Sleep Number (SNBR) 10-Q 2008 Q3 Quarterly report

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

FORM 10-Q

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

For the Quarterly Period Ended September 27, 2008

Commission File Number: 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

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES x    NO o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	x	Accelerated filer     o
Non-accelerated filer	o (Do not check if a smaller reporting company)	Smaller reporting company     o

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

As of September 27, 2008, 45,003,300 shares of Common Stock of the Registrant were outstanding.

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SELECT COMFORT CORPORATION
AND SUBSIDIARIES

INDEX

PART I: FINANCIAL INFORMATION
		Page
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of September 27, 2008 and December 29, 2007	3
	Condensed Consolidated Statements of Operations for the Three and Nine Months ended September 27, 2008 and September 29, 2007	4
	Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months ended September 27, 2008	5
	Condensed Consolidated Statements of Cash Flows for the Nine Months ended September 27, 2008 and September 29, 2007	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	19
Item 4.	Controls and Procedures	20
PART II: OTHER INFORMATION
Item 1.	Legal Proceedings	21
Item 1A.	Risk Factors	21
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	22
Item 3.	Defaults Upon Senior Securities	22
Item 4.	Submission of Matters to a Vote of Security Holders	22
Item 5.	Other Information	22
Item 6.	Exhibits	22
SIGNATURES		23

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PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

	(unaudited) September 27, 2008		December 29, 2007
Assets
Current assets:
Cash and cash equivalents	$	6,205	$	7,279
Accounts receivable, net of allowance for doubtful accounts of $737 and $876, respectively		7,680		18,902
Inventories		19,961		32,517
Prepaid expenses		18,487		9,816
Deferred income taxes		6,254		6,796
Other current assets		1,488		3,833
Total current assets		60,075		79,143
Property and equipment, net		86,760		80,409
Deferred income taxes		27,062		25,543
Other assets		6,179		5,394
Total assets	$	180,076	$	190,489
Liabilities and Shareholders’ Equity
Current liabilities:
Borrowings under revolving credit facility	$	60,000	$	37,890
Accounts payable		43,620		69,775
Customer prepayments		9,236		8,327
Accruals:
Sales returns		3,304		3,751
Compensation and benefits		15,345		14,865
Taxes and withholding		4,473		4,812
Other current liabilities		8,727		9,723
Total current liabilities		144,705		149,143
Non-current liabilities:
Warranty liabilities		5,436		6,747
Capital lease obligations		579		—
Other long-term liabilities		14,062		10,473
Total non-current liabilities		20,077		17,220
Total liabilities		164,782		166,363
Shareholders’ equity:
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding		—		—
Common stock, $0.01 par value; 142,500 shares authorized, 45,003 and 44,597 shares issued and outstanding, respectively		450		446
Additional paid-in capital		3,905		—
Retained earnings		10,939		23,680
Total shareholders’ equity		15,294		24,126
Total liabilities and shareholders’ equity	$	180,076	$	190,489

See accompanying notes to condensed consolidated financial statements.

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

	Three Months Ended						Nine Months Ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
Net sales	$	157,231		$	213,070		$	477,451		$	608,570
Cost of sales		59,475			81,892			192,125			233,697
Gross profit		97,756			131,178			285,326			374,873
Operating expenses:
Sales and marketing		82,047			95,741			258,074			280,635
General and administrative		11,618			14,872			41,880			49,102
Research and development		562			1,290			2,079			4,231
Asset impairment charges		1,477			198			2,534			198
Total operating expenses		95,704			112,101			304,567			334,166
Operating income (loss)		2,052			19,077			(19,241	)		40,707
Other (expense) income, net		(1,117	)		(261	)		(1,996	)		169
Income (loss) before income taxes		935			18,816			(21,237	)		40,876
Income tax (benefit) expense		(48	)		6,953			(8,496	)		15,424
Net income (loss)	$	983		$	11,863			(12,741	)	$	25,452
Net income (loss) per share – basic	$	0.02		$	0.27		$	(0.29	)	$	0.54
Weighted-average shares – basic		44,232			44,447			44,143			47,381
Net income (loss) per share – diluted	$	0.02		$	0.26		$	(0.29	)	$	0.52
Weighted-average shares – diluted		44,651			46,137			44,143			49,264

See accompanying notes to condensed consolidated financial statements.

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SELECT COMFORT CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statement of Shareholders’ Equity
(unaudited – in thousands)

	Common Stock				Additional Paid-In Capital		Retained Earnings
	Shares		Amount							Total
Balance at December 29, 2007		44,597	$	446	$	—	$	23,680		$	24,126
Exercise of common stock options		61		1		92		—			93
Tax benefit from stock-based compensation		—		—		26		—			26
Stock-based compensation		—		—		3,337		—			3,337
Issuances of common stock		345		3		450		—			453
Net loss		—		—		—		(12,741	)		(12,741	)
Balance at September 27, 2008		45,003	$	450	$	3,905	$	10,939		$	15,294

See accompanying notes to condensed consolidated financial statements.

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SELECT COMFORT CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(unaudited – in thousands)

	Nine Months Ended
	September 27, 2008			September 29, 2007
Cash flows from operating activities:
Net (loss) income	$	(12,741	)	$	25,452
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization		17,183			18,869
Stock-based compensation		3,337			5,560
Excess tax benefits from stock-based compensation		(17	)		(1,389	)
Disposals and impairments of assets		2,508			391
Changes in deferred income taxes		(977	)		(3,262	)
Other, net		—			270
Changes in operating assets and liabilities:
Accounts receivable		11,222			(4,461	)
Inventories		12,556			(5,863	)
Prepaid expenses and other assets		(5,972	)		286
Accounts payable		(16,612	)		18,174
Customer prepayments		909			862
Accrued sales returns		(447	)		156
Accrued compensation and benefits		492			(3,996	)
Accrued taxes and withholding		(313	)		5,612
Warranty liabilities		(1,847	)		(682	)
Other accruals and liabilities		2,884			265
Net cash provided by operating activities		12,165			56,244
Cash flows from investing activities:
Purchases of property and equipment		(28,141	)		(30,393	)
Proceeds from sales and maturity of marketable debt securities		—			81,086
Net cash (used in) provided by investing activities		(28,141	)		50,693
Cash flows from financing activities:
Net increase in short-term borrowings		15,823			21,564
Repurchases of common stock		—			(134,452	)
Proceeds from issuance of common stock		534			4,265
Excess tax benefits from stock-based compensation		17			1,389
Issuance costs related to debt		(1,472	)		—
Net cash provided by (used in) financing activities		14,902			(107,234	)
Decrease in cash and cash equivalents		(1,074	)		(297	)
Cash and cash equivalents, at beginning of period		7,279			8,819
Cash and cash equivalents, at end of period	$	6,205		$	8,522

See accompanying notes to condensed consolidated financial statements.

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SELECT COMFORT CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)

1. Basis of Financial Statement Presentation

We prepared the condensed consolidated financial statements as of and for the three and nine months ended September 27, 2008 of Select Comfort Corporation and subsidiaries (“Select Comfort” or the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and they reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly our financial position as of September 27, 2008, and December 29, 2007 and the results of operations and cash flows for the periods presented. Our historical results of operations may not be indicative of the results that may be achieved for any future period.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with our most recent audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Operating results for any quarterly period may not be indicative of operating results for the full year.

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of sales and expenses during the reporting period. Predicting future events is inherently an imprecise activity and as such requires the use of judgment. Future results could be materially affected if actual results differ from these estimates and assumptions. Critical accounting policies consist of asset impairment charges, stock-based compensation, self-insured liabilities, warranty liabilities and revenue recognition.

New Accounting Pronouncements

We adopted the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements” on December 30, 2007, the beginning of our 2008 fiscal year. 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 are 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 February 12, 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) FAS 157-2, which deferred the effective date of SFAS No. 157 for one year, as it relates to nonfinancial assets and liabilities. Accordingly, our adoption related only to financial assets and liabilities. At December 30, 2007, and September 27, 2008, we had no financial assets or liabilities which required a fair value measurement on a recurring basis.

We adopted the provisions of SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities – Including an Amendment of FASB Statement No. 115” on December 30, 2007, the beginning of our 2008 fiscal year. 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 are reported as a cumulative adjustment to beginning retained earnings. We did not elect the Fair Value Option. If we had elected the Fair Value Option for certain financial assets and liabilities, we would report unrealized gains and losses due to changes in their fair value in net income at each subsequent reporting date. The adoption of this statement had no impact on our consolidated financial statements.

2. Marketable Debt Securities

Through December 30, 2006, we classified our marketable debt securities as “held-to-maturity” in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” We historically valued our marketable debt securities at amortized cost based upon our intent and ability to hold these securities to maturity.

On March 23, 2007, all marketable debt securities, carried at an amortized cost of $67.8 million with an unrealized net loss of $250,000, were transferred from “held-to-maturity” classification to “available-for-sale” classification. Investments classified as “available-for-sale” are carried at fair market value. The classification change was made to increase liquidity and fund our common stock repurchase program. Based on the change in classification, we reduced both the carrying value of our marketable debt securities and shareholders’ equity (accumulated other comprehensive loss) by $250,000 on the date the securities were transferred to “available-for-sale” classification.

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During the three and nine months ended September 29, 2007, and subsequent to the classification change, marketable debt securities with a cost of $1.6 million and $64.4 million, respectively, were sold at a realized loss of $15,000 and $270,000, respectively.

We did not hold any marketable debt securities at September 27, 2008, or December 29, 2007.

3. Inventories

Inventories consisted of the following (in thousands):

	September 27, 2008		December 29, 2007
Raw materials	$	4,209	$	10,685
Work in progress		108		225
Finished goods		15,644		21,607
Inventories	$	19,961	$	32,517

4. Debt

Credit Agreement

In June 2006, we entered into a Credit Agreement (the “Credit Agreement”) with a syndicate of banks (the “Lenders”). The Credit Agreement, as amended to date, provides a revolving credit facility in an initial aggregate amount of $100 million to be used for general corporate purposes (however certain liquidity requirements described below effectively limit our borrowings plus outstanding letters of credit to $90 million as of September 27, 2008, which amount decreases periodically thereafter to $80 million as of July 1, 2009). The Credit Agreement terminates in June 2010.

The Credit Agreement was amended on February 1, 2008 and on May 30, 2008 to allow greater flexibility under the existing financial covenants, provide additional financial covenants and monthly measurement of financial covenants, modify the credit limit and maturity date, increase the cost of borrowing, provide the Lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries, and impose additional restrictions and covenants with respect to our operations.

At September 27, 2008, borrowings under the credit facility bore interest at a floating rate and could be maintained as base rate loans (tied to the prime rate, plus a margin of up to 2.00% or the federal funds rate plus 3.00%) or as Eurocurrency rate loans (tied to LIBOR, plus a margin up to 3.0% depending on our leverage ratio, as defined). We also pay certain facility and agent fees. We are subject to certain financial covenants under the agreement consisting of maximum leverage ratio, liquidity requirements, minimum interest coverage ratios, minimum EBITDA and capital expenditure limits. Minimum liquidity is defined as the amount available under the credit facility less outstanding letters of credit. The minimum liquidity requirements are $10 million as of September 1, 2008, $15 million as of December 1, 2008 and $20 million as of July 1, 2009.

We had outstanding borrowings of $60.0 million and $37.9 million, under the credit facility as of September 27, 2008, and December 29, 2007, respectively. As of September 27, 2008, and December 29, 2007, interest rates on borrowings outstanding under the Credit Agreement were 5.6% and 5.2%, respectively. At September 27, 2008, and December 29, 2007, $23.6 million and $62.1 million, respectively, were available under this credit facility.

As of the end of the third quarter of fiscal 2008, we were in full compliance with all financial covenants. With the increased uncertainty in the current macroeconomic environment, however, we believe that we may fall out of compliance with these financial covenants, either during the fourth quarter of 2008 or early in 2009. Failure to remain in compliance with the financial covenants could severely constrain our operating flexibility and our ability to fund our business operations.

In light of these increased uncertainties, we are considering options to enhance our financial flexibility and fund our operations including, additional actions to reduce our cost structure and improve profitability, the need to raise equity or debt capital, or the need to amend the financial covenants under our debt agreement. Any amendment of the Credit Agreement may significantly increase the cost of credit provided under the credit facility and related expenses, which may adversely impact our profitability. Whether or not we obtain an amendment of the Credit Agreement, we may need to or choose to seek additional capital through the issuance of debt or equity securities. The issuance of any additional debt securities could materially and adversely impact our profitability and financial condition. The issuance of additional equity securities could be substantially dilutive to our existing shareholders.

Our agreement under which GE Money Bank offers to our qualified customers revolving credit arrangements to finance purchases from us (the “GE Agreement”) contains certain financial covenants, including maximum leverage ratio and minimum interest coverage. As our recent results placed us outside of these financial covenants, we were required under the terms of the GE Agreement to provide GE Money Bank a letter of credit as collateral security.

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Capital Lease

During the three and nine months ended September 27, 2008, we entered into capital leases totaling $370,000 and $932,000, respectively, for certain computer equipment. At September 27, 2008, $245,000 was included in other current liabilities and $579,000 was included in capital lease obligations in our consolidated balance sheet.

5. Repurchases of Common Stock

On April 20, 2007, our Board of Directors authorized the repurchase of up to an additional $250.0 million of our common stock, bringing the total availability under our share repurchase program to $290.0 million. We did not repurchase any shares during the three or nine months ended September 27, 2008. We repurchased and retired 2,259,000 and 7,617,000 shares through open market purchases at a cost of $37.6 million and $131.9 million (based on trade dates), respectively, during the three and nine months ended September 29, 2007. As of September 27, 2008, the remaining authorization under our share repurchase program was $206.8 million. There is no expiration date governing the period over which we can repurchase shares.

6. Stock-Based Compensation

We compensate officers, directors and key employees with stock-based compensation under three plans approved by our shareholders in 1990, 1997 and 2004 and administered under the supervision of our Board of Directors. Stock-based compensation awards are generally granted annually during the first quarter. We have awarded stock options, performance shares and restricted stock under these plans. Stock-based compensation expense is determined based on the grant-date fair value and is recognized ratably over the vesting period of each grant, which is generally four years. Stock-based compensation expense for the three and nine months ended September 27, 2008 was $1.2 million and $3.3 million, respectively, and for the three and nine months ended September 29, 2007 was $1.5 million and $5.6 million, respectively.

7. Asset Impairment Charges

During the three and nine months ended September 27, 2008, we recognized impairment charges of $1.5 million and $2.5 million, respectively. During 2008, we reviewed all of our stores for impairment and determined that certain store assets at underperforming stores were impaired. We recognized impairment charges for the difference between the fair value and the carrying amounts of the related long-lived assets. We estimate fair values based on the cash-flows expected to be generated by the assets. During the three months ended September 29, 2007, we determined that certain store assets at underperforming stores were impaired and recognized impairment charges of $0.2 million for the difference between fair value and the carrying amounts of the related long-lived assets.

Asset impairment charges is one of our critical accounting estimates and requires management to make estimates about future events including sales growth rates, cash flows and asset fair values. In addition, our impairment calculations assume the ongoing availability of consumer credit and our ability to provide cost-effective consumer credit options. However, the recent tightening of credit standards, for our customers who seek extended financing from our third party financiers, was considered in our estimates. Predicting future events is inherently an imprecise activity. If actual results are not consistent with the estimates and assumptions used in our asset impairment calculations, we may incur additional impairment charges in the near term.

8. Other (Expense) Income, Net

Other (expense) income, net, consisted of the following (in thousands):

	Three Months Ended						Nine Months Ended
	September 27, 2008			September 29, 2007			September 27, 2008			September 29, 2007
Interest income	$	—		$	94		$	89		$	1,055
Interest expense		(1,302	)		(449	)		(2,550	)		(793	)
Write-off unamortized debt cost		—			—			(131	)		—
Capitalized interest expense		185			109			596			177
Realized loss on sales of marketable debt securities		—			(15	)		—			(270	)
Other (expense) income, net	$	(1,117	)	$	(261	)	$	(1,996	)	$	169

9. Income Taxes

During the third quarter of fiscal 2008, we recognized $0.6 million of discrete tax benefit adjustments related to research and development tax credits for prior years based on the recognition guidance outlined in FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes. The third quarter of fiscal 2007 income tax expense included $0.2 million of discrete tax benefit adjustments related to the resolution of certain federal and state income tax matters.

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10. Net Income (Loss) per Common Share

The following computations reconcile net income (loss) per share – basic with net income (loss) per share – diluted (in thousands, except per share amounts):

	Three Months Ended				Nine Months Ended
	September 27, 2008		September 29, 2007		September 27, 2008			September 29, 2007
Net income (loss)	$	983	$	11,863	$	(12,741	)	$	25,452
Reconciliation of weighted-average shares outstanding:
Basic weighted-average shares outstanding		44,232		44,447		44,143			47,381
Effect of dilutive securities:
Options		114		1,443		—		��	1,614
Restricted shares		305		247		—			269
Diluted weighted-average shares outstanding		44,651		46,137		44,143			49,264
Net income (loss) per share – basic	$	0.02	$	0.27	$	(0.29	)	$	0.54
Net income (loss) per share – diluted	$	0.02	$	0.26	$	(0.29	)	$	0.52

We excluded potentially dilutive stock options totaling 4,776,000 and 5,025,000 for the three and nine months ended September 27, 2008, respectively, and 1,991,000 and 1,668,000 for the three and nine months ended September 29, 2007, respectively, from diluted net income (loss) per share because these securities’ exercise prices were greater than the average market price of our common shares. In addition, for the nine months ended September 27, 2008, we excluded 400,000 shares of restricted stock, and 282,000 stock options, from diluted net income (loss) per share as their inclusion would have had an anti-dilutive effect on our net loss per diluted share.

11. Commitments and Contingencies

On April 25, 2008, a lawsuit was filed against one of our subsidiaries in state court in California by one of our customers. The complaint asserts various claims related to products liability and misrepresentation and seeks class certification. The complaint alleges that products sold by us prior to 2006 had a unique propensity to develop mold, alleges that the plaintiff suffered adverse health effects, and seeks various forms of legal and equitable relief. We removed the case to the U.S. District Court for the Northern District of California. On September 30, 2008, the Court granted our motion to dismiss and strike the purported class action claims, and allowed the plaintiff leave to amend the complaint. As of September 27, 2008, no accrual had been established as we believe the claims are without merit and we intend to vigorously defend the litigation.

We are involved from time to time in various other 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. With respect to these other matters, we believe that we have valid defenses to claims asserted against us and we do not expect the outcome of these other 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.

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our 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:

• Risk Factors

• Overview

• Results of Operations

• Liquidity and Capital Resources

• Outlook

• Off-Balance-Sheet Arrangements and Contractual Obligations

• Critical Accounting Policies

Risk Factors

The following discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the Notes thereto included herein. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “will,” “should,” “expects,” “anticipates,” “contemplates,” “estimates,” “believes,” “plans,” “projects,” “predicts,” “potential” or “continue” or the negative of these or similar terms. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Important factors known to us that could cause such material differences are identified and discussed in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 29, 2007, which discussion is incorporated herein by reference. These important factors include, but are 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;

• Liquidity and Capital Resources – our ability to obtain and maintain sufficient liquidity and capital resources to fund our operations and the increasing cost of credit, including our ability to remain in compliance with financial covenants under our revolving credit facility during periods of volatile and uncertain sales trends, and the potential need to seek additional capital through the issuance of debt or equity securities to fund our operations or to invest in growth or profit-enhancement opportunities;

• 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, tighter consumer credit standards from the providers of credit to our customers and our ability to provide cost-effective consumer credit options;

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• 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, fluctuating currency rates, increasing industry regulatory requirements and the impact of lower sales volume on a fixed cost structure 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, consumer credit quality 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.

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

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 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;

• 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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New Product Launches

During the third quarter of fiscal 2008, we launched the Sleep Number Memory Foam® bed which combines memory foam conforming comfort with the ability to adjust firmness and provide personalized comfort. Also during the third quarter, we introduced the Sleep Number personalized pillow, which gives consumers the ability to personalize the outer comfort, inner support and pillow protector materials in their bed pillow.

Results of Operations

Quarterly and Annual Results

Quarterly and annual operating results may fluctuate significantly as a result of a variety of factors, including increases or decreases in sales, the timing, amount and effectiveness of advertising expenditures, any changes in sales return rates or warranty experience, the timing of new store openings and related expenses, net sales contributed by new stores, the timing of promotional offerings, competitive factors, changes in commodity costs, any disruptions in supplies or third-party service providers, seasonality of retail sales, timing of QVC shows and wholesale sales, consumer confidence and general economic conditions. Furthermore, a substantial portion of our net sales is often realized in the last month of a quarter, due in part to our promotional schedule and commission structure. As a result, we may be unable to adjust spending in a timely manner, and our business, financial condition and operating results may be significantly harmed. Our historical results of operations may not be indicative of the results that may be achieved for any future period.

Highlights

Key financial highlights for the three months ended September 27, 2008 were as follows:

• Net income totaled $1.0 million, or $0.02 per diluted share, compared with $11.9 million or $0.26 per diluted share, for the same period one year ago.

• Net sales decreased 26% to $157.2 million, compared with $213.1 million for the same period one year ago, primarily due to a 27% comparable-store sales decline for our company-owned retail stores.

• Our gross profit rate increased to 62.2% of net sales, compared with 61.6% of net sales for the same period last year. The gross profit rate increase was primarily due to product price increases for our company-owned sales channels and a sales mix shift to higher margin products, partially offset by the deleveraging impact of the 26% sales decrease and higher commodity and logistics costs.

• Sales and marketing expenses decreased 14% to $82.0 million, or 52.2% of net sales, compared with $95.7 million, or 44.9% of net sales, for the same period one year ago. The rate increase was primarily due to the deleveraging impact of the 26% sales decrease.

• General and administrative expenses declined $3.3 million compared with the prior year, but increased slightly to 7.4% of net sales.

• Cash from operating activities totaled $12.2 million for the first nine months of 2008, compared with $56.2 million for the same period one year ago.

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The following table sets forth, for the periods indicated, our results of operations expressed as dollars and percentages of net sales. Figures are in millions, except percentages and per share amounts. Amounts may not add due to rounding differences.

	Three Months Ended										Nine Months Ended
	September 27, 2008					September 29, 2007					September 27, 2008					September 29, 2007
Net sales	$	157.2		100.0%		$	213.1		100.0%		$	477.5		100.0%		$	608.6	100.0%
Cost of sales		59.5		37.8%			81.9		38.4%			192.1		40.2%			233.7	38.4%
Gross profit		97.8		62.2%			131.2		61.6%			285.3		59.8%			374.9	61.6%
Operating expenses:
Sales and marketing		82.0		52.2%			95.7		44.9%			258.1		54.1%			280.6	46.1%
General and administrative		11.6		7.4%			14.9		7.0%			41.9		8.8%			49.1	8.1%
Research and development		0.6		0.4%			1.3		0.6%			2.1		0.4%			4.2	0.7%
Asset impairment charges		1.5		0.9%			0.2		0.1%			2.5		0.5%			0.2	0.0%
Total operating expenses		95.7		60.9%			112.1		52.6%			304.6		63.8%			334.2	54.9%
Operating income (loss)		2.1		1.3%			19.1		9.0%			(19.2	)	(4.0%	)		40.7	6.7%
Other (expense) income, net		(1.1	)	(0.7%	)		(0.3	)	(0.1%	)		(2.0	)	(0.4%	)		0.2	0.0%
Income (loss) before income taxes		0.9		0.6%			18.8		8.8%			(21.2	)	(4.4%	)		40.9	6.7%
Income tax (benefit) expense		(0.1	)	0.0%			7.0		3.3%			(8.5	)	(1.8%	)		15.4	2.5%
Net income (loss)	$	1.0		0.6%		$	11.9		5.6%		$	(12.7	)	(2.7%	)	$	25.5	4.2%
Net income (loss) per share:
Basic	$ 0.02					$ 0.27					$ (0.29)					$ 0.54
Diluted	$ 0.02					$ 0.26					$ (0.29)					$ 0.52
Weighted-average number of common shares:
Basic	44.2					44.4					44.1					47.4
Diluted	44.7					46.1					44.1					49.3

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

	Three Months Ended		Nine Months Ended
	September 27, 2008	September 29, 2007	September 27, 2008	September 29, 2007
Percent of net sales:
Retail	78.9%	76.6%	77.4%	75.7%
Direct	7.7%	7.2%	8.0%	8.1%
E-Commerce	5.3%	6.7%	6.1%	6.8%
Wholesale	8.1%	9.5%	8.5%	9.4%
Total	100.0%	100.0%	100.0%	100.0%

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

	Three Months Ended				Nine Months Ended
	September 27, 2008		September 29, 2007		September 27, 2008		September 29, 2007
Net sales growth rates:
Comparable stores	(27%	)	(6%	)	(24%	)	(10%	)
Net new stores	3%		9%		4%		9%
Retail total	(24%	)	3%		(20%	)	(1%	)
Direct	(20%	)	(15%	)	(23%	)	(16%	)
E-Commerce	(42%	)	30%		(29%	)	26%
Wholesale	(37%	)	(1%	)	(29%	)	14%
Total net sales growth	(26%	)	3%		(22%	)	0%

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The numbers of company-owned retail stores and independently owned and operated retail partner stores was as follows:

	Three Months Ended				Nine Months Ended
	September 27, 2008		September 29, 2007		September 27, 2008		September 29, 2007
Company-owned retail stores:
Beginning of period	478		460		478		442
Opened	5		14		18		37
Closed	(8	)	(3	)	(21	)	(8	)
End of period	475		471		475		471
Retail partner doors	794		770		794		770

Comparison of Three Months Ended September 27, 2008 with Three Months Ended September 29, 2007

Net sales
Net sales decreased 26% to $157.2 million for the three months ended September 27, 2008, compared with $213.1 million for the same period one year ago. The sales decrease was due to a 27% comparable-store sales decline in our company-owned retail stores and a decrease in wholesale, E-Commerce and direct channel sales, partially offset by sales from four net new company-owned retail stores opened in the past 12 months. Total sales of mattress units decreased 36% compared to the same period one year ago, and the average selling price per bed (mattress sales only divided by mattress units) in our company-controlled channels increased 11% to $1,917, while sales of other products and services decreased by 23%.

The $55.8 million net sales decrease compared with the same period one year ago was comprised of the following: (i) a $39.3 million net decrease in sales from our company-owned retail stores, comprised of a $42.2 million decrease from comparable-stores and a $2.9 million increase from new stores, net of stores closed; (ii) a $7.4 million decrease in wholesale sales; (iii) a $6.0 million decrease in E-Commerce sales; and (iv) a $3.1 million decrease in direct channel sales.

Gross profit
The gross profit rate increased to 62.2% of net sales for the three months ended September 27, 2008, compared with 61.6% for the same period one year ago. A majority of the gross profit rate increase was due to various pricing initiatives implemented in our company-owned sales channels which favorably impacted average selling prices and added approximately 1.0 percentage point (“ppt”) to our third quarter gross profit rate compared to the same period last year. In addition, a sales mix shift to higher margin products and an increase in the percentage of net sales from higher gross margin channels increased the gross profit rate by approximately 0.4 ppt and 0.3 ppt, respectively, compared to the same period one year ago. These items were partially offset by the deleveraging impact of the 26% net sales decrease, higher commodity costs and increased logistics costs, including the impact of higher fuel prices.

Sales and marketing expenses
Sales and marketing expenses for the three months ended September 27, 2008 decreased 14% to $82.0 million, or 52.2% of net sales, compared with $95.7 million, or 44.9% of net sales, for the same period one year ago. The $13.7 million decrease was primarily due to the following: (i) a 14% reduction in media spending compared to the same period one year ago; (ii) reduced variable selling expenses due to the net sales decline including lower financing costs, percentage rents and variable store compensation; partially offset by (iii) operating costs associated with new stores opened in the past 12 months. The 7.3 ppt sales and marketing expense rate increase was principally due to the deleveraging impact of the 26% sales decline, partially offset by a $13.7 million expense decrease compared with the same period one year ago.

General and administrative expenses
General and administrative (“G&A”) expenses decreased 22% to $11.6 million for the three months ended September 27, 2008, compared with $14.9 million for the same period one year ago. The $3.3 million decrease in G&A expenses was primarily due to reduced compensation and benefit costs resulting from workforce reductions, and discretionary spending cuts. 

Research and development expenses
Research and development (“R&D”) expenses decreased to $0.6 million for the third quarter of fiscal 2008 compared with $1.3 million for the same period one year ago, and decreased as a percentage of net sales to 0.4% from 0.6% for the comparable prior-year period.

Asset impairment charges
During the three months ended September 27, 2008, we recognized impairment charges of $1.5 million. During 2008, we reviewed all of our stores for impairment and determined that certain store assets at underperforming stores were impaired. We recognized impairment charges for the difference between the fair value and the carrying amounts of the related long-lived assets. We estimate fair values based on the cash-flows expected to be

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generated by the assets. During the three months ended September 29, 2007, we determined that certain store assets at underperforming stores were impaired and recognized impairment charges of $0.2 million for the difference between fair value and the carrying amounts of the related long-lived assets.

Other (expense) income, net
Other expense was $1.1 million for the three months ended September 27, 2008, compared with $0.3 million of expense for the same period one year ago. The $0.9 million increase in other expense was driven by increased interest expense from borrowings under our revolving line of credit due to higher average debt balances and increased interest rates compared to the same period one year ago.

Income tax (benefit) expense
Income tax benefit was $0.1 million for the three months ended September 27, 2008, compared with $7.0 million of income tax expense for the same period one year ago. The effective tax rate was (5.1)% for the third quarter of fiscal 2008 and 37.0% for the same period one year ago. During the three months ended September 27, 2008, we recognized $0.6 million of discrete tax benefit adjustments related to research and development tax credits for prior years based on the recognition guidance outlined in FASB Interpretations No. 48,Accounting for Uncertainty in Income Taxes.

Comparison of Nine Months Ended September 27, 2008 with Nine Months Ended September 29, 2007

Net sales
Net sales for the first nine months of fiscal 2008 decreased 22% to $477.5 million compared with $608.6 million for the same period one year ago. The sales decrease was driven by a 24% comparable-store sales decline in our company-owned retail stores and a decrease in wholesale, E-Commerce and direct channel sales, partially offset by sales from four net new company-owned retail stores opened in the past 12 months. Total sales of mattress units decreased 28% compared to the same period one year ago, and the average selling price per bed (mattress sales only divided by mattress units) in our company-controlled channels increased 4% to $1,779, while sales of other products and services decreased by 16%.

The $131.1 million net sales decrease compared with the same period one year ago was comprised of the following: (i) a $91.2 million net decrease in sales from our company-owned retail stores, comprised of a $109.6 million decrease from comparable-stores and a $18.4 million increase from new stores, net of stores closed; (ii) a $16.5 million decrease in wholesale sales; (iii) a $12.2 million decrease in E-Commerce sales; and (iv) an $11.2 million decrease in direct channel sales. 

Gross profit
The gross profit rate decreased to 59.8% of net sales for the first nine months of fiscal 2008 compared with 61.6% of net sales for the same period one year ago. A majority of the gross profit rate decline was driven by higher commodity and logistics costs including the impact of higher fuel prices, increased production costs for our new line of beds and fire-retardant products launched last year, and the deleveraging impact of the 22% net sales decrease. In addition, a sales mix shift to lower margin products and increased warranty costs each reduced the gross profit rate by approximately 0.2 ppt, compared to the same period one year ago. These items were partially offset by an increase in the percentage of net sales from our retail distribution channel which increased the gross profit rate by approximately 0.3 ppt. Pricing initiatives implemented in our company-owned sales channels also favorably impacted our gross profit rate as compared to the same period one year ago.

Sales and marketing expenses
Sales and marketing expenses for the nine months ended September 27, 2008 decreased to $258.1 million, or 54.1% of net sales, compared with $280.6 million, or 46.1% of net sales, for the same period one year ago. The $22.6 million decrease was primarily due to the following: (i) an $11.4 million or 14% reduction in media spending compared with the same period one-year ago; (ii) reduced variable selling expenses due to the net sales decline including lower financing costs, percentage rents and variable store compensation; partially offset by (iii) operating costs associated with new stores opened in the past 12 months. The 8.0 ppt sales and marketing expense rate increase was principally due to the deleveraging impact of the 22% net sales decline, partially offset by a $22.6 million expense decrease compared with the same period one year ago.

General and administrative expenses
General and administrative expenses decreased to $41.9 million for the nine months ended September 27, 2008 compared with $49.1 million for the same period one year ago, but increased 0.7 ppt on a rate basis. The $7.2 million decrease in G&A expenses was primarily due to workforce reductions, reduced stock-based compensation expense, lower depreciation expense, decreased consulting fees and other discretionary spending reductions. The year-over-year decline in stock-based compensation expense was primarily due to an increase in our estimated forfeiture rates resulting from the workforce reductions.

Research and development expenses
Research and development expenses decreased to $2.1 million for the first nine months of fiscal 2008 compared with $4.2 million for the same period one year ago, and decreased as a percentage of net sales to 0.4% from 0.7%. The prior year’s first nine months

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included additional R&D expenses related to the development of new fire retardant products and an upgrade of our entire line of bed models.

Asset impairment charges
During the nine months ended September 27, 2008, we recognized impairment charges of $2.5 million. During 2008, we reviewed all of our stores for impairment and determined that certain store assets at underperforming stores were impaired. We recognized impairment charges for the difference between the fair value and the carrying amounts of the related long-lived assets. We estimate fair values based on the cash-flows expected to be generated by the assets. During the nine months ended September 29, 2007, we determined that certain store assets at underperforming stores were impaired and recognized impairment charges of $0.2 million for the difference between fair value and the carrying amounts of the related long-lived assets.

Other (expense) income, net
Other expense was $2.0 million for the nine months ended September 27, 2008 compared with other income of $0.2 million for the same period one year ago. The $2.2 million decrease was driven by increased interest expense from borrowings under our revolving line of credit due to higher average debt balances and increased interest rates, and lower average cash and investment balances compared to the same period one year ago.

Income tax (benefit) expense
Income tax benefit was $8.5 million for the nine months ended September 27, 2008 compared with $15.4 million of income tax expense for the same period one year ago. The effective tax rate was (40.0)% and 37.7% in 2008 and 2007, respectively. During the nine months ended September 27, 2008, we recognized $0.6 million of discrete benefit tax adjustments related to research and development tax credits for prior years based on the recognition guidance under FASB Interpretations No. 48,Accounting for Uncertainty in Income Taxes. Income tax expense, for the nine months ended September 29, 2007, included $0.2 million of discrete tax benefit adjustments related to the resolution of certain federal and state income tax matters.

Liquidity and Capital Resources

As of September 27, 2008, we had cash and cash equivalents of $6.2 million compared with $7.3 million as of December 29, 2007. The $1.1 million decrease in cash and cash equivalents was primarily due to $28.1 million of capital expenditures, partially offset by $12.2 million of cash provided by operating activities and a $15.8 million net increase in short-term borrowings.

The following table summarizes our cash flows for the nine months ended September 27, 2008, and September 29, 2007 ($ in millions):

	Nine Months Ended
	September 27, 2008			September 29, 2007
Total cash provided by (used in):
Operating activities	$	12.2		$	56.2
Investing activities		(28.1	)		50.7
Financing activities		14.9			(107.2	)
Decrease in cash and cash equivalents	$	(1.1	)	$	(0.3	)

Cash provided by operating activities for the nine months ended September 27, 2008, and September 29, 2007 was $12.2 million and $56.2 million, respectively. The $44.1 million year-over-year decrease in cash from operating activities was comprised of a $38.2 million decline in net (loss) income and a $7.5 million decrease in cash from changes in operating assets and liabilities, partially offset by a $1.6 million increase in adjustments to reconcile net (loss) income to cash provided by operating activities. The year-over-year decrease in cash from changes in operating assets and liabilities was due to a current-year decrease in accounts payable (timing of payments, reduced business volume and reduced inventory levels), a decrease in accrued taxes and withholding (year-to-date pre-tax loss in current fiscal year), partially offset by a decrease in accounts receivable (lower current-year wholesale volume and timing of wholesale receipts), a current-year decrease in inventories, and a current year increase in accrued compensation and benefits (prior-year’s reduction included payment of fiscal 2006 bonus in the first quarter of fiscal 2007).

Net cash used in investing activities was $28.1 million for the nine months ended September 27, 2008 compared with net cash provided by investing activities of $50.7 million for the same period one year ago. The $78.8 million decrease in net cash (used in) provided by investing activities was principally due to no proceeds from the sales and maturity of marketable debt securities for the first nine months of fiscal 2008, compared with $81.1 million of proceeds from the sales and maturity of marketable debt securities for the same period one year ago, as we liquidated our marketable securities in fiscal 2007 to fund common stock repurchases. During the first nine months of fiscal 2008, we invested $28.1 million in property and equipment, compared to $30.4 million for the same period one year ago. In both periods, our capital expenditures related primarily to new and remodeled retail stores and investments in

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information technology. For the first nine months of fiscal 2008 we opened 18 new retail stores, compared with 37 new retail stores opened during the same period one year ago.

Net cash provided by financing activities was $14.9 million for the nine months ended September 27, 2008, compared with net cash used in financing activities of $107.2 million for the same period one year ago. The $122.1 million increase in cash provided by (used in) financing activities resulted from $134.5 million of common stock repurchases for the first nine months of fiscal 2007 compared with no repurchases for the current fiscal year, and increased short-term borrowings under our revolving line of credit, partially offset by a $3.7 million reduction in proceeds from the issuance of common stock related to stock option exercises and employee purchases, a $1.4 million reduction in tax benefits from stock-based compensation and a $1.5 million increase in debt issuance costs related to our amended credit agreement. Book overdrafts are included in the net change in short-term borrowings.

On April 20, 2007, our Board of Directors authorized the company to repurchase up to an additional $250 million of its common stock, bringing the total availability under our share repurchase program to $290 million. In the third quarter of fiscal 2007, we curtailed our share repurchases following the tightening of credit markets and the continued deterioration in the general economic environment. As of September 27, 2008, the remaining authorization under our share repurchase program was $207 million. There is no expiration date governing the period over which we can repurchase shares.

In June 2006, we entered into a Credit Agreement (the “Credit Agreement”) with a syndicate of banks (the “Lenders”). The Credit Agreement, as amended to date, provides a revolving credit facility in an initial aggregate amount of $100 million to be used for general corporate purposes (however certain liquidity requirements described below effectively limit our borrowings plus outstanding letters of credit to $90 million at September 27, 2008, which amount decreases periodically thereafter to $80 million as of July 1, 2009). The Credit Agreement terminates in June 2010.

The Credit Agreement was amended on February 1, 2008 and on May 30, 2008 to allow greater flexibility under the existing financial covenants, provide additional financial covenants and monthly measurement of financial covenants, modify the credit limit and maturity date, increase the cost of borrowing, provide the Lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries, and impose additional restrictions and covenants with respect to our operations.

At September 27, 2008, borrowings under the credit facility bore interest at a floating rate and could be maintained as base rate loans (tied to the prime rate, plus a margin of up to 2.00% or the federal funds rate plus 3.00%) or as Eurocurrency rate loans (tied to LIBOR, plus a margin up to 3.0% depending on our leverage ratio, as defined). We also pay certain facility and agent fees. We are subject to certain financial covenants under the agreement consisting of maximum leverage ratio, liquidity requirements, minimum interest coverage ratios, minimum EBITDA and capital expenditure limits. Minimum liquidity is defined as the amount available under the credit facility less outstanding letters of credit. The minimum liquidity requirements are $10 million as of September 1, 2008, $15 million as of December 1, 2008 and $20 million as of July 1, 2009.

We had outstanding borrowings of $60.0 million and $37.9 million, under the credit facility as of September 27, 2008, and December 29, 2007, respectively. As of September 27, 2008, and December 29, 2007, interest rates on borrowings outstanding under the Credit Agreement were 5.6% and 5.2%, respectively. At September 27, 2008, and December 29, 2007, $23.6 million and $62.1 million, respectively, were available under this credit facility.

As of the end of the third quarter of fiscal 2008, we were in full compliance with all financial covenants. With the increased uncertainty in the current macroeconomic environment, however, we believe that we may fall out of compliance with these financial covenants, either during the fourth quarter of 2008 or early in 2009. Failure to remain in compliance with the financial covenants could severely constrain our operating flexibility and our ability to fund our business operations.

In light of these increased uncertainties, we are considering options to enhance our financial flexibility and fund our operations including, additional actions to reduce our cost structure and improve profitability, the need to raise equity or debt capital, or the need to amend the financial covenants under our debt agreement. Any amendment of the Credit Agreement may significantly increase the cost of credit provided under the credit facility and related expenses, which may adversely impact our profitability. Whether or not we obtain an amendment of the Credit Agreement, we may need to or choose to seek additional capital through the issuance of debt or equity securities. The issuance of any additional debt securities could materially and adversely impact our profitability and financial condition. The issuance of additional equity securities could be substantially dilutive to our existing shareholders.

Our agreement under which GE Money Bank offers to our qualified customers revolving credit arrangements to finance purchases from us (the “GE Agreement”) contains certain financial covenants, including maximum leverage ratio and minimum interest coverage. As our recent results placed us outside of these financial covenants, we were required under the terms of the GE Agreement to provide GE Money Bank a letter of credit as collateral security.

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Outlook

We have not provided specific earnings guidance for fiscal 2008. However, summarized below are key business drivers and trends, which we believe will assist investors and analysts in understanding and analyzing our business.

We anticipate that macro-economic pressures will increase in the fourth quarter of fiscal 2008. We expect the difficult economic conditions to persist through 2009 and consumer buying to continue to weaken. Maintaining our gross profit rate at the fiscal 2008 third quarter rate of 62.2% will be a challenge due to deleverage resulting from anticipated lower unit volumes. However, we project our gross profit rate will remain above 60% during the fourth quarter as we focus on reducing our fixed costs. Results for fiscal 2008 will benefit from a fifty-third week in the fourth quarter.

The company will focus on several key areas in the fourth quarter and into 2009 to mitigate the impact of the challenging economic environment, which include:

• Product cost and pricing – We plan to reduce product costs and create price flexibility within the product line to better enable us to respond to increased price sensitivity of consumers in the current environment.

• Infrastructure costs – We will close five stores during the fourth quarter of 2008, bringing the anticipated number of store closing for the year to 26 stores. In 2009, we plan to be more aggressive in reducing our store base. We expect to reduce our store count by up to 20 stores during the first quarter of fiscal 2009 through the expiration of store leases and lease exit clauses of underperforming stores. We will continue to align general and administrative costs with projected sales trends while preserving core strategic capabilities.

• Media and marketing – We will continue to work toward improving the effectiveness and efficiency of both sales and marketing. Media spend will be lower in fourth quarter, and will remain flexible in 2009 based on sales trends.

• Cash – We will remain focused on preserving cash. We anticipate that operating cash flows for 2008 will be positive. We will reduce capital expenditures in 2009 as commitments for store openings and our SAP project are fulfilled.

Finally, we will continue to analyze our existing manufacturing, distribution and retail operations to optimize our business performance. As a result, in future periods, we may incur restructuring expenses or asset impairment charges.

Off-Balance-Sheet Arrangements and Contractual Obligations

Other than operating leases, we do not have any off-balance-sheet financing. We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships. As of September 27, 2008, we are not involved in any unconsolidated special purpose entity transactions.

There has been no material change in our contractual obligations since the end of fiscal 2007 other than increasing borrowings under our revolving credit facility from $37.9 million as of December 29, 2007 to $60.0 million as of September 27, 2008. See Note 4,Debt, of the Notes to our Condensed Consolidated Financial Statements. See our Annual Report on Form 10-K for the fiscal year ended December 29, 2007 for additional information regarding our contractual obligations.

Critical Accounting Policies

We discuss our critical accounting policies and estimates inManagement’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 29, 2007. There were no significant changes in our accounting policies since the end of fiscal 2007.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

At September 27, 2008, 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 of outstanding borrowings under our credit facility as of September 27, 2008 would change our annual consolidated pre-tax income or loss by $0.6 million.

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ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), that are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer), to allow timely decisions regarding required disclosure. We have established a Disclosure Committee, consisting of certain members of management, to assist in this evaluation. The Disclosure Committee meets on a regular quarterly basis, and as needed.

Our management, including our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934), at September 27, 2008. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, at September 27, 2008, our disclosure controls and procedures were effective.

Changes in Internal Controls

There was no change in internal control over financial reporting during the fiscal quarter ended September 27, 2008, that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.

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PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On April 25, 2008, a lawsuit was filed against one of our subsidiaries in state court in California by one of our customers. The complaint asserts various claims related to products liability and misrepresentation and seeks class certification. The complaint alleges that products sold by us prior to 2006 had a unique propensity to develop mold, alleges that the plaintiff suffered adverse health effects, and seeks various forms of legal and equitable relief. We removed the case to the U.S. District Court for the Northern District of California. On September 30, 2008, the Court granted our motion to dismiss and strike the purported class action claims, and allowed the plaintiff leave to amend the complaint.

We are involved from time to time in various other 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. With respect to these other matters, we believe that we have valid defenses to claims asserted against us and we do not expect the outcome of these other 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 1A. RISK FACTORS

Our business, financial condition and operating results are subject to a number of risks and uncertainties, including both those that are specific to our business and others that affect all businesses operating in a global environment. Investors should carefully consider the information in this report under the heading, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and also the information under the heading, “Risk Factors” in our most recent Annual Report on Form 10-K. The risk factors discussed in the Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q do not identify all risks that we face because our business operations could also be affected by additional risk factors that are not presently known to us or that we currently consider to be immaterial to our operations.

We face a risk of non-compliance with certain financial covenants in our Credit Agreement. We may need to seek an amendment of the Credit Agreement and may need to obtain additional capital through the issuance of debt or equity securities in order to remain in compliance and to fund our operations.

Effective May 30, 2008, the Credit Agreement related to our revolving credit facility was amended to provide greater flexibility under the existing financial covenants, to include additional financial covenants and monthly measurement of financial covenants, to modify the credit limit and maturity date, to increase the cost of borrowing, to provide the lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries, and to impose additional restrictions and covenants with respect to our operations. As of the end of the third quarter of fiscal 2008, we were in full compliance with all financial covenants. With the increased uncertainty in the current macroeconomic environment, however, we believe that we may fall out of compliance with these financial covenants, either during the fourth quarter of 2008 or early in 2009. Failure to remain in compliance with the financial covenants could severely constrain our operating flexibility and our ability to fund our business operations.

In light of these increased uncertainties, we are considering options to enhance our financial flexibility and fund our operations including, additional actions to reduce our cost structure and improve profitability, the need to raise equity or debt capital, or the need to amend the financial covenants under our debt agreement. Any amendment of the Credit Agreement may significantly increase the cost of credit provided under the credit facility and related expenses, which may adversely impact our profitability. Whether or not we obtain an amendment of the Credit Agreement, we may need to or choose to seek additional capital through the issuance of debt or equity securities. The issuance of any additional debt securities could materially and adversely impact our profitability and financial condition. The issuance of additional equity securities could be substantially dilutive to our existing shareholders.

Failure to satisfy NASDAQ Global Select Market listing requirements may result in our common stock being removed from listing on the NASDAQ Global Select Market.

Our common stock is currently listed on the NASDAQ Global Select Market under the symbol “SCSS.” For continued inclusion on the NASDAQ Global Select Market, we must generally maintain, among other requirements, either (a) shareholders’ equity of at least $10 million, a minimum closing bid price of $1.00 per share and a market value of our public float of at least $5 million; or (b) market capitalization of at least $50 million, a minimum closing bid price of $1.00 per share and a market value of our public float of at least $15 million. NASDAQ has recently suspended enforcement, through January 16, 2009, of the rules requiring a minimum closing bid price and a minimum market value of public float. After January 16, 2009, however, if we fail to meet the minimum closing bid price or the minimum market value standards described above for at least 30 consecutive trading days, our common stock could be at risk of being removed from listing on the NASDAQ Global Select Market. If our common stock were removed from listing on the NASDAQ Global Select Market, our common stock may be transferred to the NASDAQ Capital Market if we satisfy the listing criteria for the NASDAQ Capital Market, or trading of our common stock may be conducted in the over-the-counter market in the so-called “pink sheets” or, if available, the National Association of Securities Dealer’s “Electronic Bulletin Board.” Consequently, broker-dealers may be less willing or able to sell and/or make a market in our common stock, which may make it more difficult for shareholders to dispose of, or to obtain accurate quotations for the price of, our common stock. Removal of our common stock from listing on the NASDAQ Global Select Market may also make it more difficult for us to raise capital through the sale of our securities.

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

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

Fiscal Period	Total Number of Shares 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
July 2008		—	NA		—
August 2008		—	NA		—
September 2008		—	NA		—
Total		—	NA		—		$	206,762

(1)  On April 20, 2007, our Board of Directors authorized the company to repurchase up to an additional $250 million of its common stock, bringing the total availability under our share repurchase program to $290 million. 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. We may terminate or limit the stock repurchase program at any time.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

                              Not applicable.

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

                              Not applicable

ITEM 5. OTHER INFORMATION

                              Not applicable.

ITEM 6. EXHIBITS

Exhibit Number		Description		Method of Filing
10.1	Amended and Restated Select Comfort Corporation Executive Severance Pay Plan dated as of August 21, 2008		Incorporated by reference to Exhibit 10.1 contained in Select Comfort’s Current Report on Form 8-K filed August 27, 2008
31.1	Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed herewith
31.2	Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed herewith
32.1	Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350		Filed herewith
32.2	Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350		Filed herewith

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	SELECT COMFORT CORPORATION
	(Registrant)
Dated: October 29, 2008	By:	/s/ William R. McLaughlin
		William R. McLaughlin
		Chief Executive Officer
		(principal executive officer)
	By:	/s/ James C. Raabe
		James C. Raabe
		Chief Financial Officer
		(principal financial and accounting officer)

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EXHIBIT INDEX

Exhibit Number		Description		Method of Filing
10.1	Amended and Restated Select Comfort Corporation Executive Severance Pay Plan dated as of August 21, 2008		Incorporated by reference to Exhibit 10.1 contained in Select Comfort’s Current Report on Form 8-K filed August 27, 2008
31.1	Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed herewith
31.2	Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		Filed herewith
32.1	Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350		Filed herewith
32.2	Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350		Filed herewith

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