 

40%

 

54%

 

73%

 

 

 

 

 

 

 

 

 

Total sales growth

 

17%

 

24%

 

22%

 

 

(1)

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


 

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Table of Contents

The number of company-operated retail stores during the last three years, and independently owned and operated retail partner stores are summarized as follows:

 

 

 

2006

 

2005

 

2004

 

Company-owned retail stores:

 

 

 

 

 

 

 

Beginning of year

 

396

 

370

 

344

 

Opened

 

51

 

40

 

31

 

Closed

 

(5

)

(14

)

(5

)

End of year

 

442

 

396

 

370

 

 

 

 

 

 

 

 

 

Retail partner stores

 

822

 

353

 

89

 

 

We anticipate opening 40 net new retail stores and to relocate or expand 30 or more stores in 2007. We expect the number of stores in our retail partner program to remain at approximately 800 in 2007.

 

Our growth plans are centered on increasing market-by-market awareness of our products and stores through expansion of media, increasing distribution – primarily through new retail store openings and 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. We believe long-term opportunities exist for international sales. In December 2005, we entered the Canadian market through a retail partner with locations in major metropolitan markets.

 

Sales growth and a higher gross profit rate enabled us to increase operating income by 6% in 2006. Historically, the majority of our operating margin improvement has been generated through leverage in selling expenses (increased sales through the existing store base) and leverage of our existing infrastructure (general and administrative expenses). We expect any future improvements in operating margin to be derived from similar sources. Our long-term growth targets are to sustain annual sales growth rates of 15% or more and annual earnings growth rates of 20% or more. We expect a challenging economic environment in 2007 which may affect our ability to achieve these targets in 2007.

 






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Table of Contents

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 earnings per share amounts. Amounts may not add due to rounding differences.

 

 

 

2006

 

2005

 

2004

 

 

 

$

 

% of
Net Sales

 

$

 

% of
Net Sales

 

$

 

% of
Net Sales

 

Net sales

 

$

806.0

 

100.0

%

$

689.5

 

100.0

%

$

557.6

 

100.0

%

Cost of sales

 

 

315.5

 

39.1

 

 

283.1

 

41.1

 

 

217.8

 

39.1

 

Gross profit

 

 

490.5

 

60.9

 

 

406.5

 

58.9

 

 

339.8

 

60.9

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

341.6

 

42.4

 

 

286.2

 

41.5

 

 

250.6

 

44.9

 

General and administrative

 

 

65.4

 

8.1

 

 

49.3

 

7.1

 

 

37.8

 

6.8

 

Research and development

 

 

4.7

 

0.6

 

 

2.2

 

0.3

 

 

1.9

 

0.3

 

Asset impairment charges

 

 

6.0

 

0.7

 

 

0.2

 

0.0

 

 

0.0

 

0.0

 

Total operating expenses

 

 

417.7

 

51.8

 

 

337.9

 

49.0

 

 

290.3

 

52.1

 

Operating income

 

 

72.8

 

9.0

 

 

68.6

 

9.9

 

 

49.5

 

8.9

 

Interest income

 

 

3.0

 

0.4

 

 

2.2

 

0.3

 

 

1.4

 

0.3

 

Income before income taxes

 

 

75.8

 

9.4

 

 

70.8

 

10.3

 

 

50.9

 

9.1

 

Income tax expense

 

 

28.6

 

3.6

 

 

27.0

 

3.9

 

 

19.4

 

3.5

 

Net income

 

$

47.2

 

5.9

%

$

43.8

 

6.3

%

$

31.6

 

5.7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2006

 

 

 

2005

 

 

 

2004

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.89

 

 

 

$

0.82

 

 

 

$

0.58

 

 

 

Diluted

 

 

0.85

 

 

 

 

0.76

 

 

 

 

0.53

 

 

 

Weighted-average number of common shares:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

52.8

 

 

 

 

53.4

 

 

 

 

54.0

 

 

 

Diluted

 

 

55.6

 

 

 

 

57.7

 

 

 

 

59.5

 

 

 

 

Net Sales

We recognize revenue when the sales price is fixed or determinable, collectibility is reasonably assured and title passes. 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, and adjusted for any current trends as appropriate. If actual returns vary from expected rates, revenue in future periods is adjusted. Historically, we have not experienced material adjustments to the financial statements due to changes to estimates of returns.

 

Cost of Sales

Cost of sales includes costs associated with purchasing, manufacturing, shipping, handling and delivering our products to our customers, including related occupancy and depreciation expenses. Cost of sales also includes estimated costs to service warranty claims of customers. This estimate is based on historical claim rates experienced during the warranty period and adjusted for any current trends as appropriate. Because this estimate covers an extended period of time, a revision of estimated claim rates could result in a significant adjustment of estimated future costs of fulfilling warranty commitments and could have a material adverse effect on future results of operations. We revise our estimates of warranty liabilities to reflect changes in projected claim rates and projected costs of fulfilling warranty claims. However, these estimate revisions have not historically materially affected our annual results.

 

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. Similarly, sales directly to consumers through company-controlled channels typically generate higher gross margins than sales through our wholesale channels because we capture both the manufacturer’s and retailer’s margin.

 


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Table of Contents

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, customer service, store occupancy costs and related depreciation expense.

 

Advertising expense was $105.3 million in 2006, $89.4 million in 2005, and $78.5 million in 2004. Future advertising expenditures will depend on the effectiveness and efficiency of the advertising in creating awareness of our products and brand names, generating consumer inquiries and driving consumer traffic to our points of sale. We anticipate that full-year advertising expenditures in 2007 will increase by approximately 10%.

 

General and Administrative Expenses

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

 

Research and Development Expenses

Research and development (“R&D”) expenses includes internal labor and benefits, outside consulting services and testing equipment. R&D spending is expected to increase by up to 50% in 2007 as we accelerate our innovation, leading with a series of cost and quality enhancements for our products.

 

Asset Impairment Charges

Asset impairment charges relate to long-lived assets that have been written-off when the carrying amount of an asset is not expected to be recoverable from future cash flows. We evaluate our long-lived assets, including leaseholds and fixtures in existing stores, based on estimated future cash flows after considering the potential impact of planned operational improvements, marketing programs, industry economic factors and the profitability of future business strategies. 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.

 

Quarterly and Annual Operating 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, rising commodity costs, any disruptions in supplies or third-party services, 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 impacted. Our historical results of operations may not be indicative of the results that may be achieved for any future period.

 

Comparison of 2006 and 2005

 

Net Sales

 

Net sales in 2006 increased 17% to $806.0 million from $689.5 million in 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 6% to $1,699, while sales of other products and services increased by 24%. The higher average selling price per bed resulted primarily from a price increase in late 2005 and a shift in the net sales mix to higher priced mattress models.

 

The $116.5 million increase in net sales was attributable to (i) an $84.4 million increase in net sales from our retail stores, including an increase in comparable-store sales of $36.9 million and an increase of $47.5 million from new stores, net of stores closed, (ii) a $1.1 million increase in direct marketing net sales, (iii) a $10.9 million increase in net sales from our e-commerce channel, and (iv) a $20.1 million increase in net sales from our wholesale channel.

 


32



Table of Contents

Gross Profit

 

Gross profit increased to 60.9% in 2006 from 58.9% in 2005, primarily due to higher average selling prices of mattresses and productivity improvements in manufacturing and logistics which reduced the Company’s cost of sales. This was partially offset by an increase in the percentage of net sales from lower margin channels which reduced the gross profit rate by 0.4 percentage points (ppt) and a correction in warranty liabilities to include freight costs which had not been included in prior periods. This correction was immaterial to current and prior periods.

 

Sales and Marketing Expenses

 

Sales and marketing expenses in 2006 increased 19% to $341.6 million from $286.2 million in 2005 and increased as a percentage of net sales to 42.4% from 41.5% for the comparable prior-year period. The $55.4 million increase was primarily due to additional media investments, increased number of stores and markets served, and an increase in variable costs due to higher sales. The 0.9 ppt increase as a percentage of net sales was primarily due to a 0.7 ppt of net sales increase in financing, promotion and other marketing costs. 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 $65.4 million in 2006 from $49.3 million in 2005 and increased as a percentage of net sales to 8.1% from 7.1% for the comparable prior-year period. The dollar and percentage increases in G&A were primarily due to increased compensation costs related to the adoption of SFAS 123R which required the expensing of $5.5 million (0.7 ppt) of stock option compensation, increased compensation and benefits expenses related to additional headcount of $4.9 million, higher professional fees of $2.9 million, and additional depreciation and maintenance expense from information technology infrastructure investments of $2.5 million, partially offset by lower incentive compensation costs of $2.5 million resulting from our all-employee incentive compensation program. 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.

 

Research and Development

 

Research and development expenses increased $2.5 million to $4.7 million in 2006 from $2.2 million in 2005 and increased as a percentage of net sales to 0.6% from 0.3% for the comparable prior-year period. The significant dollar and percentage increases in R&D expenses in fiscal year 2006 was due to our strategic decision to accelerate our investment in new product innovation.

 

Asset Impairment Charges

 

Asset impairment charges increased to $6.0 million in 2006 from $0.2 million in 2005. The charges in 2006 relate primarily to the $5.4 million write-off of software projects abandoned in connection with our decision to implement a new SAP® enterprise resource planning system. In addition, the charges in 2006 include $0.6 million associated with store asset impairments.

 

Interest Income

 

Interest income increased $0.8 million to $3.0 million in 2006 from $2.2 million in 2005. The increase in interest income resulted from higher interest rates on invested balances.

 

Income Tax Expense

 

Income tax expense increased $1.6 million to $28.6 in 2006 from $27.0 in 2005 principally due to the increase in pre-tax income. The effective tax rates were 37.8% in 2006 and 38.1% in 2005. The decrease in the effective tax rate was principally due to increased interest income from tax-exempt securities.

 


33



Table of Contents

Comparison of 2005 and 2004

 

Net Sales

 

Net sales in 2005 increased 24% to $689.5 million from $557.6 million in 2004. Sales of mattress units increased 19% overall, and the average selling price per bed (mattress sales divided by mattress units) in our company-controlled channels increased 5% to $1,597, while sales of other products and services increased by 28%. The higher average selling price resulted primarily from a price increase introduced at the beginning of 2005 and improvements in product mix. 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 $94.9 million increase in net sales from our retail stores, including an increase in comparable-store sales of $64.9 million and an increase of $30.0 million from new stores, net of stores closed, (ii) a $10.4 million increase in direct marketing net sales, (iii) an $8.9 million increase in net sales from our e-commerce channel, and (iv) a $17.7 million increase in net sales from our wholesale channel.

 

Gross Profit

 

Gross profit decreased to 58.9% in 2005 from 60.9% in 2004, primarily due to changes in channel mix (i.e., increased percentage of total net sales from lower margin channels), higher warranty expense, and increased product and delivery costs resulting from rising commodity and fuel costs, offset partially by sales price increases and favorable sales return rates.

 

Sales and Marketing Expenses

 

Sales and marketing expenses in 2005 increased 12% to $286.2 million from $250.6 million in 2004 and decreased as a percentage of net sales to 41.5% from 44.9% for the comparable prior-year period. The $35.6 million increase was primarily due to additional media investments, increased number of stores and increased variable costs due to higher sales. The decrease as a percentage of net sales was comprised primarily of a 1.1 ppt increase in leverage of media investments, 0.6 ppt of other marketing leverage and a 1.7 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 in 2005 increased 30% to $49.3 million from $37.8 million in 2004 and increased as a percentage of net sales to 7.1% from 6.8% for the comparable prior-year period. The dollar increase in G&A was primarily due to increased incentive compensation expense of $6.5 million resulting from our all-employee incentive compensation program, increased compensation and benefits expenses related to additional headcount of $3.4 million, increased professional fees of $2.7 million, and $1.0 million in additional depreciation and maintenance expense from information technology infrastructure investments.

 

Research and Development

 

Research and development expenses increased $0.3 million to $2.2 million in 2005 from $1.9 million in 2004.

 

Interest Income

 

Interest income increased $0.8 million to $2.2 million in 2005 from $1.4 million in 2004. The increase in interest income resulted from higher average balances of invested cash and higher interest rates.

 

Income Tax Expense

 

Income tax expense increased $7.6 million to $27.0 in 2005 from $19.4 in 2004 principally due to higher pre-tax income. The effective tax rate was 38.1% in both 2005 and 2004.

 


34



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Liquidity and Capital Resources

 

As of December 30, 2006, we had cash, cash equivalents and marketable securities of $90.2 million, of which $46.6 million was classified as a current asset compared to $123.1 million of cash, cash equivalents and marketable securities as of December 31, 2005, of which $68.0 million was classified as a current asset. The $32.9 million decrease in cash, cash equivalents and marketable securities was the result of $59.4 million of cash provided by operating activities, reduced by $31.1 million of capital expenditures and $61.2 million of cash used in financing activities (which included $77.2 million of repurchases of our common stock, net of cash from stock option exercises and related tax benefits).

 

We generated cash from operations of $59.4 million in 2006. Cash from operations for 2006 is comprised of net income of $47.2 million, plus adjustments to reconcile net income to cash provided by operating activities of $17.7 million, and a decrease in cash from changes in assets and liabilities of $5.5 million, due primarily to increases in accounts receivable and inventory combined with decreases in customer prepayments and accrued compensation and benefits, partially offset by increases in accounts payable. Cash from operations for 2005 was $87.5 million, $28.1 million more than 2006. Cash from operations in 2005 is comprised of net income of $43.8 million, $3.4 million less than 2006; adjustments to reconcile net income to cash provided by operating activities of $15.4 million, $2.3 million less than 2006 due primarily to increases in asset impairment charges taken in 2006; and an increase in cash from changes in assets and liabilities of $28.4 million primarily due to increases in accrued compensation and other current liabilities in excess of changes in current assets.

 

Net cash used in investing activities was $33.2 million and $28.4 million in 2006 and 2005, respectively. The increase in net cash used in investing activities was principally due to a $5.2 million increase in capital expenditures. In both periods, our capital expenditures were primarily related to new and remodeled retail stores and investments in information technology. In 2006, we opened 51 new stores and remodeled 28 retail stores, while in 2005 we opened 40 new stores and remodeled 11 retail stores. We anticipate increasing our retail store count by 40 net new retail stores during 2007, and relocating or expanding 30 or more stores in 2007. We will fund planned capital expenditures 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. Our 2007 capital expenditures are expected to be approximately $50 million, compared to $31.1 million in 2006. The increase in capital expenditures is due to our expected implementation of SAP in the first half of fiscal year 2008 and leasehold improvement costs necessary to furnish our new corporate headquarters that we plan to move into in the fall of 2007.

 

Net cash used in financing activities was $61.2 million in 2006, compared to $40.5 million in 2005. The $20.7 million increase in cash used in financing activities resulted from a $27.5 million increase in repurchases of our common stock, offset by the change in the classification of the excess tax benefits from stock option exercises of $8.6 million from operating to financing in accordance with adoption of SFAS 123R in 2006. The use of cash for financing activities in both 2006 and 2005 was principally due to repurchases of our common stock of $77.2 million in 2006 and $49.7 million in 2005. We may make additional purchases of our common stock, subject to market conditions and at prevailing market prices, through open market purchases. The total outstanding stock repurchase authorization at February 9, 2007 was $59.4 million. 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. In addition, our business model, which can operate with minimal working capital, does not require significant additional capital to fund operations and organic growth. In 2006, we obtained a $100 million bank revolving line of credit for general corporate purposes including the funding of any short-term cash needs or investment opportunities. This line of credit is a five-year senior unsecured revolving facility expiring June 2011. 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 interest coverage and leverage ratios. We have remained and expect to remain in full compliance with the financial covenants. Although the Company had no borrowings against the credit facility as of December 30, 2006, we expect to incur borrowings during 2007 as we continue to repurchase our common stock at a rate that on a short-term basis may exceed the maturities of our held-to-maturity marketable securities portfolio.

 



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Table of Contents

Other than operating leases, we do not have any off-balance-sheet financing. A summary of our operating lease obligations by fiscal year is included in the “Contractual Obligations” section below. Additional information regarding our operating leases is available in Item 2, Properties, and Note 5, Leases, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.

 

Contractual Obligations

 

The following table presents information regarding our contractual obligations by fiscal year (in thousands):

 

 

 

Payments Due by Period

 

 

 

Total

 

< 1 Year

 

1 – 3 Years

 

3 – 5 Years

 

> 5 Years

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

$

155,304

 

$

28,429

 

$

53,927

 

$

38,019

 

$

34,929

 

Inventory purchase commitments

 

 

325,000

 

 

122,000

 

 

153,000

 

 

50,000

 

 

 

Total

 

$

480,304

 

$

150,429

 

$

206,927

 

$

88,019

 

$

34,929

 

 

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, sales returns, warranty liabilities, asset impairment charges and stock-based compensation.

 

Revenue Recognition

 

We recognize revenue when the sales price is fixed or determinable, collectibility is reasonably assured and title passes. Amounts billed to customers for delivery and set up are included in net sales.

 

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.

 

Warranty Liabilities

 

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.

 

Asset Impairment Charges

 

We evaluate our long-lived assets for impairment based on estimated future cash flows after considering the potential impact of planned operational improvements, marketing programs, industry economic factors and the profitability of future business strategies. 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 cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds its fair value.

 

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 option-pricing model with the most significant inputs into the model being exercise price, our estimate of expected stock price volatility and the

 

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Table of Contents

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 had a material impact on our consolidated results of operations and earnings per share.

 

Recent Accounting Pronouncements

 

In May 2005, the FASB issued Statement of Financial Accounting Standard’s (“SFAS”) No. 154, “Accounting Changes and Error Corrections,” which supersedes Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application of changes in accounting principles to prior period financial statements as of the earliest date practicable. This statement also redefines “restatement” as the revising of previously issued financial statements to reflect the correction of an error. The provisions of SFAS 154 were effective for the Company in fiscal year 2006. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

 

In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes.” FIN 48 defines the threshold for recognizing the benefits of tax positions in the financial statements as “more-likely-than-not” to be sustained upon examination. The interpretation also provides guidance on the derecognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of required disclosures associated with any recorded income tax uncertainties. The differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption are to be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. FIN 48 is effective for the Company beginning in fiscal year 2007. The Company is evaluating the impact of the adoption of FIN 48, but does not expect FIN 48 to have a material impact on its consolidated financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” 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 this statement, fair value measurements are required to be separately disclosed, by level, within the fair value hierarchy. SFAS 157 is effective for the Company beginning in fiscal 2008. The Company is currently evaluating the impact of SFAS 157, but does not expect its adoption to have a material impact on its 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. The provisions of SAB 108 were effective for the Company’s fiscal year ending December 30, 2006. The adoption of SAB 108 did not have a material impact on the Company’s consolidated financial statements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE 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.

 

Changes in the overall level of interest rates affect income generated from our short- and long-term investments in cash, cash equivalents and marketable securities. If overall interest rates were one percentage point lower than current rates, our annual interest income would decline by approximately $0.9 million based on our short- and long-term investments as of December 30, 2006. We do not manage our investment interest-rate volatility risk through the use of derivative instruments.

 


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Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON

INTERNAL CONTROL OVER FINANCIAL REPORTING

The Board of Directors and Shareholders

Select Comfort Corporation:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Select Comfort Corporation maintained effective internal control over financial reporting as of December 30, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Select Comfort Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Select Comfort Corporation maintained effective internal control over financial reporting as of December 30, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Select Comfort Corporation maintained, in all material respects, effective internal control over financial reporting as of December 30, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Select Comfort Corporation and subsidiaries as of December 30, 2006 and December 31, 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 30, 2006 and our report dated February 26, 2007 expressed an unqualified opinion on those consolidated financial statements.

 


 

Minneapolis, Minnesota

February 26, 2007

 

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

The Board of Directors and Shareholders

Select Comfort Corporation:

 

We have audited the accompanying consolidated balance sheets of Select Comfort Corporation and subsidiaries as of December 30, 2006 and December 31, 2005, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 30, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement Schedule II – Valuation and Qualifying Accounts. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Select Comfort Corporation and subsidiaries as of December 30, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 30, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As described in Notes 1 and 7 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, Share-Based Payment, on January 1, 2006.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Select Comfort Corporation’s internal control over financial reporting as of December 30, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 26, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 


 

Minneapolis, Minnesota

February 26, 2007

 



39



Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Balance Sheets

December 30, 2006 and December 31, 2005

(in thousands, except per share amounts)

 

 

 

2006

 

2005

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

8,819

 

$

43,867

 

Marketable securities – current

 

 

37,748

 

 

24,122

 

Accounts receivable, net of allowance for doubtful accounts of $529 and $552, respectively

 

 

12,164

 

 

6,234

 

Inventories

 

 

24,120

 

 

21,982

 

Prepaid expenses

 

 

10,227

 

 

9,841

 

Deferred income taxes

 

 

5,785

 

 

6,139

 

Other current assets

 

 

4,305

 

 

3,875

 

Total current assets

 

 

103,168

 

 

116,060

 

 

 

 

 

 

 

 

 

Marketable securities – non-current

 

 

43,608

 

 

55,102

 

Property and equipment, net

 

 

59,384

 

 

53,866

 

Deferred income taxes

 

 

19,275

 

 

11,256

 

Other assets

 

 

3,526

 

 

3,554

 

Total assets

 

$

228,961

 

$

239,838

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

46,061

 

$

42,659

 

Customer prepayments

 

 

9,552

 

 

14,718

 

Accruals:

 

 

 

 

 

 

 

Sales returns

 

 

3,907

 

 

5,403

 

Compensation and benefits

 

 

20,057

 

 

24,839

 

Taxes and withholding

 

 

5,053

 

 

9,624

 

Other current liabilities

 

 

12,901

 

 

8,659

 

Total current liabilities

 

 

97,531

 

 

105,902

 

 

 

 

 

 

 

 

 

Warranty liabilities

 

 

7,769

 

 

5,354

 

Other long-term liabilities

 

 

7,967

 

 

7,235

 

Total liabilities

 

 

113,267

 

 

118,491

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

Undesignated preferred stock; 5,000 shares authorized,
no shares issued and outstanding

 

 

 

 

 

Common stock, $0.01 par value; 142,500 shares authorized,
51,544 and 53,598 shares issued and outstanding, respectively

 

 

515

 

 

536

 

Additional paid-in capital

 

 

4,039

 

 

56,854

 

Retained earnings

 

 

111,140

 

 

63,957

 

Total shareholders’ equity

 

 

115,694

 

 

121,347

 

Total liabilities and shareholders’ equity

 

$

228,961

 

$

239,838

 

 

See accompanying notes to consolidated financial statements.


 

40



Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Statements of Operations

Years ended December 30, 2006, December 31, 2005 and January 1, 2005

(in thousands, except per share amounts)

 

 

 

2006

 

2005

 

2004

 

 

Net sales

 

$

806,038

 

$

689,548

 

$

557,639

 

Cost of sales

 

 

315,530

 

 

283,072

 

 

217,801

 

Gross profit

 

 

490,508

 

 

406,476

 

 

339,838

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

341,630

 

 

286,206

 

 

250,628

 

General and administrative

 

 

65,401

 

 

49,300

 

 

37,826

 

Research and development

 

 

4,687

 

 

2,219

 

 

1,853

 

Asset impairment charges

 

 

5,980

 

 

162

 

 

 

Total operating expenses

 

 

417,698

 

 

337,887

 

 

290,307

 

Operating income

 

 

72,810

 

 

68,589

 

 

49,531

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

 

3,018

 

 

2,174

 

 

1,414

 

Income before income taxes

 

 

75,828

 

 

70,763

 

 

50,945

 

Income tax expense

 

 

28,645

 

 

26,996

 

 

19,390

 

Net income

 

$

47,183

 

$

43,767

 

$

31,555

 

 

 

 

 

 

 

 

 

 

 

 

Basic net income per share:

 

 

 

 

 

 

 

 

 

 

Net income per share – basic

 

$

0.89

 

$

0.82

 

$

0.58

 

Weighted-average common shares – basic

 

 

52,837

 

 

53,357

 

 

54,015

 

Diluted net income per share:

 

 

 

 

 

 

 

 

 

 

Net income per share – diluted

 

$

0.85

 

$

0.76

 

$

0.53

 

Weighted-average common shares – diluted

 

 

55,587

 

 

57,674

 

 

59,525

 

 

See accompanying notes to consolidated financial statements.

 



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Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Statements of Shareholders’ Equity

Years ended December 30, 2006, December 31, 2005 and January 1, 2005

(in thousands)

 

 

 

Common Stock

 

Additional
Paid-In

 

Retained Earnings/
(Accumulated

 

 

 

 

 

Shares

 

Amount

 

Capital

 

Deficit)

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at January 3, 2004

 

53,655

 

$

537

 

$

103,029

 

$

(11,365

)

$

92,201

 

Exercise of common stock options

 

1,525

 

 

15

 

 

4,428

 

 

 

 

4,443

 

Exercise of common stock warrants

 

53

 

 

1

 

 

4

 

 

 

 

5

 

Tax benefit from equity compensation

 

 

 

 

 

4,641

 

 

 

 

4,641

 

Repurchases of common stock

 

(1,707

)

 

(17

)

 

(20,836

)

 

 

 

(20,853

)

Issuances of common stock

 

216

 

 

2

 

 

2,350

 

 

 

 

2,352

 

Net income

 

 

 

 

 

 

 

31,555

 

 

31,555

 

Balance at January 1, 2005

 

53,742

 

 

538

 

 

93,616

 

 

20,190

 

 

114,344

 

Exercise of common stock options

 

1,458

 

 

15

 

 

6,967

 

 

 

 

6,982

 

Exercise of common stock warrants

 

1,772

 

 

18

 

 

(9

)

 

 

 

9

 

Tax benefit from equity compensation

 

 

 

 

 

3,758

 

 

 

 

3,758

 

Repurchases of common stock

 

(3,653

)

 

(37

)

 

(49,690

)

 

 

 

(49,727

)

Issuances of common stock

 

279

 

 

2

 

 

2,212

 

 

 

 

2,214

 

Net income

 

 

 

 

 

 

 

43,767

 

 

43,767

 

Balance at December 31, 2005

 

53,598

 

 

536

 

 

56,854

 

 

63,957

 

 

121,347

 

Exercise of common stock options

 

1,544

 

 

15

 

 

7,495

 

 

 

 

7,510

 

Exercise of common stock warrants

 

75

 

 

1

 

 

 

 

 

 

1

 

Tax benefit from equity compensation

 

 

 

 

 

9,769

 

 

 

 

9,769

 

Stock-based compensation

 

 

 

 

 

8,325

 

 

 

 

8,325

 

Repurchases of common stock

 

(3,889

)

 

(39

)

 

(79,700

)

 

 

 

(79,739

)

Issuances of common stock

 

216

 

 

2

 

 

1,296

 

 

 

 

1,298

 

Net income

 

 

 

 

 

 

 

47,183

 

 

47,183

 

Balance at December 30, 2006

 

51,544

 

$

515

 

$

4,039

 

$

111,140

 

$

115,694

 

 

 

See accompanying notes to consolidated financial statements.

 



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Table of Contents

SELECT COMFORT CORPORATION
AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

Years ended December 30, 2006, December 31, 2005 and January 1, 2005

(in thousands)

 

 

 

2006

 

2005

 

2004

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

 

Net income

 

$

47,183

 

$

43,767

 

$

31,555

 

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

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

19,684

 

 

15,747

 

 

13,643

 

Stock-based compensation

 

 

8,325

 

 

793

 

 

405

 

Disposals and impairments of assets

 

 

5,912

 

 

172

 

 

11

 

Excess tax benefits from stock-based compensation

 

 

(8,565

)

 

 

 

 

Changes in deferred income taxes

 

 

(7,665

)

 

(1,353

)

 

(4,032

)

Change in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(5,930

)

 

(397

)

 

(1,042

)

Inventories

 

 

(2,138

)

 

(1,501

)

 

(6,371

)

Prepaid expenses and other assets

 

 

(823

)

 

(3,506

)

 

(2,492

)

Accounts payable

 

 

6,091

 

 

5,388

 

 

9,765

 

Customer prepayments

 

 

(5,166

)

 

5,350

 

 

3,398

 

Accrued sales returns

 

 

(1,496

)

 

365

 

 

1,569

 

Accrued compensation and benefits

 

 

(4,782

)

 

10,926

 

 

(3,390

)

Accrued taxes and withholding

 

 

5,198

 

 

6,990

 

 

7,372

 

Warranty liabilities

 

 

2,574

 

 

3,805

 

 

(418

)

Other accruals and liabilities

 

 

974

 

 

952

 

 

2,509

 

Net cash provided by operating activities

 

 

59,376

 

 

87,498

 

 

52,482

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(31,079

)

 

(25,840

)

 

(21,399

)

Investments in marketable securities

 

 

(28,072

)

 

(39,172

)

 

(72,540

)

Proceeds from maturity of marketable securities

 

 

25,940

 

 

36,625

 

 

46,256

 

Net cash used in investing activities

 

 

(33,211

)

 

(28,387

)

 

(47,683

)

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

 

Net (decrease) increase in short-term borrowings

 

 

(1,388

)

 

784

 

 

10,220

 

Repurchases of common stock

 

 

(77,199

)

 

(49,727

)

 

(20,853

)

Proceeds from issuance of common stock