SELECT COMFORT CORPORATIONFORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 29, 2007

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 29, 2007

 

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.)

 

 

 

9800 59th Avenue 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. x

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, 2007, was $732,000,000 (based on the last reported sale price of the Registrant’s common stock on that date as reported by NASDAQ).

 

As of January 26, 2008, there were 44,622,344 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 29, 2007 (the “Annual Report to Shareholders”) or (b) the Proxy Statement for the Registrant’s 2008 Annual Meeting of Shareholders to be held on May 14, 2008 (the “Proxy Statement”), a definitive copy of which will be filed within 120 days of Registrant’s 2007 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 – 21 of this document

 

 

 

 

 

Item 1B.

 

Unresolved Staff Comments

 

Unresolved Staff Comments, page 21 of this document

 

 

 

 

 

Item 2.

 

Properties

 

Properties, page 22 of this document

 

 

 

 

 

Item 3.

 

Legal Proceedings

 

Legal Proceedings, page 23 of this document

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

Submission of Matters to a Vote of Security Holders, page 23 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 24-26 of this document

 

 

 

 

 

Item 6.

 

Selected Financial Data

 

Selected Consolidated Financial Data, page 27 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 28-39 of this document

 

 

 

 

 

Item 7A.

 

Quantitative and Qualitative Disclosures about Market Risk

 

Quantitative and Qualitative Disclosure about Market Risk, page 39 of this document

 

 

 

 

 

Item 8.

 

Financial Statements and Supplementary Data

 

Pages 40-61 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 62 of this document

 

 

 

 

 

Item 9A.

 

Controls and Procedures

 

Controls and Procedures; Management’s Report on Internal Control over Financial Reporting set forth on page 62 of this document

 

 

 

 

 

Item 9B.

 

Other Information

 

Other Information, page 62 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, page 10 of this document; Directors, Executive Officers and Corporate Governance, page 63 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

 

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

 

 

 

 

 

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

Corporate Governance in the Proxy Statement

 

 

 

 

 

Item 14.

 

Principal Accounting 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
64-65 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®, The Sleep Number Store by Select Comfort (logo)®, You can only find your Sleep Number® setting on a Sleep Number Bed by Select Comfort™, Select Comfort Creator of the Sleep Number Bed®, What’s Your Sleep Number® setting?, 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. Our fiscal year ended January 3, 2009 will have 53 weeks.

 

 

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TABLE OF CONTENTS

 

PART I

2

 

 

 

 

 

Item 1.

Business

2

 

 

 

 

 

Item 1A.

Risk Factors

12

 

 

 

 

 

Item 1B.

Unresolved Staff Comments

21

 

 

 

 

 

Item 2.

Properties

22

 

 

 

 

 

Item 3.

Legal Proceedings

23

 

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

23

 

 

 

 

PART II

24

 

 

 

 

 

Item 5.

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

24

 

 

 

 

 

Item 6.

Selected Financial Data

27

 

 

 

 

 

Item 7.

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

28

 

 

 

 

 

Item 7A.

Quantitative and Qualitative Disclosure about Market Risk

39

 

 

 

 

 

Item 8.

Financial Statements and Supplementary Data

40

 

 

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

62

 

 

 

 

 

Item 9A.

Controls and Procedures

62

 

 

 

 

 

Item 9B.

Other Information

62

 

 

 

 

PART III

63

 

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

63

 

 

 

 

 

Item 11.

Executive Compensation

63

 

 

 

 

 

Item 12.

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

63

 

 

 

 

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

63

 

 

 

 

 

Item 14.

Principal Accounting Fees and Services

63

 

 

 

 

PART IV

64

 

 

 

 

 

Item 15.

Exhibits, Financial Statement Schedules

64

 

 

 

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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 mattresses. Select Comfort has evolved from a specialty, niche direct marketer, to a nationwide multi-channel business with fiscal 2007 net sales of $799 million.

 

Our principal business is to develop, manufacture, market and distribute premium quality, adjustable-firmness beds and other sleep-related accessory products. 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 have a mission-driven culture focused on serving the needs of our customers. Our mission is to improve people’s lives through better sleep. Our goal is to educate our consumers on the importance of a better night’s sleep and the unique benefits of our products.

 

In 1998, Select Comfort became a publicly-traded company and is 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

 

The unique benefits of our proprietary Sleep Number bed have been validated through clinical sleep research. Clinical sleep research has shown that people who sleep on a Sleep Number bed generally 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. Our dual chamber technology (two independent air chambers) allows consumers to adjust the firmness on both sides of the bed to meet each person’s individual

 

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preference. Our clinical research has shown that our bed’s sleep surface generally provides better sleep quality and greater relief of back pain in comparison with traditional innerspring mattress products.

 

Distinctive Brand 

 

In 2001, we created the Sleep Number brand. This branding strategy allows our marketing communications to focus on our bed’s distinguishing and proprietary features – adjustable firmness and support for personalized comfort. This is 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® setting represents an ideal level of mattress comfort, firmness and support; and

 

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

 

Controlled Selling Environment

 

Over 90% of our sales are generated through our company-controlled distribution channels – Retail, Direct Marketing and E-Commerce. Our nationwide chain of retail stores provides a unique mattress shopping experience and offers 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 and delivery of our products, 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 production process which requires minimal inventory in our stores and manufacturing plants, resulting in reduced working capital levels. This just-in-time production process also allows our stores to serve primarily as showrooms, without requiring significant product storage capacity.

 

Growth Strategy

 

For 2006, we ranked as the 5th largest mattress manufacturer according to the June 18, 2007 edition of Furniture/Today, with a 6% 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 13, 2007 edition of Furniture/Today. Our vision is to be a leading brand in the bedding industry.

 

Building Brand Awareness

 

Our most significant growth driver has been building brand awareness. 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 partners which increases awareness of our brand through media exposure, trial sales and word-of-mouth. These commercial partners 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 over 600 company-owned stores in the U.S. with annual square footage growth increasing by 5% to 7% per year. We supplement our company-controlled distribution channels with sales through a limited number of leading home furnishings and specialty bedding retailers.

 

In 2005, we expanded our distribution network outside the U.S. with a retail partner relationship in Canada. In 2007, the Canadian retail partner relationship grew to 127 doors. During 2007, we formed a strategic alliance with two Australian-based companies to manufacture and distribute Sleep Number beds and accessories in Australia and New Zealand.

 

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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. During 2007, we upgraded our entire line of bed models. We believe the new line represents the highest-quality, most technologically advanced beds we have ever produced. Our top-end 7000 and 9000 models were re-launched in June 2007. The new versions of our 3000, 4000 and 5000 models were introduced to all of our stores in July 2007. All of our new models emphasize enhanced comfort-layer materials, and several feature advancements in temperature balancing technology. Our 2008 innovation plans include the launch of two new mattress models which will fill in key price points in our product line-up and provide easier step-up opportunities for our sales professionals.

 

Leveraging our Infrastructure

 

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 second half of 2008, optimization of our new hub and spoke network, value engineering, marketing and sales initiatives, and a Six Sigma initiative to improve product and service quality.

 

Our Products

 

Mattress Sets

 

At the end of 2007, we offered five different Sleep Number bed models through our U.S. 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, additional cushion and padding, higher overall mattress profiles, quieter Firmness Control Systems with additional functions, temperature balancing fabrics, 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 U.S. mattress price points range from approximately $1,000 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 which sells for approximately $2,000. These prices are subject to 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 (not including our Precision Comfort adjustable foundation) comes 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 completely satisfied with the bed. The customer is responsible for the return shipping costs. Independent durability testing has shown our Sleep Number beds can 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

 

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sleepers. We also market our Personal Warmth Collection™, a group of comforters and blankets designed to be warmer on one half of the bed than the other, accommodating varying warmth preferences among couples.

 

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 in selected U.S. markets. The Sleep Number SofaBed features a queen-size Sleep Number mattress inside a 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 net 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 75% of our net sales in 2007. Average net sales per company-owned store were $1,318,000 in 2007 versus $626,000 in 2001, with average sales per square foot of $1,024 in 2007 versus $666 in 2001. New stores are expected to average in excess of $1,000,000 in net sales in the first year of operations. In 2007, 73% 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 net sales in 2007. 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. At the end of 2007, our retail program included 10 retail partners in the U.S. and Canada with a total of 891 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.

 

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 look to our direct response advertising on national cable TV as an economical means to generate leads for our stores. Through our dedicated call center, we are able to provide the inquiring consumer more information or send a video and brochure. Our total media spending was approximately $110 million in 2007, $105 million in 2006, and $89 million in 2005.

 

Owners of Sleep Number beds purchased through company-controlled channels are members of our Comfort Club, our customer loyalty program designed primarily to increase referrals and repeat purchases. 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 2007, approximately 36,000 new customers bought beds after receiving referrals from our Comfort Club members, and existing owners bought approximately 32,000 additional beds.

 

Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Money Bank. Approximately 44% of our net sales during 2007 were financed by GE Money Bank. In 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 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

 

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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 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. 

 

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 currently 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. However, we believe we can obtain these raw materials and components from other sources of supply in the ordinary course of business, if necessary.

 

Our proprietary air chambers are produced to our specifications by a sole source 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 a single domestic supplier under an agreement that expires in December 2010. 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 2007 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 2007, we continued improving our home delivery efficiency and service by consolidating over 100 individually managed cross-dock distribution locations into a new Hub and Spoke network organized around 13 regional hubs. Twelve of 13 hubs were operational as of December 2007.

 

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 segment these issues, implement immediate solutions and provide inputs for long-term improvements to product and service design.

 

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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 new bed models, a quieter Firmness Control System, remote controls with digital settings, more luxurious fabrics and covers, new generations of foams and foundation systems. Our research and development expenses were $5.7 million in 2007, $4.7 million in 2006, and $2.2 million in 2005.

 

Information Systems

 

We use information technology systems to operate, 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 various software vendors and internally developed programs. Our production data center and E-Commerce Web site have recently been relocated to our new state-of-the-art corporate headquarters with redundant environmental systems. We maintain a disaster recovery plan that is tested annually.

 

During the second half of fiscal 2008, we plan on implementing an integrated suite of SAP®-based applications, including enterprise resources planning, retail store, customer relationship management, human capital management, strategic enterprise management, business intelligence and enterprise portal systems to replace most of our current systems. We believe this SAP® -based IT architecture, along with best-practices-based processes and greater utilization of off-the-shelf, highly integrated packaged solutions with minimal customization and enhancement, will provide greater flexibility and functionality for our growing and evolving business model and be less expensive to maintain over the long-term.

 

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 March 2009 and June 2022, and five U.S. patent applications pending. We also hold 31 foreign patents and 9 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.

 

Industry and Competition

 

The U.S. bedding manufacturing industry is a mature and stable industry. According to the 2006 Annual Report by the International Sleep Products Association (ISPA), industry wholesale shipments of mattresses and foundations were estimated to be $6.8 billion in 2006, a 5% increase compared to $6.5 billion in 2005. We estimate that traditional innerspring mattresses represent approximately 77% of total U.S. bedding sales. Furniture/Today, a furniture industry trade publication, has ranked Select Comfort as the largest U.S. bedding retailer for seven consecutive years, most recently in its August 13, 2007 issue.

 

According to the 2006 Annual Report by ISPA, 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 2006, the value of U.S. wholesale bedding shipments increased at compound annual growth rates of 8.1%, 7.3% and 6.5%, respectively. We believe that industry unit growth has been primarily driven by population growth, and an increase in the number of homes

 

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(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 fragmented and very 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 three largest manufacturers of innerspring bedding with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand name, Serta, and Simmons. 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 state consumer protection and other regulations relating to the bedding industry. These regulations vary among the jurisdictions in which we do business, but generally impose requirements as to the proper labeling of bedding merchandise.

 

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 other states do not allow the sale of refurbished bedding products.

 

The bedding industry is subject to federal fire retardancy standards developed by the U.S. Consumer Product Safety Commission, which became effective nationwide in July 2007. Compliance with these requirements has increased the cost and complexity of manufacturing our products, potentially reducing our manufacturing capacity. These regulations also result in higher product development costs as new products must undergo rigorous flammability testing.

 

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, limiting our ability to market our products directly to consumers over the telephone, by e-mail or by regular mail.

 

We are subject to emerging federal, state and foreign data privacy regulations related to the safeguarding of sensitive customer and employee data, which may limit our ability to maintain or use consumer or customer information in our business.

 

We are subject to 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.

 

We are subject to federal and state laws and regulations relating to 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, Australia, New Zealand 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.

 

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 2007, 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 net sales, and the loss of any one customer would not have a material impact on our business.

 

Seasonality

 

Our business is modestly impacted by seasonal influences inherent in the U.S. bedding industry and general retail shopping patterns. The U.S. bedding industry generally experiences lower sales in the second quarter and increased sales during selected holiday or promotional periods.

 

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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 or indirect marketing 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. However, we may elect to seek additional sources of capital to fund growth initiatives, or if a prolonged or more severe economic downturn impacts our ability to meet our financial covenants.

 

Employees

 

At December 29, 2007, we employed 3,247 persons, including 1,691 retail sales and support employees, 214 direct marketing and customer service employees, 1,007 manufacturing and logistics employees, and 335 management and administrative employees. Approximately 190 of our employees were employed on a part-time basis at December 29, 2007. 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 are 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, 51, joined our company in March 2000 as President and Chief Executive Officer. Mr. McLaughlin also served as Chairman of our Board of Directors from May 2004 to February 2008. 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.

 

Catherine B. Hall, 46, joined Select Comfort as Senior Vice President and Chief Marketing Officer in November 2007. From 2005 to 2007, she served as Vice President, Marketing Programs and Advertising for Midas International, a provider of automotive services. From 2004 to 2005, Ms. Hall served as Midas International’s Director, Marketing Programs and Advertising. From 2001 to 2004, Ms. Hall served as Senior Vice President and Group Account Director for BBDO Chicago, an advertising agency. From 2000 to 2001, Ms. Hall was a Group Account Director at Agency.com, an internet strategy and web development firm. From 1987 to 2000, Ms. Hall held successive positions with Leo Burnett Company, a marketing communications company, most recently as Vice President, Account Director.

 

Shelly R. Ibach, 48, joined Select Comfort as Senior Vice President, U.S. Sales - Company Owned Channels in April 2007. From 1982 to 2007, she held various leadership positions within Macy’s North, formerly Marshall Field’s Department Stores - Target Corporation. From 2004 to 2007, Ms. Ibach served as Senior Vice President and General Merchandise Manager for the Home division, within Macy’s North. Other key positions included Vice President - Divisional Merchandise Manager, Director of Planning and Regional Director of Stores.

 

Mark A. Kimball, 49, 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, 55, 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. Mr. Park announced his plans to leave the company effective as of February 29, 2008.

 

Scott F. Peterson, 48, 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, 47, 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, 47, 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, 41, 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. In February 2008, Ms. Schoppert also assumed the responsibilities of Chief Information Officer for the company.

 

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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

9800 59th Avenue North

Minneapolis, MN 55442

 




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ITEM 1A. RISK FACTORS

 

Our future growth and profitability will depend on a number of factors.

 

After more than five consecutive years of growth in both sales and profitability through fiscal 2006, our sales and profitability declined in 2007 versus the prior year. We may not be able to regain growth in sales or growth in 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:

 

Marketing Effectiveness and Efficiency -- 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;

 

Consumer Acceptance -- the level of consumer acceptance of our products, new product offerings and brand image;

 

Need for Continuous Product Improvement -- our ability to continuously improve our products to offer new and enhanced consumer benefits, better quality and reduced costs;

 

Competition -- 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;

 

Execution of Our Retail Distribution Strategy -- 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;

 

International Growth -- our ability to cost-effectively execute plans to expand our distribution internationally;

 

Consumer Credit – the availability of consumer credit and our ability to provide cost-effective consumer credit options;

 

Sources of Supply -- 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;

 

Inflationary Pressures -- rising fuel and commodity costs, as well as fluctuating currency rates and increasing industry regulatory requirements, which may increase our cost of goods and may adversely impact our profitability or our ability to maintain sales volumes to the extent that we choose to increase prices;

 

Impact of Federal Flame Retardancy Standards -- new federal flame retardancy standards for mattress products effective since mid-2007, which have added compliance costs to our business and have added risks of non-compliance, which could disrupt our business;

 

Management Information Systems -- our current management information systems, which may not adequately meet the requirements of our evolving business, and our ability to successfully implement our planned SAP®-based enterprise-wide information technology architecture;

 

Retention of Senior Leadership and other Key Employees -- our ability to retain senior leadership and other key employees, including qualified retail store management and sales professionals, in the wake of recent business performance that has not met our expectations;

 

General Economic Conditions and Consumer Confidence -- adverse trends in general economic conditions, including in particular the housing market, retail trends and consumer confidence, and the possibility of an economic recession; and

 

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

 

We may not be successful in executing our growth strategy or in regaining growth in sales or growth in profitability. Failure to successfully execute any material part of our strategic plan or growth strategy could harm our sales, profitability and financial condition.

 

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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 $110 million in 2007, $105 million in 2006, $89 million in 2005, $79 million in 2004, and $60 million in 2003) in generating consumer awareness and sales of our products. In recent periods, including in particular 2007, our marketing messages have not been as effective as in prior periods. If our marketing messages are ineffective or our advertising expenditures and other marketing programs are inefficient in creating awareness of our products and brand name, driving consumer traffic to our points of distribution and motivating consumers to purchase our products, our sales, profitability and financial condition may be 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 sales, profitability and financial condition.

 

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. 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. In addition, consumers or others may post negative information regarding our products or our company on internet sites or blogs, which could 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, sales, profitability and financial condition may be 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 sales, profitability and financial condition could be adversely affected.

 

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

 

We estimate that innerspring mattress sales represent approximately 77% or more 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 harm our sales, profitability 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 regain growth in sales or growth in 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

 

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and marketing. Any failure to continue to develop and market enhanced or new products in a cost-effective manner could harm our ability to regain growth in sales or growth in profitability.

 

The mattress industry is highly competitive. Our business could be 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 three largest manufacturers of innerspring mattresses with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand, Serta and Simmons. 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 three largest innerspring mattress manufacturers and Tempur-Pedic, 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-controlled 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 harm our sales, profitability and financial condition.

 

Our future growth and profitability will depend in large part upon our ability to execute our retail store distribution strategy, including increasing sales and profitability through our existing company-controlled stores, which carry significant fixed costs. If we are unable to regain growth in sales through our company-controlled stores, we may be required to incur significant costs to close underperforming stores, which could harm our profitability and financial condition.

 

Our company-controlled retail store distribution channel is our largest distribution channel and represents our largest opportunity for growth in sales and profitability. After several years of consistent growth in comparable-store sales results through fiscal 2006, in 2007 we experienced a decline of 11% in our comparable stores sales versus 2006. 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;

 

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

 

Consumer shopping trends, including mall traffic and internet shopping trends;

 

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

 

The level and effectiveness of competitive activity;

 

The availability of cost-effective consumer credit options through our third-party providers;

 

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

 

General economic conditions, including in particular the housing market, retail trends and consumer confidence; and

 

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

 

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Future fluctuations or decreases in our comparable-store sales or other operating results could harm our sales, profitability and financial condition. We may also be required to incur significant costs to close underperforming stores if we are unable to regain growth in sales through our company-controlled stores. In addition, failure to regain growth in comparable-store sales or other operating results may disappoint securities analysts or investors and result in a decline in our stock price.

 

We may seek to obtain additional capital, which could adversely impact our profitability and financial condition, or which could be dilutive to our shareholders.

 

As of December 29, 2007, we had cash, cash equivalents and marketable debt securities of $7.3 million and $37.9 million in outstanding borrowings against our $100 million line of credit. We currently expect cash generated from operations and our existing credit facility provide sufficient liquidity for our operating and capital needs. However, a severe or prolonged downturn in macroeconomic factors or in our operating results may affect our ability to maintain compliance with financial covenants under our credit facility, potentially impacting our cost of borrowings and the availability of funds under the credit facility. In such an event, we may need to seek additional capital through the issuance of debt or equity securities. Alternatively, we may elect to seek additional capital through the issuance of debt or equity securities to fund strategic growth initiatives, or in anticipation of a deeper, more prolonged downturn in our business, whether due to macroeconomic factors or otherwise. The issuance of any additional debt could adversely impact our profitability and financial condition. The issuance of additional equity securities could be dilutive to our existing shareholders.

 

We are highly dependent on discretionary consumer spending. Adverse trends in general economic conditions, including in particular the housing market, retail shopping patterns and consumer confidence, and the possibility of an economic recession, may adversely affect our sales, profitability and financial condition.

 

The success of our business models depends to a significant extent upon discretionary consumer spending, which is subject to a number of factors, including without limitation general economic conditions, consumer confidence, the housing market, employment levels, business conditions, interest rates, availability of credit, inflation and taxation. Adverse trends in any of these economic indicators may adversely affect our sales, profitability and financial condition. Also, because a high percentage of our net sales are made on credit, any adverse impact on the availability of consumer credit or any increase in interest rates may adversely affect our sales, profitability and financial condition. We are also dependent upon the continued popularity of malls as shopping destinations and the ability of mall anchor tenants and other attractions to generate customer traffic for our retail stores. Any decrease in mall traffic could adversely affect our sales, profitability and financial condition.

 

We have established wholesale relationships with a limited number of mattress retailers and with the QVC shopping channel. These relationships may not yield the benefits we expect and may adversely impact sales through our company-controlled distribution channels. The loss of a significant wholesale account or the loss of distribution through QVC could adversely impact our sales, profitability and financial condition.

 

An important element of our growth strategy has been expansion of profitable distribution through our existing company-controlled distribution channels and by increasing opportunities for consumers to become aware of, and to purchase, our products through additional points of distribution. We have only recently established wholesale relationships with a limited number of mattress retailers and with 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. The gross margin from wholesale sales is also less than the gross margin we generate in our company-controlled channels. The loss of a significant wholesale account or the loss of distribution through QVC could adversely impact our sales, profitability and financial condition.

 

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 and financial condition.

 

Our business is subject to some seasonal influences, with typically lower sales in the second quarter, and increased sales during selected holiday or promotional periods. 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 sales, profitability and financial condition may be harmed.

 

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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 harm our sales, profitability 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. Return rates may not remain within acceptable levels. An unexpected increase in return rates could harm our sales, profitability and financial condition. We also provide our customers with a 20-year limited warranty on our beds. We may receive significant and unexpected claims under these warranty obligations that could exceed our warranty reserves. Warranty claims in excess of our warranty reserves could harm our profitability 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 an independent retailer. In late 2007 we entered into relationships with an Australian-based manufacturer and an Australian-based retailer to begin distribution of Sleep Number beds in Australia and New Zealand. We plan to pursue distribution of our products in some other foreign countries in the near future. 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 harm our sales, profitability 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 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 harm our profitability 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 generally 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, which could harm our profitability and financial condition. 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.

 

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We rely upon several key suppliers that are, in some instances, the only source of supply currently used by the company for particular materials or components. The failure of one or more of these suppliers or our other key suppliers to supply materials or components for our products on a timely basis, or a material change in the purchase terms for the materials or components, could harm our sales, profitability and financial condition.

 

We currently obtain all of the materials and components used to produce our beds from outside sources. In several cases, including our proprietary air chambers, our proprietary blow-molded foundations, the wood foundations sold to our wholesale and hospitality channels, our adjustable foundations, various components for our Firmness Control Systems, as well as fabrics and zippers, we have chosen to obtain these materials and components from suppliers who serve as the only source of supply used by the company at this time. While we believe that these materials and components, or suitable replacements, could be obtained from other sources of supply, in the event that any of the company’s current suppliers became unable to supply the relevant materials or components for any reason, and alternatives were not readily available from other sources of supply, our sales, profitability and financial condition could be harmed. 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 purchase some of our materials and components through purchase orders and do not have long-term purchase agreements with, or other contractual assurances of continued supply, pricing or access from, our suppliers, except for the suppliers of our air chambers, blow-molded foundations, foam, circuit boards and various components used for our covers, including fiber, fabrics, thread and tick. If prices for our key materials or 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 profitability and financial condition may be harmed. The loss of one or more of our key suppliers, the failure of one or more of our key suppliers to supply materials or components on a timely basis, or a material change in the purchase terms for our components could harm our sales, profitability and financial condition.

 

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

 

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. To the extent we are unable to offset any such increased costs through value engineering and similar initiatives underway, or through price increases, our profitability and financial condition may be adversely impacted. If we choose to increase prices to offset the increased costs, our unit sales volumes could be adversely impacted.

 

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 harm our sales, profitability and financial condition.

 

Since our air chambers and some of our other components are manufactured outside the United States, our operations could be 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;

 

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 harm our sales, profitability 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 adversely affect our sales, profitability and financial condition.

 

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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 sales, profitability and financial condition.

 

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 sales, profitability and financial condition.

 

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 sales, profitability and financial condition.

 

In December 2005 we entered into an amended and restated agreement under which GE Money Bank offers our qualified customers a revolving credit arrangement to finance purchases from us. This agreement extends 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. 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.

 

Approximately 44% of our net sales during 2007 were financed by GE Money 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 sales, profitability 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 second half of 2008 and we expect to incur significant increases in expenses and capital expenditures 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 harm our sales, profitability 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 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 adversely impact our business, reputation, sales, profitability and financial condition.

 

We have recently undertaken plans to implement an integrated suite of SAP®-based applications including enterprise resources planning, retail store, customer relationship management, human capital management, strategic enterprise management, business intelligence and enterprise portal systems to replace most of our current systems. We believe this SAP®-based IT

 

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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 harm our sales, profitability and financial condition.

 

We are subject to a wide variety of government regulations. Any failure to comply with any of these regulations could harm our business, reputation, sales, profitability and financial condition. 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;

 

Environmental regulations;

 

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 profitability and financial condition. 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 adversely impact our business, reputation, sales, profitability and financial condition.

 

All mattresses and mattress and foundation sets, including ours, became subject to new federal flammability standards and related regulations in July 2007. Compliance with these regulations has increased our product costs, has required 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 adopted a new flammability standard and related regulations which became effective nationwide in July 2007 for mattresses and mattress and foundation sets. Compliance with these requirements has resulted in higher materials and manufacturing costs for our products, and has required modifications to our information systems and business operations, further increasing our costs. To the extent we are unable to offset increased costs through

 

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value engineering and similar initiatives, or through price increases, our profitability may be adversely impacted. If we choose to increase prices to offset the increased costs, our unit sales volumes could be adversely impacted.

 

Compliance also requires more complicated manufacturing processes, which may reduce our manufacturing capacity and may require us to expand our manufacturing capacity sooner than otherwise anticipated.

 

The new regulations require manufacturers to implement quality assurance programs 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 are 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 harm our business, reputation, sales, profitability 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 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, profitability and financial condition.

 

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 sales, profitability and financial condition.

 

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

 

We are currently dependent upon the continued services, ability and experience of our executive management team, particularly William R. McLaughlin, our Chief Executive Officer. The loss of the services of Mr. McLaughlin or any other member of our executive management team could have an adverse effect on our ability to execute our business strategy and growth initiatives and on our sales, profitability 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 adversely impact our sales, profitability, financial condition 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 an adverse impact on our sales, profitability and financial condition, and may result in volatility of our stock price.

 

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 adversely impact on our profitability and financial condition. Similarly, such events could adversely impact consumer confidence and consumer demand generally, which could adversely impact our sales, profitability and financial condition.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 





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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 seven 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 478 company-owned stores and 891 retail partner doors as of December 29, 2007:

 

 

Company-

Retail

 

 

 

Company-

Retail

 

Owned

Partner

 

 

 

Owned

Partner

 

Stores

Doors

 

 

 

Stores

Doors

Alabama

5

-

 

 

Montana

3

2

Alaska

-

3

 

 

Nebraska

3

4

Arizona

10

39

 

 

Nevada

4

17

Arkansas

4

-

 

 

New Hampshire

4

-

California

54

149

 

 

New Jersey

14

-

Colorado

15

1

 

 

New Mexico

2

-

Connecticut

7

16

 

 

New York

17

-

Delaware

2

-

 

 

North Carolina

13

36

Florida

32

50

 

 

North Dakota

2

7

Georgia

14

36

 

 

Ohio

18

21

Hawaii

-

8

 

 

Oklahoma

3

4

Idaho

1

-

 

 

Oregon

5

28

Illinois

23

3

 

 

Pennsylvania

21

2

Indiana

12

12

 

 

Rhode Island

1

-

Iowa

6

14

 

 

South Carolina

6

5

Kansas

5

7

 

 

South Dakota

2

10

Kentucky

4

1

 

 

Tennessee

11

15

Louisiana

5

5

 

 

Texas

38

152

Maine

2

-

 

 

Utah

4

-

Maryland

13

6

 

 

Vermont

1

-

Massachusetts

11

7

 

 

Virginia

13

1

Michigan

14

-

 

 

Washington

13

40

Minnesota

16

34

 

 

West Virginia

1

-

Mississippi

2

-

 

 

Wisconsin

10

15

Missouri

12

14

 

 

Wyoming

-

-

 

 

 

 

 

Canada

-

127

 

 

 

 

 

Total

478

891

 

Manufacturing and Headquarters

 

We entered into a lease agreement with a developer in July 2006, pursuant to which the developer built our new 159,000-square-foot corporate headquarters in Minneapolis, Minnesota. The new facility was completed during the second half of 2007. The lease commenced in November and runs through 2017 with two five-year renewal options.

 

We also lease approximately 122,000 square feet in Minneapolis, Minnesota that includes 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 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 2013, and the Salt Lake City facility through April 2009, with a five-year renewal option thereafter.

 

To support our accessories business and our program with Radisson Hotels and Resorts, we lease approximately 40,000 square feet in Omaha, Nebraska, through July 2008. This lease also has a one-year renewal option. 

 

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ITEM 3. LEGAL PROCEEDINGS

 

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, employment and intellectual property claims. In accordance with generally accepted accounting principles in the United States, we record a liability in our consolidated financial statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Beyond those matters for which we have recorded a liability, we believe that we have valid defenses to claims asserted against us and we do not expect the outcome of these matters to have a material effect on our results of operations or financial position. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our results of operations or financial position.

 

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

 

Not applicable.

 

 







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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 January 26, 2008, there were 171 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 2007

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High

 

$

14.75

 

 

$

18.00

 

 

$

19.03

 

 

$

20.17

 

 

Low

 

 

6.11

 

 

 

13.90

 

 

 

15.94

 

 

 

16.77

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High

 

$

25.25

 

 

$

24.28

 

 

$

28.52

 

 

$

27.50

 

 

Low

 

 

16.83

 

 

 

17.36

 

 

 

20.28

 

 

 

17.46

 

 

 

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 2007 is set forth below:

 

Fiscal Period

 

Total Number of
Shares
Purchased

 

Average Price
Paid per Share

 

Total Number of Shares
Purchased as Part of
Publicly Announced Plans
or Programs (1)

 

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

 

October 2007

 

 

 

 

 

 

 

 

 

 

November 2007

 

 

 

 

 

 

 

 

 

 

December 2007

 

 

 

 

 

 

$

206,762,000

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

___________________________

(1)

On April 20, 2007, our Board of Directors authorized the company to repurchase up to an additional $250 million of its common stock. The Finance Committee of the Board of Directors reviews repurchases under this program on a quarterly basis. There is no expiration date governing the period over which we can repurchase shares. As of January 26, 2008, the total outstanding authorization was $206.8 million. We may terminate or limit the stock repurchase program at any time.

 

 

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Table of Contents

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 28, 2002. 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


 

 

 

 

12/28/2002

 

1/3/2004

 

1/1/2005

 

12/31/2005

 

12/30/2006

 

12/29/2007

 

Select Comfort Corporation

 

$

100

 

$

273

 

$

198

 

$

302

 

$

288

 

$

119

 

S&P 400 Specialty Stores Index

 

 

100

 

 

136

 

 

160

 

 

168

 

 

189

 

 

157

 

The NASDAQ Stock Market (U.S.) Index

 

 

100

 

 

150

 

 

163

 

 

167

 

 

184

 

 

202

 

 

 

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Table of Contents

Securities Authorized for Issuance under Equity Compensation Plans

 

The following table summarizes information about our equity compensation plans as of December 29, 2007:

 

EQUITY COMPENSATION PLAN INFORMATION

  

Plan Category

 

Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights(1)

 

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

 

5,274,000

 

$12.40

 

1,570,000

 

 

 

 

 

 

 

 

 

Equity compensation plans not approved by security holders

 

None

 

Not applicable

 

None

 

 

 

 

 

 

 

 

 

Total

 

5,274,000

 

$12.40

 

1,570,000

 

 

________________________

(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 on Form 10-K. 

 

 

 

Year

 

 

 

2007

 

2006(1)

 

2005

 

2004

 

2003(2)

 

2002

 

Consolidated Statements of Operations Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

799,242

 

$

806,038

 

$

689,548

 

$

557,639

 

$

458,489

 

$

335,795

 

Gross profit

 

 

486,415

 

 

490,508

 

 

406,476

 

 

339,838

 

 

285,324

 

 

208,663

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

372,467

 

 

341,630

 

 

286,206

 

 

250,628

 

 

207,400

 

 

156,307

 

General and administrative

 

 

64,351

 

 

65,401

 

 

49,300

 

 

37,826

 

 

33,974

 

 

30,123

 

Research and development

 

 

5,682

 

 

4,687

 

 

2,219

 

 

1,853

 

 

1,295

 

 

936

 

Asset impairment charges

 

 

409

 

 

5,980

 

 

162

 

 

 

 

71

 

 

233

 

Operating income

 

 

43,506

 

 

72,810

 

 

68,589

 

 

49,531

 

 

42,584

 

 

21,064

 

Net income

 

$

27,620

 

$

47,183

 

$

43,767

 

$

31,555

 

$

27,102

 

$

37,466

 

Net income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.59

 

$

0.89

 

$

0.82

 

$

0.58

 

$

0.55

 

$

1.02

 

Diluted

 

 

0.57

 

 

0.85

 

 

0.76

 

 

0.53

 

 

0.46

 

 

0.72

 

Shares used in calculation of net income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

46,536

 

 

52,837

 

 

53,357

 

 

54,015

 

 

49,157

 

 

36,824

 

Diluted

 

 

48,292

 

 

55,587

 

 

57,674

 

 

59,525

 

 

58,916

 

 

51,798

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash, cash equivalents and marketable debt securities

 

$

7,279

 

$

90,175

 

$

123,091

 

$

101,963

 

$

75,118

 

$

40,824

 

Working capital

 

 

(70,000

 

5,637

 

 

10,158

 

 

23,479

 

 

53,972

 

 

27,064

 

Total assets

 

 

190,489

 

 

228,961

 

 

239,838

 

 

202,033

 

 

153,506

 

 

108,633

 

Long-term debt, less current maturities

 

 

 

 

 

 

 

 

 

 

 

 

2,991

 

Total shareholders’ equity

 

 

24,126

 

 

115,694

 

 

121,347

 

 

114,344

 

 

92,201

 

 

54,024

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Operating Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stores open at period-end(3)

 

 

478

 

 

442

 

 

396

 

 

370

 

 

344

 

 

322

 

Stores opened during period

 

 

45

 

 

51

 

 

40

 

 

31

 

 

27

 

 

15

 

Stores closed during period

 

 

9

 

 

5

 

 

14

 

 

5

 

 

5

 

 

21

 

Retail partner doors

 

 

891

 

 

822

 

 

353

 

 

89

 

 

77

 

 

71

 

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

 

$

1,318

 

$

1,493

 

$

1,417

 

$

1,247

 

$

1,101

 

$

817

 

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

 

 

73

%

 

81

%

 

77

%

 

64

%

 

49

%

 

24

%

Comparable-store sales (decrease) increase(5)

 

 

(11

%)

 

7

%

 

15

%

 

16

%

 

31

%

 

27

%

Average square footage per store open during period(4)

 

 

1,315

 

 

1,200

 

 

1,121

 

 

1,032

 

 

990

 

 

972

 

Net sales per square foot(4)

 

$

1,024

 

$

1,244

 

$

1,264

 

$

1,208

 

$

1,113

 

$

841

 

Average store age (in months at period end)

 

 

84

 

 

81

 

 

79

 

 

75

 

 

70

 

 

61

 

 

 

(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 and, accordingly, financial results for fiscal years prior to 2006 have not been restated. Stock-based compensation expense for fiscal 2007 and 2006 was $6,252 and $8,325, respectively. Prior to the adoption of SFAS No. 123R, we followed the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” to account for our 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 our 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, and 2003, respectively; and none in 2002.

 

(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 2007, 2006 and 2005; and 13 in 2004, 2003 and 2002).

 

(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 432, 391, 354, 339, 316 and 307 for 2007, 2006, 2005, 2004, 2003 and 2002, 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 uncertainties arising from general and industry economic trends, global events, consumer confidence, and the effectiveness of our marketing messages and efficiency of our advertising and promotional efforts; 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; our dependence on significant suppliers, and the vulnerability of any suppliers to recessionary pressures, labor negotiations, liquidity concerns or other factors; our dependence on the availability of consumer credit; rising commodity costs; increasing government regulations, including new flammability standards for the bedding industry and the ability to successfully implement our planned SAP®-based applications. Additional information concerning these and other risks and uncertainties is contained under the caption “Risk Factors” in this Annual Report on Form 10-K.

 

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

 

 

Overview

 

Results of Operations

 

Liquidity and Capital Resources

 

Outlook

 

Off-Balance-Sheet Arrangements and Contractual Obligations

 

Critical Accounting Policies and Estimates

 

Recent Accounting Pronouncements

 

Overview

 

Business 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 for consumers.

 

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 and through leading home furnishings retailers, specialty bedding retailers, the QVC shopping channel and to several end users such as Radisson Hotels and Resorts®. 

 

Vision and Strategy

 

Our vision is to be a leading brand in the bedding industry, while improving people’s lives through better sleep.

 

We are executing against a defined growth strategy which focuses on the following key components:

 

Building brand awareness and increasing store traffic through effective marketing programs;

 

Prudently managing our business in the current economic environment through disciplined controls over costs and cash;

 

Expanding distribution, primarily through our company-owned stores, with a long-term goal of operating over 600 company-owned stores in the U.S.;

 

Accelerating product innovation to lead the industry in innovative sleep products; and

 

Leveraging our infrastructure in order to facilitate long-term profitable growth.

 

 

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Table of Contents

Results of Operations

 

Fiscal 2007 Summary

 

Financial highlights for the fiscal year ended December 29, 2007 were as follows:

 

 

Net income totaled $27.6 million, or $0.57 per diluted share, compared with $47.2 million or $0.85 per diluted share in 2006.

 

 

Net sales decreased 1% to $799.2 million, compared with $806.0 million for the prior year, primarily due to an 11% comparable-store sales decline in our company-owned retail stores, partially offset by 36 net new company-owned retail stores opened in the past 12 months.

 

 

Our 2007 gross profit rate of 60.9% was consistent with the prior year. Increased manufacturing costs to comply with the new fire retardant product regulations and increased material costs for our new bed line, were offset by continued efficiency gains in manufacturing and logistics.

 

 

Sales and marketing expenses increased to 46.6% of net sales in 2007, compared with 42.4% of net sales for the prior year. The rate increase was driven by the deleveraging impact of an 11% comparable-store sales decrease.

 

 

General and administrative expenses declined $1.0 million compared with the prior year and remained consistent as a percentage of net sales.

 

 

Cash provided by operating activities in 2007 totaled $44.0 million, compared with $59.4 million for the prior year.

 

 

During 2007, we repurchased $131.9 million or 7.6 million shares of common stock (based on trade dates) compared with $79.7 million or 3.9 million shares in 2006.

 

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.

 

 

 

2007

 

2006

 

2005

 

 

 

$

 

% of
Net Sales

 

$

 

% of
Net Sales

 

$

 

% of
Net Sales

 

Net sales

 

$

799.2

 

100.0

%

$

806.0

 

100.0

%

$

689.5

 

100.0

%

Cost of sales

 

 

312.8

 

39.1

 

 

315.5

 

39.1

 

 

283.1

 

41.1

 

Gross profit

 

 

486.4

 

60.9

 

 

490.5

 

60.9

 

 

406.5

 

58.9

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

372.5

 

46.6

 

 

341.6

 

42.4

 

 

286.2

 

41.5

 

General and administrative

 

 

64.4

 

8.1

 

 

65.4

 

8.1

 

 

49.3

 

7.1

 

Research and development

 

 

5.7

 

0.7

 

 

4.7

 

0.6

 

 

2.2

 

0.3

 

Asset impairment charges

 

 

0.4

 

0.1

 

 

6.0

 

0.7

 

 

0.2

 

0.0

 

Total operating expenses

 

 

442.9

 

55.4

 

 

417.7

 

51.8

 

 

337.9

 

49.0

 

Operating income

 

 

43.5

 

5.4

 

 

72.8

 

9.0

 

 

68.6

 

9.9

 

Other (expense) income, net

 

 

 

 

 

3.0

 

0.4

 

 

2.2

 

0.3

 

Income before income taxes

 

 

43.5

 

5.4

 

 

75.8

 

9.4

 

 

70.8

 

10.3

 

Income tax expense

 

 

15.8

 

2.0

 

 

28.6

 

3.6

 

 

27.0

 

3.9

 

Net income

 

$

27.6

 

3.5

%

$

47.2

 

5.9

%

$

43.8

 

6.3

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2007

 

 

 

2006

 

 

 

2005

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.59

 

 

 

$

0.89

 

 

 

$

0.82

 

 

 

Diluted

 

 

0.57

 

 

 

 

0.85

 

 

 

 

0.76

 

 

 

Weighted-average number of common shares:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

46.5

 

 

 

 

52.8

 

 

 

 

53.4

 

 

 

Diluted

 

 

48.3

 

 

 

 

55.6

 

 

 

 

57.7

 

 

 

 

 

29



Table of Contents

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

 

 

 

2007

 

2006

 

2005

 

Retail

 

75.4%

 

76.2%

 

76.9%

 

Direct

 

8.0%

 

9.4%

 

10.8%

 

E-Commerce

 

6.8%

 

5.6%

 

5.0%

 

Wholesale

 

9.8%

 

8.8%

 

7.3%

 

Total

 

100.0%

 

100.0%

 

100.0%

 

 

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

 

 

 

2007

 

2006

 

2005

 

 

 

Channel
increase/ (decrease)

 

Channel
increase

 

Channel
increase

 

Comparable stores(1)

 

(11%)

 

7%

 

15%

 

Net new stores

 

9%

 

9%

 

7%

 

Retail total

 

(2%)

 

16%

 

22%

 

Direct

 

(16%)

 

1%

 

16%

 

E-Commerce

 

20%

 

31%

 

34%

 

Wholesale

 

11%

 

40%

 

54%

 

Total sales change

 

(1%)

 

17%

 

24%

 

 

(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 remain in the comparable-store base.

 

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

 

 

 

2007

 

2006

 

2005

 

Company-owned retail stores:

 

 

 

 

 

 

 

Beginning of year

 

442

 

396

 

370

 

Opened

 

45

 

51

 

40

 

Closed

 

(9

)

(5

)

(14

)

End of year

 

478

 

442

 

396

 

 

 

 

 

 

 

 

 

Retail partner stores

 

891

 

822

 

353

 

 

Comparison of 2007 and 2006

 

Net Sales

 

Net sales in 2007 decreased 1% to $799.2 million, compared with $806.0 million in 2006. The sales decrease was due to an 11% comparable-store sales decline in our company-owned retail stores and a decrease in direct channel sales, partially offset by sales from 36 net new company-owned retail stores opened in the past 12 months and sales growth in our E-Commerce and wholesale distribution channels. Total sales of mattress units decreased 1% compared to 2006, and the average selling price per bed (mattress sales only divided by mattress units) in our company-controlled channels was essentially flat at $1,694, while sales of other product and services increased by 2%.

 

The $6.8 million net sales decrease compared with 2006 was comprised of the following: (i) a $12.2 million decrease in direct marketing sales and (ii) an $11.6 million net decrease in sales from our company-owned retail stores, comprised of a $66.3 million decrease from comparable-stores and a $54.7 million increase from new stores, net of stores closed, partially offset by, (iii) a $9.0 million increase in E-Commerce sales and (iv) an $8.0 million increase in wholesale sales.

 

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Table of Contents

Gross Profit

 

The gross profit rate of 60.9% in 2007 was consistent with the prior year. The gross profit rate benefited from improvements in sourcing, manufacturing productivity and our ongoing implementation of a hub-and-spoke logistics network which reduced our cost of sales. The gross profit rate also benefited from a reduction in warranty costs per unit.

 

These items were offset by increased costs to comply with the new open flame fire retardancy standards which became effective for all products manufactured after July 1, 2007 and increased production costs associated with our new line of beds. In addition, the gross profit rate was negatively impacted by a sales mix shift to lower margin products which reduced the gross profit rate by approximately 0.4 percentage points (“ppt”).

 

Sales and Marketing Expenses

 

Sales and marketing expenses in 2007 increased to $372.5 million, or 46.6% of net sales, compared with $341.6 million, or 42.4% of net sales in 2006. The $30.9 million expense increase was primarily due to operating costs associated with 36 net new stores opened in the past 12 months, an increased use of promotional financing offers and increased media spending. The 4.2 ppt sales and marketing expense rate increase was primarily due to the deleveraging impact of an 11% comparable-store sales decline and the $30.9 million expense increase compared with the prior year. Total media spending increased 4% compared with 2006 and was 0.7 ppt higher on a rate basis.

 

General and Administrative Expenses

 

General and administrative (“G&A”) expenses decreased $1.0 million to $64.4 million in 2007, compared with $65.4 million in 2006, and remained consistent with the prior year on a rate basis. G&A expenses were favorably impacted by a $3.7 million reduction in incentive-based compensation costs compared to the prior year, partially offset by an increase in other expenses of $2.7 million, including increased information technology expenses and occupancy costs.

 

Research and Development

 

Research and development (“R&D”) expenses increased to $5.7 million in 2007 compared with $4.7 million in 2006, and increased as a percentage of net sales to 0.7% from 0.6%. The dollar and percentage of net sales increases in R&D expenses were the result of continued investment in new product innovation and increased development costs to comply with the new open flame fire retardancy standards. 

 

Asset Impairment Charges

 

Asset impairment charges decreased to $0.4 million in 2007, compared with $6.0 million in 2006. The 2007 asset impairment charges primarily related to assets at underperforming stores. The 2006 asset impairment charges included $5.4 million for abandoned software in connection with our decision to implement a new SAP® enterprise resource planning system, and $0.6 million related to assets at underperforming stores.

 

Other (Expense) Income, Net

 

Other expense was flat in 2007, compared with $3.0 million of other income in 2006. The $3.0 million decrease was driven by lower average cash and investment balances compared with 2006 which resulted in reduced interest income, increased interest expense from borrowings under our revolving line of credit to fund 2007 common stock repurchases and $0.3 million of net realized losses on the sales of marketable debt securities. 

 

Income Tax Expense

 

Income tax expense decreased to $15.8 million in 2007, compared with $28.6 million in 2006. The effective tax rate was 36.5% and 37.8% in 2007 and 2006, respectively. The lower effective tax rate in 2007 was primarily due to research and development income tax credits recognized in 2007 based on federal tax law changes, and increased tax benefit related to manufacturing deductions.

 

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Table of Contents

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.

 

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 our 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 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.

 

General and Administrative Expenses

 

General and administrative 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 No. 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.

 

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.

 

Other (Expense) Income, Net

 

Other income increased $0.8 million to $3.0 million in 2006 from $2.2 million in 2005. The increase in other income was primarily due to increased interest income resulting from higher interest rates on invested balances.

 

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Table of Contents

Income Tax Expense

 

Income tax expense increased $1.6 million to $28.6 million in 2006 from $27.0 million 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.

 

Liquidity and Capital Resources

 

The following table summarizes our cash, cash equivalents and marketable debt securities as of December 29, 2007, and December 30, 2006 ($ in millions):

 

 

 

December 29,

2007

 

December 30,

2006

 

Cash and cash equivalents

 

$

7.3

 

$

8.8

 

Marketable debt securities – current

 

 

 

 

37.7

 

Marketable debt securities – non-current

 

 

 

 

43.6

 

Total cash, cash equivalents and marketable debt securities

 

$

7.3

 

$

90.2

 

 

As of December 29, 2007, we had cash, cash equivalents and marketable debt securities of $7.3 million compared to $90.2 million as of December 30, 2006. The $82.9 million decrease in cash, cash equivalents and marketable debt securities was primarily due to $134.5 million of common stock repurchases (based on settlement dates) and $43.5 million of capital expenditures, partially offset by $44.0 million of cash provided by operating activities and a $45.2 million net increase in short-term borrowings.

 

The following table summarizes our cash flows for the fiscal year ended December 29, 2007, and December 30, 2006 ($ in millions):

 

 

 

Fiscal Year Ended

 

 

 

December 29,

2007

 

December 30,

2006

 

Total cash provided by (used in):

 

 

 

 

 

 

 

Operating activities

 

$

44.0

 

$

59.4

 

Investing activities

 

 

37.6

 

 

(33.2

)

Financing activities

 

 

(83.1

)

 

(61.2

)

Decrease in cash and cash equivalents

 

$

(1.5

)

$

(35.0

)

 

Cash provided by operating activities for the fiscal year ended December 29, 2007 and December 30, 2006 was $44.0 million and $59.4 million, respectively. The $15.4 million year-over-year decrease in cash from operations was comprised of a $19.6 million decline in net income and a $1.2 million decrease in cash from changes in operating assets and liabilities, partially offset by a $5.4 million increase in adjustments to reconcile net income to cash provided by operating activities. The year-over-year increase in adjustments to reconcile net income to cash provided by operating activities was primarily due to higher depreciation and amortization compared with 2006, and the reduced impact of excess tax benefits from stock-based compensation, partially offset by reduced asset impairments. The decrease in cash from changes in operating assets and liabilities was primarily due to a greater increase in inventories (increased accessories and component inventories), reduced benefit related to accrued taxes and withholding (timing of tax payments), and a current year decrease in warranty liabilities (reduced warranty costs per unit compared with the prior year), partially offset by a greater increase in accounts payable (timing of payments and extended terms) and a lower reduction in customer prepayments (timing of cash received on customer orders in advance of fulfillment).

 

Net cash provided by investing activities was $37.6 million for 2007, compared with net cash used in investing activities of $33.2 million in 2006. The $70.8 million increase in net cash provided by investing activities was principally due to $81.1 million of proceeds from the sales and maturity of marketable debt securities in 2007. We invested $43.5 million in property and equipment in 2007, compared with $31.1 million in 2006. In both periods, our capital expenditures related primarily to new and remodeled retail stores and investments in information technology. The year-over-year increase in capital expenditures was primarily due to additional costs related to our planned implementation of an integrated suite of SAP®-based applications in 2008. In 2007 we opened 45 new retail stores, while in 2006 we opened 51 new retail stores.

 

Net cash used in financing activities increased to $83.1 million in 2007, compared with $61.2 million in 2006. The $21.9 million increase in cash used in financing activities resulted from a $57.3 million year-over-year increase in common stock

 

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repurchases, a $7.1 million reduction in tax benefits from stock-based compensation, and a $4.2 million reduction in proceeds from the issuance of common stock related to stock options and employee stock purchases, partially offset by a $45.2 million net increase in short-term borrowings during the current-year to fund stock repurchases compared to a $1.4 million net reduction in short-term borrowings in 2006.

 

On April 20, 2007, our Board of Directors authorized us to repurchase up to an additional $250 million of our common stock. During 2007, we repurchased 7.6 million shares of common stock at a total cost of $134.5 million (based on settlement dates). In the third quarter of 2007, we curtailed our share repurchases following the tightening of credit markets and the continued deterioration in the general economic environment. We believe that returning to a debt-free balance sheet and maintaining the greatest level of flexibility to pursue actions that drive the long-term growth of the business are the best use of capital and the most prudent course of action at this time. As of December 29, 2007, the remaining authorization under our stock repurchase program was $207 million. There is no expiration date governing the period over which we can repurchase shares.

 

Cash generated from operations and existing credit facilities are expected to 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. However, we may elect to seek additional sources of capital to fund growth initiatives, or if a prolonged or more severe economic downturn impacts our ability to meet our financial covenants.

 

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. Effective February 1, 2008, we amended the Credit Agreement. Borrowings under the amended credit facility bear interest at a floating rate and may be maintained as base rate loans tied to the greater of the prime rate or the federal funds rate plus 0.6%, or as Eurocurrency rate loans tied to LIBOR, plus a margin up to 0.6% depending on our leverage ratio, as defined in our credit agreement. We are subject to certain financial covenants under the agreement, principally consisting of interest coverage and leverage ratios. At December 29, 2007, we were not in compliance with the minimum interest coverage ratio covenant requirement and obtained a waiver of the covenant from the lender. Effective February 1, 2008, we amended the Credit Agreement to revise the permissible minimum interest coverage ratio. As of December 29, 2007, we had $37.9 million in borrowings outstanding under the revolving line of credit.

 

Outlook

 

We do not plan to provide specific earnings guidance for 2008. However, we have outlined our key business drivers and trends, which we believe will assist investors and analysts in understanding and analyzing our business.

 

We are planning for no improvement in macro-economic conditions during 2008. Programs that we expect to partially offset the impact of negative market trends include the introduction of two new products, new store openings, a new media campaign, and the benefits of our new store design. We believe we can improve on execution, and anticipate we will receive the benefits of these programs in the second half of 2008.

 

2008 sales assumptions include the anticipated opening of 30 new stores and closing of 15 or more stores. Additionally, the company plans to remodel 50 stores. 2008 sales are projected to benefit from a price increase on select products that took effect in January 2008, higher contributions from international operations, and a 53rd week. Overall we expect negative sales growth in the first half of 2008, partially offset by positive growth in the second half of the year.

 

We project our gross margin rate to be flat to slightly lower in 2008 as compared to 2007. Rising commodity costs are projected to be largely offset by our pricing actions, but we anticipate that our product mix could remain weighted towards entry level models until the economy improves.

 

Sales and marketing expenses are projected to be somewhat higher in 2008. We plan to manage our marketing investment as a variable cost to sales, leaving marketing and media expenses flat to slightly lower than 2007. Store costs are projected to increase as we add stores during 2008 and recognize the full-year expense impact of stores added during 2007.

 

We expect general and administrative expenses to be slightly higher than 2007. While core personnel costs are being held essentially flat to 2007, we have restructured our bonus program with a payout based on both company and personal performance. The restructured bonus program allows eligible employees the opportunity to earn a bonus in this challenging economic environment. This program is expected to add approximately $6 million to 2008 G&A.

 

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Table of Contents

We expect an effective tax rate of approximately 38 percent for the year and a share count of approximately 46 million shares. Capital expenditures are projected to be approximately $32 million versus $43.5 million in 2007, with efforts focused on reducing working capital, primarily through inventory reduction. Included in our capital expenditures forecast for the year – in addition to new stores and store remodels – is $8 million for our SAP® implementation. This SAP® implementation is expected to reduce operating costs and improve our data analysis capabilities. 

 

Off-Balance Sheet Arrangements and Contractual Obligations

 

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(1)

 

 

 

Total

 

< 1 Year

 

1 – 3 Years

 

3 – 5 Years

 

> 5 Years

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term debt obligations

 

$

37,890

 

$

37,890

 

$

 

$

 

$

 

Operating leases

 

 

180,041

 

 

36,152

 

 

62,802

 

 

44,322

 

 

36,765

 

Purchase commitments

 

 

305,200

 

 

119,900

 

 

150,800

 

 

34,500

 

 

 

Total

 

$

523,131

 

$

193,942

 

$

213,602

 

$

78,822

 

$

36,765

 

(1)   Our unrecognized tax benefit liability of $97 thousand has not been included in the Contractual Obligations table as we are not able to determine a reasonable estimate of timing of the cash settlement with the respective taxing authorities.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). In connection with the preparation of our financial statements, we are required to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, sales, expenses and the related disclosure. 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. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.

 

Our significant accounting policies are discussed in Note 1, Business and Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Management believes the accounting policies discussed below are the most critical because they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and estimates and related disclosures with the Audit Committee of our Board.

 

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Table of Contents

Our critical accounting policies and estimates relate to asset impairment charges, stock-based compensation, self-insured liabilities, warranty liabilities and revenue recognition.

 

Description

 

 

Judgments and Uncertainties

 

Effect if Actual Results

Differ From Assumptions

Asset Impairment Charges

 

 

 

 

Long-lived assets other than goodwill and other intangible assets, which are separately tested for impairment, are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. 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.

 

Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted cash flows expected to be generated by the asset plus net proceeds expected from disposition of the asset (if any). When we recognize an impairment loss, the carrying amount of the asset is reduced to estimated fair value based on discounted cash flows, quoted market prices or other valuation techniques.

 

Assets to be disposed of are reported at the lower of the carrying amount of the asset or fair value less costs to sell. We review store assets for potential impairment based on historical cash flows, lease termination provisions and expected future store operating results.

 

If we recognize an impairment loss, the adjusted carrying amount of the asset becomes its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset.

 

Asset impairment charges totaled $409,000, $5,980,000, and $162,000, respectively, for 2007, 2006 and 2005.

 

Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to identify events or changes in circumstances indicating the carrying value of assets may not be recoverable, estimate future cash flows, estimate asset fair values, and select a discount rate that reflects the risk inherent in future cash flows.

 

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.

 

We have not made any material changes in our impairment loss assessment methodology during the past three fiscal years.

 

We do not believe there is a reasonable likelihood that there will be a material change in the identification process, estimates or assumptions we use to calculate long-lived asset impairment losses. However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and asset fair values, we may be exposed to losses that could be material.

 

 

 

 

 

 

 

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Table of Contents

 

Description

 

 

Judgments and Uncertainties

 

Effect if Actual Results

Differ From Assumptions

Stock-Based Compensation

 

 

 

 

We have a stock-based compensation plan, which includes non-qualified stock options and nonvested share awards, and an employee stock purchase plan. See Note 1,  Business and Summary of Significant Accounting Policies , and Note 7, Shareholders’ Equity, to the Notes to Consolidated Financial Statements, included in Item 8,  Financial Statements and Supplementary Data , of this Annual Report on Form 10-K, for a complete discussion of our stock-based compensation programs.

 

We determine the fair value of our non-qualified stock option awards and the resulting compensation expense at the date of grant using the Black-Scholes-Merton option-pricing model. The most significant inputs into the Black-Scholes-Merton model are exercise price, our estimate of expected stock price volatility and the expected term 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 under that standard, 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.

 

We determine the fair value of our performance-based nonvested share awards at the date of grant using generally accepted valuation techniques and the closing market price of our stock.

 

Option-pricing models and generally accepted valuation techniques require management to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the future volatility of our stock price, future employee forfeiture rates and future employee stock option exercise behaviors. Changes in these assumptions can materially affect the fair value estimate or future earnings adjustments.

 

Performance-based nonvested share awards require management to make assumptions regarding the likelihood of achieving personal performance goals.

 

We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to determine stock-based compensation expense. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to changes in stock-based compensation expense that could be material.

 

If actual results are not consistent with the assumptions used, the stock-based compensation expense reported in our financial statements may not be representative of the actual economic cost of the stock-based compensation. Also, if the actual forfeiture rates are not consistent with the assumptions used, it could result in future earnings adjustments.

 

A 10% change in our stock-based compensation expense for the year ended December 29, 2007, would have affected net income by approximately $393,000 in 2007.

 

 

 

 

 

 

 

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Table of Contents

 

Description

 

 

Judgments and Uncertainties

 

Effect if Actual Results

Differ From Assumptions

Self-Insured Liabilities

 

 

 

 

We are self-insured for certain losses related to health and workers’ compensation claims. However, we obtain third-party insurance coverage to limit our exposure to these claims.

 

When estimating our self-insured liabilities, we consider a number of factors, including historical claims experience, demographic factors, severity factors and valuations provided by third-party administrators.

 

Periodically, management reviews its assumptions and the valuations provided by third-party administrators to determine the adequacy of our self-insured liabilities.

 

Our self-insured liabilities contain uncertainties because management is required to make assumptions and to apply judgment to estimate the ultimate cost to settle reported claims and claims incurred but not reported as of the balance sheet date.

 

We have not made any material changes in the accounting methodology used to establish our self-insured liabilities during the past three fiscal years.

 

We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our self-insured liabilities. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.

 

A 10% change in our self-insured liabilities at December 29, 2007, would have affected net income by approximately $301,000 in 2007.

 

 

 

 

 

 

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.

 

We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.

 

Our warranty liability contains uncertainties 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.

 

We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our warranty liability. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.

 

A 10% change in our warranty liability at December 29, 2007, would have affected net income by approximately $598,000 in 2007.

 

 

 

 

 

Revenue Recognition

 

 

 

 

Revenue is recognized 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. Revenue is reported net of estimated sales returns and excludes sales taxes.

 

We accrue for sales returns at the time revenue is recognized and charge actual returns against the liability when they are received. Our general return policy is to allow returns for up to 30 nights following a sale. We estimate future projected returns based on historical return rates.

 

Our estimates of sales returns contains uncertainties as actual returns may vary from expected rates, resulting in adjustments to net sales in future periods. These adjustments could have a material adverse effect on future results of operations.

 

We have not made any material changes in the accounting methodology used to establish our sales returns allowance during the past three fiscal years.

 

We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our sales returns allowance. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.

 

A 10% change in our sales returns allowance at December 29, 2007, would have affected net income by approximately $236,000 in 2007.

 

 

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Table of Contents

Recent Accounting Pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS No. 157, as originally issued, was effective for fiscal years beginning after November 15, 2007, with early adoption permitted. However, on December 14, 2007, the FASB issued FASB Staff Position (“FSP”) FAS 157-b, which deferred the effective date of SFAS No. 157 for one year, as it relates to nonfinancial assets and liabilities. We will adopt SFAS No. 157, as it relates to our financial assets and liabilities for our 2008 fiscal year beginning December 30, 2007. We have evaluated the new statement, as it relates to our financial assets and liabilities and have determined that it will not have a material impact on our consolidated financial statements. We do not expect the adoption of SFAS No. 157, as it relates to nonfinancial assets and liabilities, to have a material impact on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities – Including an Amendment of FASB Statement No. 115.” SFAS No. 159 permits us to choose to measure certain financial assets and liabilities at fair value that are not currently required to be measured at fair value (the “Fair Value Option”). Election of the Fair Value Option is made on an instrument-by-instrument basis and is irrevocable. At the adoption date, unrealized gains and losses on financial assets and liabilities for which the Fair Value Option has been elected would be reported as a cumulative adjustment to beginning retained earnings. If we elect the Fair Value Option for certain financial assets and liabilities, we will report unrealized gains and losses due to changes in their fair value in net income at each subsequent reporting date. SFAS No. 159 is effective for our 2008 fiscal year beginning December 30, 2007. We have evaluated the new statement and have determined that it will not have a material impact on our consolidated financial statements.

 

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

At December 29, 2007, our short-term debt was comprised primarily of borrowings under our revolving line of credit. We do not currently manage interest rate risk on our debt through the use of derivative instruments.

 

Borrowings under our revolving credit facility are currently not subject to material interest rate risk. The credit facility’s interest rate may be reset due to fluctuations in a market-based index, such as the prime rate, federal funds rate or LIBOR. A hypothetical 100 basis point change in the interest rate on outstanding borrowings under our credit facility as of December 29, 2007 would change our annual consolidated pre-tax income by $0.4 million.

 





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Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

Select Comfort Corporation:

 

We have audited Select Comfort Corporation and subsidiaries’ internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Select Comfort Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A of this Form 10-K. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included 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, Select Comfort Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

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 29, 2007 and December 30, 2006, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended December 29, 2007, and our report dated February 26, 2008 expressed an unqualified opinion on those consolidated financial statements.

 

 

Minneapolis, Minnesota

February 26, 2008

 


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Table of Contents

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

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 29, 2007 and December 30, 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 29, 2007. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule, as listed in the accompanying index. These consolidated financial statements and financial statement schedule II 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 29, 2007 and December 30, 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 29, 2007, 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, present fairly, in all material respects, the information set forth therein.

As described in Notes 1 and 9 to the consolidated financial statements, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, on December 31, 2006.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Select Comfort Corporation and subsidiaries’ internal control over financial reporting as of December 29, 2007, 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, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

 

Minneapolis, Minnesota

February 26, 2008

 

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Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Balance Sheets

December 29, 2007 and December 30, 2006

(in thousands, except per share amounts)

 

 

 

2007

 

2006

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,279

 

$

8,819

 

Marketable debt securities – current

 

 

 

 

37,748

 

Accounts receivable, net of allowance for doubtful accounts of $876 and $529, respectively

 

 

18,902

 

 

12,164

 

Inventories

 

 

32,517

 

 

24,120

 

Prepaid expenses

 

 

9,816

 

 

10,227

 

Deferred income taxes

 

 

6,796

 

 

5,785

 

Other current assets

 

 

3,833

 

 

4,305

 

Total current assets

 

 

79,143

 

 

103,168

 

 

 

 

 

 

 

 

 

Marketable debt securities – non-current

 

 

 

 

43,608

 

Property and equipment, net

 

 

80,409

 

 

59,384

 

Deferred income taxes

 

 

25,543

 

 

19,275

 

Other assets

 

 

5,394

 

 

3,526

 

Total assets

 

$

190,489

 

$

228,961

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Borrowings under revolving credit facility

 

$

37,890

 

$

 

Accounts payable

 

 

69,775

 

 

46,061

 

Customer prepayments

 

 

8,327

 

 

9,552

 

Accruals:

 

 

 

 

 

 

 

Sales returns

 

 

3,751

 

 

3,907

 

Compensation and benefits

 

 

14,865

 

 

20,057

 

Taxes and withholding

 

 

4,812

 

 

5,053

 

Other current liabilities

 

 

9,723

 

 

12,901

 

Total current liabilities

 

 

149,143

 

 

97,531

 

 

 

 

 

 

 

 

 

Warranty liabilities

 

 

6,747

 

 

7,769

 

Other long-term liabilities

 

 

10,473

 

 

7,967

 

Total liabilities

 

 

166,363

 

 

113,267

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

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

 

 

 

 

 

Common stock, $0.01 par value; 142,500 shares authorized,
44,597 and 51,544 shares issued and outstanding, respectively

 

 

446

 

 

515

 

Additional paid-in capital

 

 

 

 

4,039

 

Retained earnings

 

 

23,680

 

 

111,140

 

Total shareholders’ equity

 

 

24,126

 

 

115,694

 

Total liabilities and shareholders’ equity

 

$

190,489

 

$

228,961

 

 

See accompanying notes to consolidated financial statements.

 

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SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Statements of Operations

Years ended December 29, 2007, December 30, 2006 and December 31, 2005

(in thousands, except per share amounts)

 

 

 

2007

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

799,242

 

$

806,038

 

$

689,548

 

Cost of sales

 

 

312,827

 

 

315,530

 

 

283,072

 

Gross profit

 

 

486,415

 

 

490,508

 

 

406,476

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

 

372,467

 

 

341,630

 

 

286,206

 

General and administrative

 

 

64,351

 

 

65,401

 

 

49,300

 

Research and development

 

 

5,682

 

 

4,687

 

 

2,219

 

Asset impairment charges

 

 

409

 

 

5,980

 

 

162

 

Total operating expenses

 

 

442,909

 

 

417,698

 

 

337,887

 

Operating income

 

 

43,506

 

 

72,810

 

 

68,589

 

Other (expense) income, net

 

 

(40)

 

 

3,018

 

 

2,174

 

Income before income taxes

 

 

43,466

 

 

75,828

 

 

70,763

 

Income tax expense

 

 

15,846

 

 

28,645

 

 

26,996

 

Net income

 

$

27,620

 

$

47,183

 

$

43,767

 

 

 

 

 

 

 

 

 

 

 

 

Basic net income per share:

 

 

 

 

 

 

 

 

 

 

Net income per share – basic

 

$

0.59

 

$

0.89

 

$

0.82

 

Weighted-average common shares – basic

 

 

46,536

 

 

52,837

 

 

53,357

 

Diluted net income per share:

 

 

 

 

 

 

 

 

 

 

Net income per share – diluted

 

$

0.57

 

$

0.85

 

$

0.76

 

Weighted-average common shares – diluted

 

 

48,292

 

 

55,587

 

 

57,674

 

 

See accompanying notes to consolidated financial statements.

 

 

 

43



Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Statements of Shareholders’ Equity

Years ended December 29, 2007, December 30, 2006 and December 31. 2005

(in thousands)

 

 

 

Common Stock

 

Additional
Paid-In

 

Retained

 

 

 

 

 

Shares

 

Amount

 

Capital

 

Earnings

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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

 

Exercise of common stock options

 

566

 

 

6

 

 

3,483

 

 

 

 

3,489

 

Tax benefit from equity compensation

 

 

 

 

 

1,887

 

 

 

 

1,887

 

Stock-based compensation

 

 

 

 

 

6,252

 

 

 

 

6,252

 

Repurchases of common stock

 

(7,617

)

 

(76

)

 

(16,756

)

 

(115,080)

 

 

(131,912

)

Issuances of common stock

 

104

 

 

1

 

 

1,095

 

 

 

 

1,096

 

Net income

 

 

 

 

 

 

 

27,620

 

 

27,620

 

Balance at December 29, 2007

 

44,597

 

$

446

 

$

 

$

23,680

 

$

24,126

 

 

 

See accompanying notes to consolidated financial statements.

 



44



Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Consolidated Statements of Cash Flows

Years ended December 29, 2007, December 30, 2006 and December 31. 2005

(in thousands)

 

 

 

2007

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

 

Net income

 

$

27,620

 

$

47,183

 

$

43,767

 

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

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

24,791

 

 

19,752

 

 

15,747

 

Stock-based compensation

 

 

6,252

 

 

8,325

 

 

793

 

Disposals and impairments of assets

 

 

596

 

 

5,912

 

 

172

 

Excess tax benefits from stock-based compensation

 

 

(1,497

)

 

(8,565

)

 

 

Changes in deferred income taxes

 

 

(7,280

)

 

(7,665

)

 

(1,353

)

Other, net

 

 

270

 

 

(68

) 

 

 

Change in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(6,738

)

 

(5,930

)

 

(397

)

Inventories

 

 

(8,397

)

 

(2,138

)

 

(1,501

)

Prepaid expenses and other assets

 

 

(1,020

)

 

(823

)

 

(3,506

)

Accounts payable

 

 

12,201

 

 

6,091

 

 

5,388

 

Customer prepayments

 

 

(1,225

)

 

(5,166

) 

 

5,350

 

Accrued sales returns

 

 

(156

)

 

(1,496

) 

 

365

 

Accrued compensation and benefits

 

 

(5,179

)

 

(4,782

) 

 

10,926

 

Accrued taxes and withholding

 

 

1,646

 

 

5,198

 

 

6,990

 

Warranty liabilities

 

 

(719

)

 

2,574

 

 

3,805

 

Other accruals and liabilities

 

 

2,866

 

 

974

 

 

952

 

Net cash provided by operating activities

 

 

44,031

 

 

59,376

 

 

87,498

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

Purchases of property and equipment

 

 

(43,514

)

 

(31,079

)

 

(25,840

)

Investments in marketable debt securities

 

 

 

 

(28,072

)

 

(39,172

)

Proceeds from sales and maturity of marketable debt securities

 

 

81,086

 

 

25,940

 

 

36,625

 

Net cash provided by (used in) investing activities

 

 

37,572

 

 

(33,211

)

 

(28,387

)

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in short-term borrowings

 

 

45,240

 

 

(1,388

) 

 

784

 

Repurchases of common stock

 

 

(134,452

)

 

(77,199

)

 

(49,727

)

Proceeds from issuance of common stock

 

 

4,572

 

 

8,809

 

 

8,413

 

Excess tax benefits from stock-based compensation

 

 

1,497

 

 

8,565

 

 

 

Net cash used in financing activities

 

 

(83,143

)

 

(61,213

)

 

(40,530

)

(Decrease) increase in cash and cash equivalents

 

 

(1,540

)

 

(35,048

)  

 

18,581

 

Cash and cash equivalents, at beginning of year

 

 

8,819

 

 

43,867

 

 

25,286

 

Cash and cash equivalents, at end of year

 

$

7,279

 

$

8,819

 

$

43,867

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental Disclosure of Cash Flow Information

 

 

 

 

 

 

 

 

 

 

Income Taxes Paid

 

$

20,622

 

$

30,628

 

$

22,563

 

Interest Paid

 

$

1,095

 

$

 

$

 

 

See accompanying notes to consolidated financial statements.

 

45



Table of Contents

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

(1)

Business and Summary of Significant Accounting Policies

 

Business

 

Select Comfort Corporation and our wholly-owned subsidiaries (“Select Comfort” or the “Company”) develops, manufactures and markets premium quality, adjustable-firmness beds and related bedding accessories in the United States. In addition, we also sell to wholesale customers in Canada, Australia and New Zealand. We sell through four distribution channels: Retail, Direct, E-Commerce and Wholesale. The percentage of our total net sales from each of our channels during the last three years was as follows:

 

 

2007

 

2006

 

2005

Retail

75.4%

 

76.2%

 

76.9%

Direct

8.0%

 

9.4%

 

10.8%

E-Commerce

6.8%

 

5.6%

 

5.0%

Wholesale

9.8%

 

8.8%

 

7.3%

Total

100.0%

 

100.0%

 

100.0%