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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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 28, 2002
[ ] 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
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SELECT COMFORT CORPORATION
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1597886
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6105 TRENTON LANE NORTH
MINNEAPOLIS, MINNESOTA 55442
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (763) 551-7000
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
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 [ ]
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 an accelerated filer (as
defined in Exchange Act Rule 12b-2). YES [X] NO [ ]
As of June 29, 2002, the last business day of Registrant's most recently
completed second fiscal quarter, 29,583,826 shares of Common Stock of the
Registrant were outstanding, and the aggregate market value of the Common Stock
of the Registrant as of that date (based upon the last reported sale price of
the Common Stock at that date as reported by the Nasdaq National Market System),
excluding outstanding shares beneficially owned by affiliates, was $88,157,052.
DOCUMENTS INCORPORATED BY REFERENCE
None
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TABLE OF CONTENTS
PART I............................................................................................................2
ITEM 1. BUSINESS...........................................................................................2
ITEM 2. PROPERTIES........................................................................................29
ITEM 3. LEGAL PROCEEDINGS.................................................................................30
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............................................30
PART II..........................................................................................................31
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.........................31
ITEM 6. SELECTED FINANCIAL DATA...........................................................................32
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............34
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.........................................43
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................................................43
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE..............43
PART III.........................................................................................................44
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................................................44
ITEM 11. EXECUTIVE COMPENSATION............................................................................49
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT....................................59
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................................................61
ITEM 14. DISCLOSURE CONTROLS AND PROCEDURES................................................................62
PART IV..........................................................................................................63
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K...........................................................................................63
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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(R), Sleep Number(R), Comfort Club(R), Sleep Better on
Air(R), The Sleep Number Bed by Select Comfort (logo)(R), Firmness Control
System(TM), Precision Comfort(TM), Corner Lock(TM), Intralux(TM), Everybody has
a Sleep Number(TM), Knowing your Sleep Number is the Key to a Perfect Night's
Sleep(TM), The Sleep Number Store by Select Comfort (logo)(R), You can only find
your Sleep Number on a Sleep Number Bed by Select Comfort,(TM) Select Comfort
Creator of the Sleep Number Bed(TM), What's Your Sleep Number?(TM) and our
stylized logos are trademarks and/or service marks of Select Comfort. This Form
10-K also contains 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 represented in this Form 10-K are 52 weeks.
Our corporate Internet website is http://www.selectcomfort.com. Through
a link to a third-party content provider, our corporate website 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
Securities and Exchange Commission.
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PART I
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This Annual Report on Form 10-K contains certain forward-looking
statements within the meaning of the Private Securities Litigation Reform Act of
1995. For this purpose, any statements contained in this Annual Report on Form
10-K that are not statements of historical fact may be deemed to be
forward-looking statements, including without limitation projections of results
of operations, revenues, 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. Without limiting the foregoing, words such as "may,"
"will," "should," "could," "expect," "anticipate," "believe," "estimate,"
"plan," "project," "predict," "intend," "potential," "continue" or the negative
of these or comparable terminology are intended to identify forward-looking
statements.
These forward-looking statements by their nature involve substantial
risks and uncertainties, and actual results may differ materially depending on a
variety of factors, including the items discussed in greater detail below under
the heading "Certain Risk Factors," as well as the risk factors listed from time
to time in the company's filings with the SEC.
ITEM 1. BUSINESS
OUR BUSINESS
We are 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 in comparison to traditional mattress products.
Unlike traditional bedding manufacturers, we are vertically integrated from
production through sales and customer service, which allows us to control
quality, cost, price and presentation. We sell our innovative products through
four distribution channels:
o Retail, through 321 company-operated stores in 46 states, of which 13 are
leased departments within other retail stores;
o Direct Marketing, through a company-operated call center;
o E-commerce, through our web site at selectcomfort.com; and
o Wholesale, through leading home furnishings retailers, specialty bedding
retailers and the QVC shopping channel.
Most of our products are made-to-order and are sold directly to consumers
through our company-controlled distribution channels: retail, direct marketing
and e-commerce. Our consumer-driven and service-oriented business model enables
us to understand and respond quickly to consumer trends and preferences. In
addition, our business model allows us to maintain low levels of inventory and
to generate an accelerated cash-conversion cycle, which enables us to operate
with minimal or no working capital.
We believe that consumers are increasingly focused on sleep quality, along with
nutrition and exercise, as an important component of overall health. The
National Sleep Foundation reported in 2002 that 74% of American adults are
experiencing a sleeping problem a few nights a week or more and 66% of adults
believe that their sleep surface is very important to them, with 89% agreeing
that a better quality mattress provides a better night's sleep. Our target
customers are primarily between the ages of 25 and 54 with household incomes in
excess of $50,000 per year. Since our inception, we
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have sold approximately 1.5 million beds and have achieved high levels of
customer satisfaction. From consumer inquiries and customers, we have compiled a
database of approximately 8,600,000 profiles that can be used for marketing and
research.
Following a change in executive management in 2000, we improved our cost
structure and rebranded our products and advertising, which led to significantly
enhanced operating results. From 2001 to 2002, our sales grew 28% to $335.8
million and comparable store sales grew 27%. We have improved our profitability
from an operating loss of $26.0 million in 2000 to operating income of $21.0
million in 2002 and achieved net income in each of the last six quarters. In
2002, we generated $28.3 million in cash flow from operations after capital
expenditures.
Our mission is to improve people's lives through better sleep and our objective
is to become the leading brand in the bedding industry. For the foreseeable
future, we believe we can achieve 15% to 25% annual net sales growth and
generate operating income growth of approximately twice our net sales growth
rate. In addition, we believe our efficient business model will generate
sufficient cash to self-finance our growth and liquidity requirements.
INDUSTRY
Overview
The U.S. wholesale bedding industry is a mature and stable industry that has
experienced a compounded annual revenue growth rate of approximately 6% over the
past 10 years. We believe that growth in wholesale unit sales, which has been
approximately 2% over this period, has been primarily due to population growth,
an increase in the number of homes, including secondary residences, and an
increase in the number of beds per home. We believe growth in average wholesale
prices, which has been approximately 4% over this period, was a result of a
shift to larger and higher quality beds which are typically more expensive. We
believe this trend toward higher price points is caused by a demographic shift
to an older U.S. population that typically spends more than younger consumers,
improved merchandising and consumer education by retailers and industry
advertising regarding the benefits of higher quality sleep.
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DOMESTIC WHOLESALE BEDDING SALES
[DOMESTIC WHOLESALE BEDDING CHART]
(IN BILLIONS)
1982 1,369
1983 1,593
1984 1,700
1985 1,796
1986 1,929
1987 2,095
1988 2,261
1989 2,309
1990 2,319
1991 2,382
1992 2,564
1993 2,762
1994 3,018
1995 3,181
1996 3,347
1997 3,621
1998 4,016
1999 4,370
2000 4,605
2001 4,592
2002 4,766
Source: International Sleep Products Association
Bedding Manufacturers
U.S. wholesale bedding sales were approximately $4.8 billion in 2002. According
to Furniture/Today, the four largest manufacturers, Sealy, Serta, Simmons and
Spring Air, accounted for 60.5% of wholesale bedding sales in 2001.
Bedding Retailers
U.S. retail bedding sales were approximately $7.6 billion in 2002, of which 85%
consisted of traditional innerspring bedding. The retail bedding market is
fragmented, with the top 10 retailers accounting for approximately 25% of total
sales in 2001. Bedding is sold to consumers through a variety of channels.
According to the International Sleep Products Association, in 2001, furniture
stores accounted for 41% of U.S. bedding sales, down from 56% in 1993; specialty
sleep stores 40%, up from 19% in 1993; and department stores 11%, at the same
level as 1993, with factory-direct outlets, warehouse clubs and other retail
outlets accounting for the balance.
The following chart lists the largest U.S. bedding retailers, based on 2001
sales:
2001 BEDDING SALES
RANK COMPANY ($ MILLIONS)
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1 Select Comfort $242.1
2 Federated Department Stores 235.0
3 The Mattress Firm 220.0
4 The Mattress Discounters 218.0
5 Sam's Club 200.0
6 Sleepy's 199.0
7 Mattress Giant 174.0
8 May Department Stores 130.0
9 Berkshire Hathaway
(furniture division) 120.0
10 Rooms to Go 120.0
11 JC Penney 103.0
12 Art Van 100.0
13 Rockaway Bedding 94.0
14 Dial-A-Mattress 90.0
15 Levitz Home Furnishings 70.0
16 The Sleep Train 66.0
17 Sleep Fair/Mattress Warehouse 63.0
18 Sears 60.0
19 Havertys 55.0
20 Costco 55.0
21 Slumberland 50.0
22 Value City 47.0
23 Sit `n Sleep 46.9
24 Rhodes 45.0
25 W.S. Badcock 42.0
Source: Furniture/Today (August 2002)
COMPETITIVE STRENGTHS
Our objective is to become the leading brand in the bedding industry, both in
revenue share and product innovation. To achieve this goal, we intend to
capitalize on the following strengths:
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Differentiated, Superior Product
Our proprietary Sleep Number bed was designed on the basis of sleep research and
is clinically proven to provide better sleep quality and greater relief of back
pain in comparison to traditional mattress products. Unlike traditional
mattresses made from innersprings, our innovative Sleep Number bed uses
proprietary air-chamber technology that allows each side of the mattress to be
easily adjusted on a hand-held remote control that digitally displays an
individual's Sleep Number. A Sleep Number is a number from zero to 100 that
represents a sleeper's ideal level of comfort, firmness and support. Our Sleep
Number bed offers dual comfort control for couples, allowing either sleeper to
adjust the mattress firmness on each side of the bed. Our research indicates
that 9 of 10 couples sleep at different Sleep Number settings, making the dual
comfort control feature a compelling differentiator from standard bedding
offerings.
Clinical research has shown that people who sleep on a Sleep Number bed fall
asleep faster and experience deeper sleep with fewer disturbances than those
sleeping on a traditional innerspring mattress. The gentle and conforming
support of the air chambers in our Sleep Number beds provides more proper spinal
alignment and relief from uncomfortable pressure points that can cause tossing
and turning and poor-quality sleep. The capability of our Sleep Number bed to
address consumer sleep problems is further evidenced by the more than 25,000
testimonials we have received from our customers over the years.
Our Sleep Number beds are priced competitively with other premium mattress
products and are also more durable than traditional innerspring products,
resulting in a stronger value proposition for the consumer. Because our Sleep
Number bed does not depend on metal coils or springs for its support structure,
it maintains its shape and support better over time than traditional innerspring
mattresses. Independent durability testing has shown our Sleep Number bed to
withstand more than 20 years of simulated use.
Proven Brand Development Strategy
In January 2001, we successfully repositioned our product and advertising
messages, creating the Sleep Number brand and a new multi-media advertising
campaign to increase awareness of our innovative, proprietary beds. The brand
message hierarchy of the Sleep Number campaign is clear and proprietary:
o A Sleep Number represents an ideal level of bedding comfort, firmness and
support;
o Everybody has a Sleep Number(TM);
o Knowing your Sleep Number is the Key to a Perfect Night's Sleep(TM); and
o You can only find your Sleep Number on a Sleep Number Bed by Select
Comfort(TM).
This branding strategy allowed our advertising and consumer communication to
focus on our bed's distinguishing and proprietary feature, personalized comfort,
as represented by the digital Sleep Number readout on the bed's hand-held remote
control. In addition to rebranding our product in 2001, we broadened our
demographic and media reach by targeting adults 25-54 years old with a message
of improved sleep quality. The Sleep Number brand was launched through our
first-ever prime-time television advertising campaign, which invited consumers
to visit their local Select Comfort retail store to find their personal Sleep
Number. By focusing on the unique Sleep Number setting of an individual, the
campaign quickly conveys the concept of our bed's comfort customization. The
Sleep Number brand and positioning have been integrated into all of our sales
channels and throughout our internal and external communication programs.
Although we have less than 5% unaided awareness nationally, average unaided
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awareness of our Sleep Number brand reached 15% by the end of 2002 in the eight
markets where the Sleep Number campaign was launched beginning in early 2001,.
In these markets, we experienced annual comparable store sales growth in the
range of 26% to 38% in 2002. Our Sleep Number campaign in now in a total of 20
markets.
Our Sleep Number campaign is efficient as well as effective. During 2002, while
overall media investment rose 34% to nearly $40 million, marketing expense as a
percent of net sales declined to 20% in 2002 from 22% in 2001 and 24% in 2000,
before our Sleep Number advertising campaign was introduced.
Company-Controlled Distribution
Unlike traditional bedding manufacturers, which primarily sell through
third-party retailers, we generate approximately 95% of our net sales through
company-controlled distribution channels: retail, direct marketing and
e-commerce. This distribution model enables us to control the selling process to
ensure that the unique benefits of our product are effectively presented to
consumers, to maintain direct contact with our customers and to capture both the
manufacturer's and retailer's margin.
Our company-controlled distribution channels are staffed by high-quality,
well-trained and passionate sales professionals who are Sleep Number bed owners.
Our retail channel comprised 77% of our net sales in 2002. We operate 321 stores
in 46 states, which allows consumers to easily experience our products and find
their personal Sleep Number. Our direct marketing call center and our web site
at selectcomfort.com provide national sales coverage, including markets not yet
served by one of our retail stores. Our web site can be used as a product
research tool, a place to purchase or as a means to locate our nearest retail
store. Through these various channels, we maintain close contact with consumers,
who provide us with important feedback for product improvement and innovation.
Flexible and Efficient Operating Model
Unlike traditional bedding manufacturers and retailers that are dependent on a
stock of finished-goods inventory to fill orders, we employ a make-to-order
manufacturing process. Through our long-term relationships with high-quality
suppliers, which have been selected through a rigorous certification and review
process, we have implemented a just-in-time materials supply system. This
operating model enables us to maintain low levels of inventory and to generate
an accelerated cash-conversion cycle, which allows us to operate with minimal or
no working capital. In 2002, our manufacturing inventory turn was 20x. Our
make-to-order manufacturing process allows us to introduce new or enhanced
products without generating significant obsolete or clearance-priced
finished-goods inventory. As a result of our flexible and modular production
process, we estimate that we can double our current production volume in our
existing manufacturing facilities with minimal capital investment.
Our efficient operating model extends from manufacturing to our stores with no
regional warehousing. Our unique air chamber technology allows our beds to be
packed in boxes and shipped via UPS or Fed Ex directly from our manufacturing
plants to our customers, anywhere in the United States, which lowers our
distribution costs. Consumers also appreciate the ease of handling and moving
our bed, particularly through hallways and tight spaces.
Our stores serve as showrooms for our Sleep Number bed, without the need for any
on-hand bed inventory. This low inventory model allows us to generate increased
sales volume from existing retail floor space without a corresponding increase
in working capital. In 2002, our retail inventory turn was 25x, and the average
net sales per store was approximately $817,000 compared to approximately
$626,000 in 2001.
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GROWTH STRATEGY
We expect sales growth in the foreseeable future to be derived primarily from
comparable store sales increases, opening stores in existing and new markets and
adding new distribution channels. We expect to enhance our profit margin
primarily by leveraging our existing infrastructure. To accomplish our growth
strategy, we intend to focus on the following priorities:
Building Brand Awareness
Our most significant barrier to growth has been a lack of awareness of our
innovative, high quality product among the broad consumer audience. With less
than 5% unaided brand awareness nationally, we have significant opportunity for
growth through increasing awareness of the Sleep Number brand, our innovative
products and our store locations. Through long-established advertising and
marketing programs, the most recognized bed brands have built national unaided
awareness to 53% (Sealy), 33% (Serta) and 19% (Simmons).
Our Sleep Number campaign was introduced regionally in early 2001, and in 2002
received substantially more national advertising, particularly on national cable
television, using a new infomercial and several direct-response advertisements
to drive awareness of our Sleep Number bed. Our proven national radio campaign
with Paul Harvey and Rush Limbaugh is being augmented by national television
advertising with a new infomercial and several new direct response ads to build
national awareness of our Sleep Number bed. As of January 2002, the Sleep Number
Bed by Select Comfort became a national sponsor of National Public Radio's
Prairie Home Companion show hosted by Garrison Keillor. We believe increased
national advertising in 2003 will further increase consumer brand awareness to
profitably generate traffic and sales at our stores, call center and web site.
Our national campaign is augmented by regional advertising that continues to
expand. We are currently in 20 markets that cover approximately 27% of the U.S.
population and 46% of our current retail sales. This regional campaign includes
a custom mix by market of prime-time and infomercial television, drive-time
radio and newspaper advertisements. In 2002, we continued to drive strong sales
growth in the eight markets where this campaign was launched in early 2001, with
comparable store sales increases ranging from 33% to 63% in the fourth quarter
of 2002. These markets are among our more mature and developed markets,
reinforcing our belief that our brand awareness will continue to grow over time
with additional advertising investment. We believe substantial opportunity
exists in broadening the reach of this campaign into other metropolitan markets.
Due to our multi-channel and direct-to-consumer sales model, we are able to cost
effectively implement an integrated multi-media advertising program, both on a
national and local-market basis. Our fully integrated direct marketing
capabilities allow us to provide inquiring consumers with product information
and to follow up with promotional literature during the buying process. We plan
to increase total media spending by 25% to approximately $50 million in 2003,
and believe we have significant opportunity to increase effective investment in
the future to drive incremental awareness, store traffic and sales.
Expanding Profitable Distribution
We plan to expand profitable distribution primarily by:
o Increasing comparable store sales, primarily through our multi-media
advertising campaign and increasing average revenue per transaction;
o Remodeling 100 older stores in 2003 to our latest store design;
o Adding 20 to 30 new retail stores in 2003;
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o Increasing our store base by 5% to 10% annually beyond 2003;
o Testing our stores in non-mall locations;
o Expanding wholesale distribution selectively through specialty retailers;
and
o Building our QVC partnership.
Comparable store sales growth will be comprised of both an increase in the
number of units sold and an increase in the average revenue per transaction.
This growth will be driven by increased advertising, improvements in our selling
process, our enhanced, performance-based sales compensation plan and improved
quality and training of our sales professionals. An increase in average revenue
per transaction will be driven by continued product innovation in our
higher-priced bed models and continued development of our accessory line. In
addition, in 2003, we plan to remodel 100 of our older stores to a newer design
with improved Sleep Number branding and product presentation. In order to expand
our appeal to a broader consumer market, we are increasing the availability of
our convenient home delivery and assembly services and extended financing
offers.
Supported by our proven advertising strategy and store economics, we are in a
position to add a program of profitable store expansion to our growth
initiatives. We now have at least one Select Comfort retail store in 119
Designated Market Areas in the United States, which represent 85% of total U.S.
household population. However, in many of those markets, including major cities
such as Boston, Los Angeles and New York, we do not have a sufficient number of
stores in relation to the size of the local population to allow us to realize an
economic return on advertising. These understored markets are the focus of our
store opening plans in 2003.
In the past two years, we have begun to develop our wholesale sales channel,
providing consumers additional opportunities to become aware of and to purchase
our Sleep Number bed. Our wholesale channel sells to a limited number of home
furnishings retailers and specialty bedding retailers in selected markets and to
consumers via the QVC shopping channel. This channel allows us to expand our
points of sale more quickly and with lower capital expenditure by leveraging our
brand building advertising.
Leading the Industry in Product Innovation
Our goal is to continue to lead the industry in product innovation and sleep
expertise by developing and marketing products that deliver personalized comfort
and better sleep. We focus our research and development resources on enhancing
performance of our core product line, improving quality and reducing costs. In
2002, we introduced more new products and product enhancements than in any other
year of our history. We improved the appearance, function and sleep-surface
comfort of every bed in our product line, which we expect to benefit from in
2003. Sales of the newly re-designed Sleep Number 5000 and 7000 models, our two
higher-end product offerings, increased as a percentage of our product mix by
eight percentage points in 2002 compared to 2001.
Our strategy is to maintain a pipeline of benefits-driven product innovation,
introducing a new product or refreshing an existing model each quarter.
Following a successful test market in the third quarter of 2002, we are
currently in a national rollout of our Precision Comfort adjustable foundation
product, which allows consumers to adjust their bed position at both the head
and feet. In February 2003, we launched our new oversized Grand King model, with
a 30% larger sleeping area than a traditional King-sized mattress, inspired by a
bed we custom made for seven-foot-tall NBA player Kevin Garnett. We also
continue to expand our line of high-quality sleep accessories that improve
comfort, such as pillows designed for specific sleep positions and
dual-controlled heated mattress pads.
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Leveraging our Infrastructure
As a result of improving our cost structure in 2000 and 2001, we believe we are
well positioned to generate profitable growth. Over this period, we eliminated
over $25 million from our cost structure and reduced the number of units we must
sell in a year to become profitable by nearly 20%. While undertaking this cost
reduction program, we have preserved our capacity to support growth, introduced
a new media campaign and reinvigorated product development.
These successful cost-containment measures continue to allow us to leverage our
fixed cost structure and realize improved operating margins through sales
growth. Our goal is to generate sales growth of 15% to 25% annually, while
containing general and administrative expense growth at less than half that rate
and leveraging the fixed costs of our retail stores. We intend to maintain
marketing and advertising investment at approximately 20% of net sales to build
our brand and generate sales growth. We expect 2003 operating income margin to
increase to at least 7% and believe we can achieve operating income margins of
10% to 12% within a three-year horizon.
Adding Product Categories, Markets and Geographies
Once we have more thoroughly penetrated the U.S. bedding market, our longer-term
goal is to extend our brand through new product introductions, new market
segments and international markets. For example:
o We are currently developing a sofa sleeper featuring our Sleep Number bed;
o We are evaluating our opportunities within OEM channels, beginning with a
partnership with Winnebago Industries, which now installs our Sleep Number
bed as standard or as an option in six of its higher-end motor home models;
o We are testing the placement of our Sleep Number bed in a hotel chain; and
o We are evaluating the benefits of expanding internationally in order to
capitalize on our differentiated product, our operating model and the
international management experience of our executive team.
HISTORY
We were founded in 1987 by an entrepreneur working in the innerspring mattress
industry believed adjustable air chamber technology provided better support and
reduced pressure points in comparison with other bedding products. In the early
1990s, we began to market an air bed directly to consumers through traditional
direct marketing and opened our own call center. We opened our first retail
store in the Minneapolis area in 1992. Since then, we have grown to 321 retail
stores in 46 states. We developed our third company-controlled distribution
channel, e-commerce, in 1999. We added a wholesale distribution channel in late
2000.
From mid-1999 to mid-2001, we experienced operating losses. In 2000, we
recruited William R. McLaughlin as our President and Chief Executive Officer.
Mr. McLaughlin has been instrumental in planning and executing our improved
operating and growth strategy. As part of this strategy, we implemented cost
containment initiatives to return our company to profitability while preserving
our capacity to support growth. In 2001, we launched our Sleep Number brand
campaign to generate sales growth.
OUR PRODUCTS
We sell a proprietary line of beds under the Sleep Number brand that features an
adjustable air chamber mattress. A Sleep Number is a number from zero to 100
representing an individual's ideal level of comfort, firmness and support.
Unlike traditional mattresses, which use a series of innersprings for support,
our
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mattress design uses air chambers. Our Sleep Number bed was designed on the
basis of sleep research and has been shown to improve sleep quality through:
o Better spinal alignment;
o Reduced pressure points;
o Greater relief of lower back pain; and
o Greater overall comfort.
Mattresses
We offer four different Sleep Number bed models. Each bed comes in standard
mattress sizes, ranging from twin to king, as well as some specialty sizes. All
Sleep Number beds feature high quality, vulcanized rubber air chambers that are
highly durable. Because air is the primary support material of the mattress,
Sleep Number beds do not lose their shape or support over time like traditional
innerspring bedding. The dual chambers allow each side of the mattress to be
independently adjusted with our Firmness Control System for personalized comfort
and support. Our Firmness Control System features a compact air compressor with
a handheld remote that is used to fill the bed's air chamber and regulate its
firmness. The Firmness Control System for our Sleep Number bed is certified by
Underwriter's Laboratories (UL).
The air chambers of a Sleep Number bed are surrounded on all sides by a
high-density foam perimeter to provide strong edge support. For added comfort,
we offer a plush pillowtop option with an extra cushion of support designed to
cradle the body. All Sleep Number mattresses are enclosed by a comfortable,
durable Belgian Damask covering. Our covers are sewn in our plants in the United
States.
Our entry-level model, the Sleep Number 3000, is 7 1/2 inches in total mattress
thickness for the traditional-style sleep surface and 9 inches for the European
pillowtop style. It comes standard with our Firmness Control System, with two
wired remote controls that allow touch-button firmness adjustment. An optional
upgrade to the digital Sleep Number remote control is available.
Our Sleep Number 4000 is our first model to feature our fully gusseted pillowtop
style and the Sleep Number Firmness Control System as standard. A single, wired
remote control with digital display is used to set each side of the bed to each
individual's preferred Sleep Number. Our Sleep Number 4000 model has added
sleep-surface cushioning and is 8 1/2 inches in total mattress thickness for the
traditional style and 10 inches for the pillowtop style.
Our best-selling model is the Sleep Number 5000, which features more comfort
padding and fiberfill loft, a higher-quality, satin-feel rayon Belgian Damask
mattress fabric, and our patent-pending Corner Lock system for crisp corner
support. Our Sleep Number 5000 features the whisper-quiet Deluxe Sleep Number
Firmness Control System, and comes with either one wireless or two wired digital
remote controls for easy Sleep Number adjustment. Our Sleep Number 5000 is 10
inches in total mattress thickness for the traditional style and 12 1/2 inches
for the pillowtop style.
Our top-of-the-line Sleep Number 7000 model incorporates the Deluxe Sleep Number
Firmness Control System and the Corner Lock system is 14 inches in mattress
thickness and is available exclusively as a Duvet-style pillowtop, covered in
Belgian Damask fabric. Our Sleep Number 7000 features three-layers of interior
foam, including Hypersoft quilting foam and a 3-inch layer of our exclusive
Intralux foam, for added comfort, support and resiliency.
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Our current retail prices for our beds (excluding foundations) range as follows:
SLEEP NUMBER MODEL TWIN FULL/DOUBLE QUEEN KING
- ------------------ ------------ ------------- ------------- --------------
3000 $300 - 560 $500 - 650 $500 - 700 $700 - 900
4000 $500 - 700 $700 - 900 $800 - 1,000 $1,100 - 1,300
5000 $700 - 1,000 $950 - 1,150 $1,100 - 1,300 $1,400 - 1,600
7000 $1,900 N/A $2,300 $2,650
These prices are subject to promotional offerings that can result in pricing at
10% to 15% below these listed retail prices. We offer a slightly different
series of Sleep Number bed models to our wholesale partners. We do not control
the prices at which our wholesale partners sell our Sleep Number beds to their
customers.
Foundations
The contouring and support of a Sleep Number mattress work best with our
specially designed, proprietary foundation. Used in place of a box spring, this
durable foundation is uniquely designed to complement the air chambers and
maintain a consistent support surface for the life of the bed. Our foundation is
designed with interlocking panels for maximum structural integrity, as well as
high-density polymer side panels and lateral support beams for additional
support. Unlike traditional box springs, our foundation can be disassembled and
easily moved through hallways, tight spaces and up and down stairs. Through
certain wholesale partners, we offer a wood foundation. The current retail
prices of our foundations range from $200 to $550, depending upon the size of
the bed.
We recently introduced our Precision Comfort adjustable foundation, which allows
consumers to adjust their bed position at both the head and feet using a
handheld remote. We believe consumers will appreciate the adjustable
foundation's comfort benefits, flexibility, therapeutic rest and pressure
relief. The current retail prices of our adjustable foundations range from
$1,200 to $2,400, depending upon the size of the bed.
Accessories
In addition to our mattresses and foundations, we offer a line of accessory
bedding products, including specialty pillows, mattress pads, comforters, sheets
and bed frames. The specialty pillows, which come in a variety of sizes,
materials and firmness, are designed to provide personalized comfort and better
quality sleep. We recently introduced a number of new accessories, including our
Imperial Mattress Pad, a luxury mattress pad filled with down resilient fiber;
our Dual-Weight Merino wool blanket, exclusively made for us by Faribault Woolen
Mills; and our Dual-Control Heated Mattress Pad, with 21 temperature settings
that allow each sleeper to customize personal warmth levels.
Delivery and Assembly Services
Our unique product design allows us to ship our beds in a modular format to
customers throughout the United States by UPS or FedEx. We regularly review our
package sizes to take advantage of more favorable shipping rates. Informational
product brochures and easy-to-follow assembly instructions accompany each Sleep
Number bed, which can be quickly and easily assembled by the customer through a
simple, tool-free process. For an additional fee between $75 and $100, the
customer can take advantage of our home delivery, assembly and mattress removal
services. At the end of 2002, these services were available through
approximately 80% of our retail stores, in certain markets by a third-party
provider. We plan ultimately to offer this service in all of the markets served
by our stores. Delivery typically takes between 10 and 14 days from the date of
order.
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Better Night's Sleep Guarantee and Warranty
Each of our Sleep Number beds comes with our 30 Night In-Home Trial and Better
Night's Sleep guarantee which allows consumers 30 nights at home to make sure
they are 100% comfortable with our bed. If the consumer is not completely
satisfied, we will authorize the return of the bed and a refund. The consumer is
responsible for the return shipping costs. Each of our Sleep Number beds is
backed by a 20-year Limited Warranty. We believe that due to our unique design
and craftsmanship, our Sleep Number bed is built to last 20 years or more.
OUR DISTRIBUTION CHANNELS
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. We also sell
through a wholesale channel to leading home furnishings retailers, specialty
bedding retailers and the QVC shopping channel. Our wholesale strategy is to
expand our points of sale more quickly in selected markets with lower capital
expenditures than opening new retail stores. In addition, our wholesale strategy
allows us to leverage our advertising and increase brand awareness in large
markets where it would otherwise not be cost effective for us to spend
advertising dollars.
Retail
Our retail stores accounted for 77% of our net sales in 2002 and 78% of our net
sales in 2001. We currently operate 321 stores in 46 states, including 13 leased
departments within other retail stores. Our stores are principally mall-based
showrooms, averaging approximately 1,000 square feet and displaying four models
of our Sleep Number beds and a full selection of our branded accessories. Our
store design incorporates a bedroom-like setting intended to convey a sense of
sophistication and quality that reinforces our Sleep Number brand name as
synonymous with sleep solutions. We intend to remodel approximately 100 of our
older stores in 2003 to the current design standard. Our sales professionals
play an important role in creating an inviting and informative retail
environment. These professionals receive extensive training regarding the
features and benefits of our Sleep Number beds and accessories, the overall
importance of sleep quality and our newly developed, standardized selling
process.
Direct marketing
Many consumers' initial exposure to our Sleep Number bed is through our direct
marketing operations. Interested consumers respond to our print, radio and cable
television advertisements by calling our toll-free number. Our direct marketing
sales professionals capture information from the consumer, begin the consumer
education process, take the order, or, if appropriate, send an information
packet. Our direct marketing operations also include a database marketing
department that is responsible for segmentation and analysis of our database to
direct the mailing of product and promotional information in response to
inquiries. We maintain a database of approximately 8,600,000 inquiries,
including customers. In 2001, we established a "Factory Direct" outlet through
our direct marketing channel, allowing us to selectively market returned
products that we have refurbished where allowed by law and discontinued models.
E-commerce
Our web site at selectcomfort.com provides consumers with a wide array of useful
information as well as the convenience of ordering our products online or
calling and ordering from one of our internet-dedicated sales professionals.
Since building the capability to take online orders in May 1999, our e-commerce
channel has continued to add functionality and content to educate consumers
regarding sleep science and research, our products and the benefits they
provide. Our web site also directs consumers to our store locations and provides
other means to contact us. Our e-commerce department has also focused on
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developing relationships with online shopping malls and other sales portals. Our
web site incorporates a look and feel that is attractive and professional and
reinforces the Select Comfort and Sleep Number brand images. Consumers can
access our web site through two other sites, sleepnumber.com and beds.com.
Wholesale
We are selectively building wholesale relationships with home furnishings
retailers and specialty bedding retailers. These wholesale relationships
increase our points of sale with lower capital requirements and we believe will
allow us to leverage our advertising spending in key markets. Since September
2000, we have tested wholesale distribution through home furnishings retailers.
Since July 2002, our Sleep Number bed has been featured in 40 Sleep Train stores
in California. Sleep Train is the first large scale, multi-store specialty
bedding retailer to offer our Sleep Number bed outside of our company-controlled
stores. In August 2002, we began to sell our Sleep Number bed through Sleep
America, a 19-store specialty retailer in the Phoenix and Tucson markets. We
plan to selectively pursue additional distribution through other wholesale
partners.
Since October 2000, we have successfully offered our products through periodic
segments on the QVC shopping channel. Our Sleep Number bed was named QVC's Home
Innovation Product Concept of the Year at QVC's 2001 QStar Awards. We believe
that our distribution through QVC has increased overall consumer awareness of
our Sleep Number brand in addition to providing us with an important sales
outlet.
STORE OPERATIONS
Store Economics
Average net sales per store were approximately $817,000 in 2002 and $626,000 in
2001, with average sales per square foot of approximately $840 in 2002 and $670
in 2001. For 2001, our sales per square foot were the fourth highest among all
bedding and furniture retailers according to a May 2002 Furniture/Today survey.
New stores opened in 2002 are expected to average approximately $800,000 of net
sales in the first year of operations. Approximately 24% of our stores generated
sales of over $1.0 million in 2002.
Our investment to open a new store is approximately $140,000, 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
breakeven on a four-wall cash flow basis with approximately $525,000 of net
sales. Our four-wall cash flow is calculated as gross profit generated from
store sales less store expenses and advertising, without deduction of
depreciation expenses. We plan to open 20 to 30 new retail stores in 2003
primarily to fill out existing markets in order to leverage brand awareness and
advertising.
Site Selection
We cluster retail stores within a metropolitan market in order to leverage our
advertising. In selecting new store sites, we generally seek high-traffic
locations of approximately 800 to 1,200 square feet within malls in metropolitan
areas. We conduct extensive analyses of potential store sites and base our
selection on a number of factors, including the location within the mall, the
demographics of the trade area, the specifications of the mall (including size,
age, sales per square foot and the location of the nearest competitive mall),
the perceived strength of the mall's anchor stores, the performance of other
specialty retail tenants in the mall, the store density of existing stores and
our marketing and advertising plans in the respective markets. We intend to test
store locations in select strip centers and lifestyle-oriented shopping centers
in 2003.
Management and Sales Professionals
Our stores are currently organized into four regional areas and 34 districts,
with seven to 12 stores in each district, depending on geographical dispersion.
Each regional sales
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director oversees eight or nine districts. Each district has a district sales
manager who is responsible for sales and operations and reports to the regional
sales director. The district sales managers frequently visit stores to review
merchandise presentation, sales force product knowledge, financial performance
and compliance with operating standards. The typical staff of one of our new
Select Comfort stores consists of one store manager and two full-time sales
professionals. Store staffing expands as store sales volume grows. Our sales
professionals devote substantially all of their efforts to sales and customer
service, which includes helping customers and responding to inquiries.
Training and Compensation
All store personnel receive comprehensive on-site training on our technology and
sleep expertise, the features and benefits of our beds, sales and customer
service techniques and operating policies and guidelines. Initial training
programs are reinforced through detailed product and operating manuals and
periodic performance appraisals. All store sales professionals receive base
compensation and are entitled to commissions and bonuses based on individual and
their store's performance. Early in 2002, we introduced a redesigned retail
sales professional compensation program that is more focused on individual
performance and more heavily commission driven, which we believe will enable us
to attract and retain quality, sales-oriented store professionals. Regional
sales directors, district sales managers and store managers are eligible to
receive, in addition to their base compensation, bonuses for the achievement of
performance objectives.
MARKETING AND ADVERTISING
Lack of awareness among the broad consumer audience of our brand, product
benefits and store locations historically has been our most significant barrier
to growth. The new Sleep Number advertising campaign was introduced early in
2001 to support our retail stores in selected markets through our first
comprehensive multi-media advertising campaign using prime-time TV, national
cable television, infomercials, drive-time radio and newspaper advertisements.
We have expanded the comprehensive multi-media Sleep Number advertising campaign
from the initial eight markets in 2001, to 16 markets in 2002 and to 20 markets
in 2003. As of January 2002, the Sleep Number Bed by Select Comfort became a
national sponsor of National Public Radio's Prairie Home Companion show hosted
by Garrison Keillor. In 2003, we plan to extend the reach of our successful
radio personality endorsement advertising by adding 65 new radio personalities
for a total of 123 radio personalities in 113 retail store markets.
In the direct marketing channel, our advertising message is communicated through
targeted print and radio advertisements, use of infomercials and short-form
direct TV advertising and through product brochures, videos and other product
and promotional materials mailed in response to consumer inquiries. The direct
marketing channel has relied heavily on our advertising through nationally
syndicated radio personalities, such as Paul Harvey and Rush Limbaugh, and print
and direct mail programs. We are continuing to increase our advertising
investment on national cable TV, predominantly purchased at advantageous direct
response media rates. This provides a base of awareness upon which local retail
store advertising cumulatively builds. Our direct marketing operations
continually monitor the effectiveness and efficiency of our advertising by
tracking the cost per inquiry and cost per order of our advertising.
The Sleep Number positioning was integrated into our marketing messages across
all of our distribution channels during 2001. To support our direct marketing
channel, a new 30-minute infomercial, a pool of two-minute short-form television
spots and new print advertisements were created around the Sleep Number
positioning. Likewise, the messaging on our web site, in promotional material
and on QVC broadcasts was successfully transitioned to focus on our Sleep Number
bed. We have increased our
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1-800 advertising on national cable TV as an economical means of increasing
national brand awareness for our Sleep Number bed. Through our dedicated call
center, we are able to provide the inquiring consumer more information or send a
video and brochure. Although total media expenditure is planned to increase by
25% to approximately $50 million in 2003, we have significant opportunity to
increase effective investment in the future, with the proven result of driving
incremental awareness, traffic and purchases.
All owners of our beds are members of our Comfort Club, our customer loyalty
program designed primarily to reward our owners for recommending our beds. Each
time a customer purchases a bed, the referring member receives a $50 coupon for
purchase of our products, with increasing benefits for multiple referrals. In
2002, approximately 23,000 beds were sold through referrals from our Comfort
Club members.
OPERATIONS
Manufacturing and Distribution
We have two manufacturing plants, one located in Columbia, South Carolina, and
the other in Salt Lake City, Utah. 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 from
contract manufactured components. In addition, our electrical Firmness Control
System is assembled from contract manufactured components in our Salt Lake City
plant. In April 2001, we discontinued manufacturing in our Minneapolis location
and have since used this facility to process returns and warranty claims.
We manufacture beds to fulfill orders rather than stocking inventory, which
enables us to maintain lower levels of finished goods inventory and operate with
no regional warehousing. Orders are currently shipped from our manufacturing
facilities, primarily via UPS, typically within 48 hours following order
receipt, and are usually received by the customer within 5 to 10 business days
after shipment. We are continually evaluating alternative carriers on a national
and regional basis, as well as expanding our in-home assembly services in
selected markets.
Suppliers
We currently obtain all of the materials and components used to produce our beds
from outside sources. Components for the Firmness Control System are obtained
from a variety of domestic sources. Quilting and ticking materials are obtained
from a supplier that produces both in Belgium and in the United States.
Components for our foundations are obtained from one domestic source.
Our proprietary air chambers are produced to our specifications by one Eastern
European supplier, which has been our sole source of supply of air chambers
since 1994. Under our agreement with this supplier, we are obligated to purchase
certain minimum quantities. This agreement runs through October 2006 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 foundations are produced to our specifications by one domestic
supplier under an agreement that expires in October 2003. This agreement is
subject to automatic annual renewal unless either party gives 180 days' notice
of its intention not to renew the agreement. 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
15
supplier's ability to maintain uninterrupted supply of materials and components.
Research and Development
Our research and development department continuously seeks to improve current
product performance and benefits based on sleep science. Through customer
surveys and consumer focus groups, we seek feedback on a regular basis to help
enhance our products. Since the introduction of our first bed, we have continued
to improve and expand our product line, including a quieter Firmness Control
System, remote controls with digital settings, more luxurious fabrics and
covers, new generations of foams and foundation systems and enhanced border
walls. Our research and development expenses were $0.9 million in 2002, $1.1
million in 2001 and $0.9 million in 2000.
Customer Service
We maintain an in-house customer service department of over 40 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 raised with retail sales professionals. Our
customer service department also makes outbound calls to new customers during
our in-home trial phase to provide solutions to possible problems in order to
enhance customer education, build customer satisfaction and reduce returns.
Consumer Credit Arrangements
Through a private label consumer credit facility provided by Mill Creek Bank, a
subsidiary of Conseco Finance Corp., our qualified customers are offered a
revolving credit arrangement to finance purchases from us. Mill Creek Bank sets
the minimum acceptable credit ratings, the interest rates, fees and all other
terms and conditions of the customer accounts, including collection policies and
procedures, and is the owner of the accounts. In connection with all purchases
financed under these arrangements, Mill Creek Bank pays us an amount equal to
the total amount of such purchases, net of promotional related discounts.
Mill Creek Bank's right to set the minimum customer credit ratings could, if
exercised, impact sales by affecting the number of customers who can finance
purchases. The term of this facility expires in May 2004, subject to automatic
one-year renewals, unless terminated by either party upon 150 days' notice prior
to the end of the then-current term. We are liable to Mill Creek Bank for
chargebacks 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 have provided
a standby letter of credit to Mill Creek Bank in the amount of $1.0 million to
protect Mill Creek Bank against potential losses from unpaid chargebacks. We are
not liable to Mill Creek Bank for credit losses arising out of our customers'
credit defaults. If we replace Mill Creek Bank with an alternative third-party
provider of consumer financing, Mill Creek Bank could request that we purchase
its portfolio of our customer accounts based on a pre-determined formula, which
reflects a discount to the face amount of these accounts. If we were to engage a
replacement provider, we would likely require this new provider to purchase the
portfolio from Mill Creek Bank, relieving us of our obligations under this
facility.
COMPETITION
The bedding industry is highly competitive. Participants in the bedding industry
compete primarily on price, quality, brand name recognition, product
availability and product performance, including the perceived levels of comfort
and support provided by a mattress. Our beds compete with a number of different
types of bedding alternatives, including innerspring bedding, foam bedding,
waterbeds, futons and other air-supported bedding that are sold through a
variety of channels, including
16
home furnishing stores, specialty bedding stores, department stores, mass
merchants, wholesale clubs, telemarketing programs, television infomercials and
catalogs. We believe that our success depends in part on increasing consumer
awareness and acceptance of our existing products and the continuing
introduction of product improvements or new products with features or benefits
that differentiate our products from those offered by other manufacturers.
Innerspring bedding sales represent approximately 85% of all bedding sales. The
traditional bedding industry is characterized by a high degree of concentration
among the four largest manufacturers of innerspring bedding with nationally
recognized brand names, including Sealy, which also owns the Stearns & Foster
brand name, Serta, Simmons and Spring Air. Numerous other manufacturers,
primarily operating on a regional or niche basis, serve the balance of the
bedding market.
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 22 issued U.S.
patents, expiring at various points between January 2005 and March 2020, and
four U.S. patent applications pending. We also hold 16 foreign patents and 14
foreign patent applications pending. Notwithstanding these patents and patent
applications, we cannot assure you 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. Applications for our new "Select Comfort" logos
with the double arrow design have been approved for registration and published
for opposition. We have a number of other registered marks, including "The Sleep
Number Bed by Select Comfort" (logo), "The Sleep Number Store by Select Comfort"
(logo), "Comfort Club" and "Sleep Better on Air." U. S. applications are pending
for a number of other marks, including "Select Comfort Creator of the Sleep
Number Bed," "What's Your Sleep Number?" and several other marks that
incorporate our new logo design. 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.
GOVERNMENTAL REGULATION
Our operations are subject to state and local consumer protection and other
regulations relating to the bedding industry. These regulations vary among the
states in which we do business. The regulations generally impose requirements as
to the proper labeling of bedding merchandise, restrictions regarding the
identification of merchandise as "new" or otherwise, controls as to hygiene and
other aspects of product handling and sale and penalties for violations. Our
direct marketing operations are or may become subject to various adopted or
proposed federal and state "do not call" list requirements.
The federal Consumer Product Safety Commission and various state regulatory
agencies are considering new rules relating to fire retardancy standards for the
bedding industry. The State of California plans to adopt, effective in the year
2004, new fire retardancy standards that have not yet been finally defined. If
adopted, such new rules may adversely affect our costs, manufacturing processes
and
17
materials. We are developing product solutions that are intended to enable
us to meet the new standards. Because the new standards have not been finally
determined, however, no assurance can be given that our solutions will enable us
to meet the new standards. We expect that any required product modifications
will add cost to our product.
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 state laws. Our sales of refurbished products are limited to
approximately 24 states, as the balance of the states do not allow the sale of
refurbished bedding products.
We believe we are in substantial compliance with each of these governmental
regulations.
INFORMATION SYSTEMS
We use technology to support our business and reduce operating costs, enhance
our customer experience and provide information to manage our business. We use
technology platforms from market leaders such as Oracle, Microsoft, Dell, Sun
and Cisco to run both packaged applications and internally developed systems. We
have purchased upgraded replacements for the majority of our technology
infrastructure over the past several years as equipment has come off of lease.
Our major systems include an in-store point of sale (POS), a retail portal
system, direct marketing and customer service in-bound/out-bound telemarketing
systems, e-commerce systems, retail partners support systems and Oracle ERP
systems. Our in-store retail systems include one or two POS systems in each
store, based on sales volume. The POS terminals are connected via a secured
Internet connection back to our enterprise systems. That same communication
connection is used to provide the stores with access to store productivity and
reporting systems via our retail portal. The retail, direct marketing, customer
service, e-commerce and retail partner applications are interfaced to provide a
fully integrated view of our customer and their activities across sales
channels. Our Oracle based ERP applications include modules in support of our
finance, human resources and manufacturing operations. We are currently
upgrading our Oracle applications to the 11i version to provide significantly
more flexibility, functionality and productivity cost savings.
We use a combination of primarily internal employees, supplemented by
consultants and contractors to deliver and maintain our technology systems and
assets. Outsourcing is occasionally used for cost effectiveness or strategic
reasons. We have a tested disaster recovery plan in place.
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EMPLOYEES
At December 28, 2002, we employed 1,805 persons, including 1,046 retail store
employees, 54 direct marketing sales employees, 66 customer service employees,
273 manufacturing employees, 181 home delivery employees and 185 management and
administrative employees. Approximately 164 of our employees were employed on a
part-time basis at December 28, 2002. Except for managerial employees and
professional support staff, all of our employees are paid on an hourly basis
plus commissions for sales associates. None of our employees is represented by a
labor union or covered by a collective bargaining agreement. We believe that our
relations with our employees are good.
CERTAIN RISK FACTORS
WE MAY BE UNABLE TO SUSTAIN GROWTH OR PROFITABILITY.
Our net sales grew in 2002 after two consecutive years of declining net sales.
Our six most recent quarters have been profitable after eight consecutive
quarters of losses. We may not be able to sustain growth or profitability on a
quarterly or annual basis in future periods. Our future growth and profitability
will depend upon a number of factors, including without limitation:
o Our ability to continue to successfully execute our strategic initiatives
and growth strategy;
o The efficiency and effectiveness of our Sleep Number advertising campaign
and other marketing programs in building product and brand awareness,
driving traffic to our points of sale and increasing sales;
o The level of consumer acceptance of our products;
o Our ability to continue to realize the benefits of our cost savings
initiatives;
o Our ability to realize increased sales and greater levels of profitability
through our retail stores;
o Our ability to cost-effectively close under-performing or unprofitable
store locations;
o Our ability to hire, train, manage and retain qualified retail store
management and sales professionals;
o Our ability to cost-effectively sell our products through wholesale or
other distribution channels in volumes sufficient to drive growth and
leverage our cost structure and advertising spending;
o Our ability to continuously improve our products to offer new and enhanced
consumer benefits, better quality and reduced costs;
o Our ability to maintain cost-effective sales, production and delivery of
our products;
o Our ability to successfully expand our home delivery, assembly and mattress
removal capability on a cost-effective basis;
o The ability of various third-party providers of delivery, assembly and
mattress removal services to provide quality services on a cost-effective
basis;
o Our ability to cost-effectively offer consumer credit options through third
party credit providers;
o Our ability to successfully identify and respond to emerging trends in the
bedding industry;
o The level of competition in the bedding industry; and
o General economic conditions and consumer confidence.
We cannot assure you that we will be successful in executing our growth strategy
or that
19
achieving our strategic plan will enable us to sustain profitability.
Failure to successfully execute any material part of our strategic plan or
growth strategy could significantly harm our business, financial condition and
operating results.
OUR COMPARABLE STORE SALES AND OTHER OPERATING RESULTS MAY FLUCTUATE
SIGNIFICANTLY AND AN UNANTICIPATED DECLINE IN COMPARABLE STORE SALES OR OTHER
OPERATING RESULTS MAY DISAPPOINT INVESTORS AND RESULT IN A DECLINE IN OUR STOCK
PRICE.
Our comparable store sales results and other operating results have fluctuated
significantly in the past. These fluctuations may continue and thus may not be a
meaningful indicator of future performance. For example, our comparable store
sales results have fluctuated significantly from quarter to quarter with
(decreases)/increases ranging from (7.7)% to 38.3% from 1998 through 2002.
Stores enter the comparable store calculation in the 13th full month of
operation. Our annual comparable store sales (decreases)/increases were 26.8%
for 2002, (3.8)% for 2001 and 0.2% for 2000. We cannot assure you that our
comparable store sales and other operating results will not fluctuate
significantly in the future. A variety of factors affect our comparable store
sales results and other operating results, including:
o Levels of consumer awareness of our products, brand name and store
locations;
o Levels of consumer acceptance of our existing and new products;
o Higher levels of sales in the first year of operations as each successive
class of new stores is opened;
o Comparable store sales performance in prior periods;
o The maturation of our store base;
o The amount, timing and relative success of promotional events, advertising
expenditures, new product introductions and product line extensions;
o The quality and tenure of store-level managers and sales professionals;
o The amount of competitive activity;
o The timing of new store openings and related expenses;
o Changes in the sales mix among our distribution channels;
o Our ability to offer effective consumer credit promotional offerings;
o The wholesale distribution of our products through home furnishings and
specialty bedding retailers into markets with existing company-operated
retail stores;
o Any increases in return rates or warranty claims;
o Any disruptions in third-party delivery services; and
o General economic conditions and consumer confidence.
Because of these fluctuations, our comparable store sales and other quarterly
operating results may not be a meaningful indicator of future performance.
Future decreases in our comparable store sales and other operating results could
significantly harm our business, financial condition and operating results. In
addition, an unanticipated decline in comparable store sales and other operating
results may disappoint securities analysts or investors and result in a decline
in our stock price.
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OUR FUTURE GROWTH AND PROFITABILITY WILL DEPEND IN LARGE PART UPON THE
EFFECTIVENESS AND EFFICIENCY OF OUR ADVERTISING EXPENDITURES AND OUR ABILITY TO
SELECT THE RIGHT MARKETS IN WHICH TO ADVERTISE.
Our advertising expenditures were $39.5 million, $29.5 million and $31.3 million
in 2002, 2001 and 2000, respectively. Our overall marketing budget is being
managed with greater emphasis toward awareness-building advertising. Our future
growth and profitability will depend in large part upon the effectiveness and
efficiency of our advertising expenditures, including our ability to:
o Create greater awareness of our products and brand name;
o Identify the most effective and efficient level of spending in each
markets;
o Determine the appropriate creative message and media mix for advertising
expenditures;
o Effectively manage advertising costs (including creative and media) in
order to maintain acceptable costs per inquiry, costs per order and
operating margins;
o Select the right markets in which to advertise; and
o Convert consumer inquiries into actual orders.
We cannot assure you that our planned advertising expenditures will result in
increased sales or will generate sufficient levels of product and brand name
awareness or that we will be able to manage our advertising expenditures on a
cost-effective basis.
THE BEDDING INDUSTRY IS HIGHLY COMPETITIVE. IF ANY OF OUR COMPETITORS OR A NEW
ENTRANT INTO THE MARKET WITH SIGNIFICANT RESOURCES AGGRESSIVELY PURSUES THE AIR
BED MARKET, OUR BUSINESS COULD BE SIGNIFICANTLY HARMED.
Our Sleep Number beds compete with a number of different types of bedding
alternatives, including innerspring bedding, foam bedding, waterbeds, futons and
other air-supported bedding that are sold through a variety of channels,
including home furnishings stores, specialty bedding stores, department stores,
mass merchants, wholesale clubs, telemarketing programs, television infomercials
and catalogs. The bedding industry is characterized by a high degree of
concentration among the four largest manufacturers with nationally recognized
brand names, including Sealy, which also owns the Stearns & Foster brand, Serta,
Simmons and Spring Air. Numerous other manufacturers, primarily operating on a
regional or niche basis, serve the balance of the bedding market. A number of
bedding manufacturers, including Simmons, have offered air beds and some of
these manufacturers have recently increased their presence in the air bed
market. Many of our competitors, including in particular the four largest
bedding manufacturers, have greater financial, marketing and manufacturing
resources and better brand name recognition than we do and sell products through
broader and more established distribution channels. We cannot assure you that
these competitors or new entrants into the market will not aggressively pursue
the air bed market or be successful in obtaining a significant presence in the
air bed market. Any such competition could significantly harm our business. In
addition, should any of our competitors reduce its prices on premium bedding
products, we may be required to implement similar price reductions in order to
remain competitive, which could significantly harm our financial condition and
operating results.
21
OUR PLAN TO PURSUE ADDITIONAL OR MAINTAIN EXISTING WHOLESALE RELATIONSHIPS WITH
HOME FURNISHINGS RETAILERS, SPECIALTY BEDDING RETAILERS AND THE QVC SHOPPING
CHANNEL MAY NOT YIELD THE BENEFITS WE EXPECT AND MAY INVOLVE OTHER RISKS THAT
MAY HARM OUR BUSINESS.
An important element of our growth strategy is to expand profitable distribution
by increasing sales through our existing channels and by increasing
opportunities for consumers to become aware of, and to purchase, our products
through additional points of distribution, such as wholesale distribution. We
have only recently established a limited number of wholesale relationships with
home furnishings retailers, specialty bedding retailers and the QVC shopping
channel and therefore have limited wholesale experience. We cannot assure you
that our wholesale relationships will result in the intended benefits. We also
expect the gross margin from wholesale sales to be less than the gross margin we
generate in our company-controlled channels. The success of our wholesale
strategy will depend upon numerous factors, including the following:
o The ability of our personnel to adequately analyze and identify suitable
wholesale distribution partners and markets in which our retail presence is
underrepresented;
o Our ability to negotiate favorable distribution terms with our wholesale
distribution partners;
o Our ability and the ability of our wholesale distribution partners to
train, motivate, incentivize and retain sales professionals who are selling
our products;
o Our ability to adapt our distribution and other operational and management
systems to an expanded network of points of sale; and
o Our ability and the ability of our wholesale distribution partners to
attract customers and generate sales sufficient to justify the expense of
establishing the wholesale distribution relationship.
WE RELY UPON SEVERAL KEY SUPPLIERS THAT ARE, IN SOME INSTANCES, OUR SOLE SOURCE
OF SUPPLY. THE FAILURE OF ONE OR MORE OF THESE SUPPLIERS OR OUR OTHER KEY
SUPPLIERS TO SUPPLY COMPONENTS FOR OUR PRODUCTS ON A TIMELY BASIS, OR A MATERIAL
CHANGE IN THE PURCHASE TERMS FOR OUR COMPONENTS, COULD SIGNIFICANTLY HARM OUR
BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS.
The major components and raw materials that we purchase for our products are air
chambers, foundations, remote controls, pumps, valves, foam and fabric. We
currently obtain the air chambers and foundations for our beds from single
supply sources. We have a supply agreement with the supplier of our air chambers
that expires in October 2006, subject to automatic annual renewal thereafter
unless either party gives 365 days' notice of non-renewal. We have a supply
agreement with the supplier of our blow molded foundations that expires in
October 2003, subject to automatic annual renewal thereafter unless either party
gives 180 days' notice of non-renewal. If our relationship with the supplier of
our air chambers or foundations is terminated, we could have difficulty in
replacing these sources since there are few other suppliers capable of
manufacturing these components.
We generally purchase many of our other components and raw materials centrally
to obtain volume discounts and achieve economies of scale. We therefore obtain a
large percentage of our components and raw materials from a small number of
suppliers. We do not have any long-term purchase agreements with, or other
contractual assurances of continued supply, pricing or access from, any of our
suppliers, except as noted above. Other than our air chambers and foundations,
we purchase most of our components and raw materials through purchase orders. If
prices increase and we are unable to pass on the increase in our costs to our
customers, then our financial condition or operating results may be
significantly harmed.
22
The loss of one or more of our key suppliers, the failure of one or more of our
key suppliers to supply components to our products on a timely basis, or a
material change in the purchase terms for our components could significantly
harm our business, financial condition and operating results.
We generally assemble our products after we receive orders from customers. Lead
times for ordered components may vary significantly and depend upon 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 longer lead times. We generally do not maintain
large volumes of component inventory, except for our air chambers, in which case
we generally carry approximately four weeks of inventory. As a result, an
unexpected and significant increase in the demand for our beds could lead to
inadequate inventory and delays in shipping our beds to customers.
THE FOREIGN MANUFACTURING OF OUR AIR CHAMBERS AND SOME OF OUR OTHER COMPONENTS
INVOLVES RISKS THAT COULD SUBSTANTIALLY HARM OUR BUSINESS.
Since our air chambers and some of our other components are manufactured outside
the United States, our operations could be significantly harmed by the risks
associated with foreign sourcing of materials, including without limitation:
o Political instability resulting in disruption of trade;
o 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;
o Any significant fluctuation in the value of the U.S. dollar against foreign
currencies; and
o Economic uncertainties, including inflation.
If any of these or other factors were to render the conduct of any of our
suppliers' businesses in particular countries undesirable or impractical, our
financial condition and operating results could be materially adversely affected
because we would have difficulty sourcing the main components of our products.
OUR AIR BEDS REPRESENT A SIGNIFICANT DEPARTURE FROM TRADITIONAL INNERSPRING
BEDDING AND THE FAILURE OF OUR BEDS TO ACHIEVE MARKET ACCEPTANCE WOULD
SIGNIFICANTLY HARM OUR BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS.
Innerspring mattress sales represent approximately 85% of all mattress sales.
Four large manufacturers of innerspring bedding dominate the U.S. bedding
market. Our air chamber technology represents a significant departure from
traditional innerspring bedding. Because no established air bed market existed
prior to the introduction of our air bed in 1988, we faced the challenge of
establishing the viability of this market, as well as gaining widespread
acceptance of our air bed. The market for air beds is now evolving and the
future success of our products will depend upon both the continued growth of
this market and market acceptance of our air beds. The failure of our beds to
achieve market acceptance for any reason would significantly harm our business,
financial condition and operating results.
APPROXIMATELY ONE-THIRD OF OUR NET SALES ARE FINANCED BY A THIRD PARTY. THE
TERMINATION OF OUR AGREEMENT WITH THIS THIRD PARTY, ANY MATERIAL CHANGE TO THE
TERMS OF OUR AGREEMENT WITH THIS THIRD PARTY OR IN THE AVAILABILITY OR TERMS OF
CREDIT OFFERED TO OUR CUSTOMERS BY THIS THIRD PARTY, OR ANY DELAY IN SECURING
REPLACEMENT CREDIT SOURCES, COULD HARM OUR BUSINESS, FINANCIAL CONDITION AND
OPERATING RESULTS.
Our qualified customers are offered a revolving credit arrangement to finance
purchases from us
23
through a private label consumer credit facility provided by Mill Creek Bank, a
subsidiary of Conseco Finance Corp. Mill Creek Bank sets the minimum acceptable
credit ratings, the interest rates, fees and all other terms and conditions of
the customer accounts, including collection policies and procedures and is the
owner of the accounts. In connection with all purchases financed under these
arrangements, Mill Creek Bank pays us an amount equal to the total amount of
such purchases, net of promotional related discounts. Mill Creek Bank's right to
set the minimum customer credit ratings could, if exercised, impact sales by
affecting the number of customers who can finance purchases. The term of this
facility expires in May 2004, subject to automatic one-year renewals, unless
terminated by either party upon 150 days' notice prior to the end of the
then-current term. We are liable to Mill Creek Bank for chargebacks 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 have provided a standby letter of credit to
Mill Creek Bank in the amount of $1.0 million to protect Mill Creek Bank against
potential losses from unpaid chargebacks. We are not liable to Mill Creek Bank
for losses arising out of our customers' credit defaults. If we replace Mill
Creek Bank with an alternative third-party provider of consumer financing, Mill
Creek Bank could request that we purchase its portfolio of our customer accounts
based on a pre-determined formula, which reflects a discount to the face amount
of these accounts. If we were to engage a replacement provider, we would likely
require this new provider to purchase the portfolio from Mill Creek Bank,
relieving us of our obligations under this facility.
Conseco Finance Corp., the parent corporation of Mill Creek Bank, has recently
experienced financial and liquidity issues and has filed for protection under
federal bankruptcy laws. Through its pending bankruptcy proceedings, Conseco
Finance Corp. has proposed to sell various of its operating assets, including
Mill Creek Bank. The sale process, including selection of the ultimate possible
purchaser of these assets, is pending. Any new owner of Mill Creek Bank could
attempt to exercise its discretion available to Mill Creek Bank under our
facility that may adversely impact our reliance on it. These financial and
liquidity issues could jeopardize the ability of Mill Creek Bank to continue to
provide consumer credit financing for our customers. In that event, we would
seek to secure consumer credit financing from other sources, but it may not be
possible to secure such arrangements without some delay or on the same or better
terms than have been available from Mill Creek Bank. Approximately 32.6% of our
net sales during 2002 and 39.8% of our net sales during 2001 were financed by
Mill Creek Bank. Termination of our agreement with Mill Creek Bank, any material
change to the terms of our agreement with Mill Creek Bank or in the availability
or terms of credit for our customers from Mill Creek Bank or any delay in
securing replacement credit sources, could harm our business, financial
condition and operating results.
OUR FUTURE GROWTH AND SUCCESS DEPEND UPON KEY PERSONNEL WHOM WE MAY NOT BE ABLE
TO RETAIN OR HIRE.
We are currently dependent upon the continued services, ability and experience
of our executive management team, particularly William R. McLaughlin, our
President and Chief Executive Officer. The loss of the services of Mr.
McLaughlin or other members of executive management could significantly harm our
business. 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.
24
OUR FUTURE GROWTH AND SUCCESS WILL DEPEND, IN PART, UPON OUR ABILITY TO ENHANCE
OUR EXISTING PRODUCTS AND TO DEVELOP AND MARKET NEW PRODUCTS, ON A TIMELY BASIS,
THAT RESPOND TO CUSTOMER NEEDS AND ACHIEVE MARKET ACCEPTANCE.
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 cannot assure you that we will be successful in developing or marketing
enhanced or new products or that the market will accept any such products.
Further, the resulting level of sales from any of our enhanced or new products
may not justify the costs associated with the development and marketing.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WE MAY BE UNABLE TO
PREVENT OTHER COMPANIES FROM USING OUR TECHNOLOGY IN COMPETITIVE PRODUCTS.
Certain elements of the design and function of our beds are the subject of U.S.
and foreign patents and patent applications owned by us. We also own several
registered and unregistered trademarks and trademark applications, including in
particular our Sleep Number trademark, 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. 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. We cannot assure you,
however, that our intellectual property rights will provide us substantial
protection or cannot and will not be circumvented by our competitors. We also
cannot assure you that our protective measures will 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.
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 cannot assure you that we will have the
financial resources necessary to enforce or defend our intellectual property
rights. Although we are unaware of any intellectual property infringement or
invalidity claims asserted against us, we cannot assure you that third parties,
including competitors, will not assert such claims against us or that, if
asserted, such claims will not be upheld. We also cannot assure you that we
would prevail in any such litigation or that, if we are unsuccessful, we would
be able to obtain any necessary licenses on reasonable terms or at all.
WE DEPEND UPON UPS AND OTHER CARRIERS TO DELIVER OUR PRODUCTS TO CUSTOMERS ON A
TIMELY AND COST-EFFECTIVE BASIS AND ANY SIGNIFICANT DELAY IN DELIVERIES TO OUR
CUSTOMERS OR INCREASE IN FREIGHT CHARGES COULD SIGNIFICANTLY HARM OUR BUSINESS,
FINANCIAL CONDITION AND OPERATING RESULTS.
Historically, we have relied almost exclusively 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. No assurance can be given that UPS will be able to avert
labor difficulties in the future or that UPS will not otherwise experience
difficulties in meeting our requirements in the future. In 2000, we began to
shift a portion of our product delivery business to FedEx. In
25
addition, we either provide directly, or contract with a third party to provide,
in-home delivery, assembly and mattress removal services, and are in the process
of increasing the availability of this service. Despite these alternative
carriers, we cannot assure you that if UPS were to experience difficulties in
meeting our requirements we would be able to deliver our products to our
customers through any one or more of these or other alternative carriers on a
timely or cost-effective basis. Any significant delay in deliveries to our
customers or increase in freight charges could significantly harm our business,
financial condition and operating results.
SIGNIFICANT AND UNEXPECTED RETURN RATES UNDER OUR 30-NIGHT TRIAL PERIOD AND
WARRANTY CLAIMS UNDER OUR LIMITED 20-YEAR WARRANTY ON OUR BEDS, IN EXCESS OF OUR
RETURNS AND WARRANTY RESERVES, COULD SIGNIFICANTLY HARM OUR BUSINESS, FINANCIAL
CONDITION AND OPERATING RESULTS.
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 100% comfortable with our product. As we expand
our sales, we cannot assure you that our return rates will remain within
acceptable levels. A significant and unexpected increase in return rates could
significantly harm our business, financial condition and operating results. Our
marketing and advertising strategy also includes providing our customers with a
limited 20-year warranty on our beds. However, since we have only been selling
beds in significant quantities since 1992, we cannot assure you that we will not
receive significant and unexpected claims under this warranty or that our
warranty reserves will be adequate to cover future warranty claims. Significant
warranty claims in excess of our warranty reserves could also significantly harm
our business, financial condition and operating results.
WE MAY BE UNABLE TO EFFECTIVELY MANAGE OUR GROWTH, WHICH COULD SIGNIFICANTLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS.
Our growth strategy has placed, and will continue to place, a significant strain
on our management, production, information systems and other resources. To
manage growth effectively, we must maintain a high level of manufacturing
quality and efficiency, continue to enhance our operational, financial and
management systems, including our database management, tracking of inquiries,
inventory control and distribution systems, and expand, train and manage our
employee base. We cannot assure you that we will be able to effectively manage
this expansion in any one or more of these areas, and any failure to do so could
significantly harm our business, financial condition and operating results.
OUR MANAGEMENT INFORMATION SYSTEMS MAY PROVE INADEQUATE AND WE ARE IN THE
PROCESS OF MIGRATING OUR CURRENT SYSTEMS TO AN UPGRADED VERSION, WHICH COULD
CAUSE INTERRUPTIONS IN OUR BUSINESS IF THIS CONVERSION DOES NOT OCCUR SMOOTHLY.
We depend upon our management information systems for many aspects of our
business. Some of our key software has been developed by our own programmers and
this software may not be easily integrated with other software and systems. Our
business will be materially and adversely affected if our management information
systems are disrupted or if we are unable to improve, upgrade, integrate or
expand upon our systems as we execute our growth strategy. We are in the process
of migrating our management information systems to an upgraded version, which
could cause interruptions in our business if this conversion does not occur
smoothly.
DAMAGE TO EITHER OF OUR MANUFACTURING FACILITIES COULD SIGNIFICANTLY HARM OUR
BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS.
We have two manufacturing plants which are located in Columbia, South Carolina
and in Salt Lake City, Utah. Since we manufacture beds to fulfill orders rather
than stocking inventory, our business, financial condition and operating results
may be significantly harmed if either of our
26
manufacturing plants was destroyed or shut down for a significant period of
time.
SIGNIFICANT AND LONG-TERM FAILURE OF OUR WEB SITE COULD HARM OUR BUSINESS,
FINANCIAL CONDITION AND OPERATING RESULTS.
We depend on our web site for a certain percentage of our net sales and for
advertising of our products. If our web site becomes unavailable for a
significant period of time due to information technology or Internet failure,
our net sales could be adversely affected.
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.
Our business is subject to some seasonal influences, with lower sales in the
second quarter and higher sales during the fourth quarter holiday season due to
greater mall traffic. Furthermore, a substantial portion of our sales is often
realized in the last month or last few weeks of a quarter, due in part to our
promotional schedule and commission structure. The level of 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 business, financial condition and operating results may be
significantly harmed.
WE ARE SUBJECT TO GOVERNMENT REGULATIONS RELATING TO THE BEDDING INDUSTRY AND
CANNOT ASSURE YOU THAT WE WILL NOT BE REQUIRED TO INCUR EXPENSE AND MODIFY OUR
OPERATIONS IN ORDER TO ENSURE COMPLIANCE WITH THESE REGULATIONS.
Our operations are subject to state and local consumer protection and other
regulations relating to the bedding industry. These regulations vary among the
states in which we do business. The regulations generally impose requirements as
to the proper labeling of bedding merchandise, restrictions regarding the
identification of merchandise as "new" or otherwise, controls as to hygiene and
other aspects of product handling and sale and penalties for violations.
Although we believe that we are in substantial compliance with these regulations
and have implemented a variety of measures to promote continuing compliance, we
cannot assure you that we will not be required in the future to incur expense
and/or modify our operations in order to ensure compliance with these
regulations which could harm our operating results.
Our direct marketing operations are or may become subject to various adopted or
proposed federal and state "do not call" list requirements. We believe that we
are in compliance with these requirements, but these requirements may be
modified over time and may adversely affect our direct marketing sales or costs.
The federal Consumer Product Safety Commission and various state regulatory
agencies are considering new rules relating to fire retardancy standards for the
bedding industry. The State of California plans to adopt, effective in the year
2004, new fire retardancy standards that have not yet been finally defined. If
adopted, such new rules may adversely affect our costs, manufacturing processes
and materials. We are developing product solutions that are intended to enable
us to meet the new standards. Because the new standards have not been finally
determined, however, no assurance can be given that our solutions will enable us
to meet the new standards. We expect that any required product modifications
will add cost to our product.
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 state laws. Our sales of refurbished products are limited to
approximately 24 states, as the remaining states
27
do not allow the sale of refurbished bedding products.
FAILURE TO COMPLY WITH HEALTH AND SAFETY REQUIREMENTS COULD EXPOSE US TO A
MATERIAL LIABILITY.
We are subject to federal, state and local laws and regulations relating to
occupational health and safety. There can be no assurance that we are at all
times in compliance with all such requirements. We have made and will continue
to make capital and other expenditures to comply with health and safety
requirements.
WE MAY FACE EXPOSURE TO PRODUCT LIABILITY.
We face an inherent business risk of exposure to product liability claims in the
event that the use of any of our products results 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. We maintain insurance against
product liability claims, but there can be no assurance that such coverage will
continue to be available on terms acceptable to us or that such coverage will 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.
WE DEPEND UPON ENDORSEMENTS BY NATIONAL RADIO PERSONALITIES TO PROMOTE OUR
PRODUCTS.
Our integrated marketing program depends in part on national radio
personalities, including Paul Harvey and Rush Limbaugh. The loss of either Paul
Harvey or Rush Limbaugh or a reduction in the effectiveness of their endorsement
could result in significant harm to our business, financial condition and
operating results.
ADDITIONAL TERRORIST ATTACKS IN THE UNITED STATES OR AGAINST U.S. TARGETS OR
ACTUAL OR THREATS OF WAR OR THE ESCALATION OF CURRENT HOSTILITIES INVOLVING THE
UNITED STATES OR ITS ALLIES COULD SIGNIFICANTLY IMPACT OUR BUSINESS, FINANCIAL
CONDITION, OPERATING RESULTS OR STOCK PRICE IN UNPREDICTABLE WAYS.
Additional terrorist attacks in the United States or against U.S. targets, or
actual 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 to our products, may impact our
operations, including, among other things, causing delays or losses in the
delivery of merchandise to us and decreased sales of our products. These events
could cause an increase in oil or other commodity prices, which could adversely
affect our materials or transportation costs, including delivery of our products
to customers. More generally, any of these events could cause consumer
confidence and spending to decrease or result in increased volatility in the
U.S. and worldwide financial markets. These events also could cause an economic
recession in the United States or abroad. Any of these occurrences could have a
significant impact on our business, financial condition and operating results
and may result in volatility of our stock price.
As a result of the terrorist attacks in the United States and the threat of war
involving the United States, we believe many consumers have traveled less and
purchased more products for their home. We believe these trends have contributed
to an increase in our net sales. We cannot assure you that these trends will
continue, that they will continue to positively affect our net sales or that we
will be able to sustain our current net sales levels.
28
ITEM 2. PROPERTIES
Retail 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 7 to
10 years with a mutual termination option if we do not achieve certain minimum
annual sales thresholds. Generally, the store leases require us to pay minimum
rent plus percentage rent based on net sales in excess of certain thresholds, as
well as certain operating expenses.
The following table provides information regarding the 321 stores we
currently operate in the following 46 states:
STATE STORES STATE STORES
----- ------ ----- ------
Alabama........................... 2 Montana............................. 2
Arizona........................... 9 Nebraska............................ 2
Arkansas.......................... 1 Nevada.............................. 3
California........................ 40 New Hampshire....................... 3
Colordo........................... 10 New Jersey.......................... 9
Connecticut....................... 5 New Mexico.......................... 2
Delaware.......................... 1 New York............................ 4
Floroda........................... 21 North Carolina...................... 7
Georgia........................... 7 North Dakota........................ 1
Idaho............................. 1 Ohio................................ 10
Illinois.......................... 14 Oklahoma............................ 2
Indiana........................... 8 Oregon.............................. 6
Iowa.............................. 5 Pennsylvania........................ 14
Kansas............................ 5 Rhode Island........................ 1
Kentucky.......................... 3 South Carolina...................... 2
Louisiana......................... 3 South Dakota........................ 1
Maine............................. 1 Tennessee........................... 8
Maryland.......................... 9 Texas............................... 25
Massachusetts..................... 5 Utah................................ 4
Michigan.......................... 13 Virginia............................ 7
Minnesota......................... 13 Washington.......................... 11
Mississippi....................... 1 West Virginia....................... 1
Missouri.......................... 10 Wisconsin........................... 9
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Manufacturing and Headquarters
We lease approximately 122,000 square feet in Minneapolis that includes our
corporate headquarters, our direct marketing call center, our customer service
group, our research and development department and a distribution center that
accepts returns and processes warranty claims. This lease expires in 2004 and
contains two five-year renewal options. We have subleased 20,000 square feet of
our Minneapolis facility through March 2003. We also lease two additional
manufacturing and distribution centers in Columbia, South Carolina and Salt Lake
City, Utah of approximately 105,000 square feet and approximately 101,000 square
feet, respectively. We lease the Columbia facility through February 2008, with a
five-year renewal option thereafter, and the Salt Lake City facility through
April 2009. We lease another 16,100 square feet of office space in the
Minneapolis area through April 2004, which we have vacated, and a portion of
which we have subleased to a third party.
ITEM 3. LEGAL PROCEEDINGS
In June 1999, we and certain of our former officers and directors were named as
defendants in a class action lawsuit filed in U.S. District Court in Minnesota.
The suit, filed on behalf of purchasers of our common stock between December 4,
1998 and June 7, 1999, alleges that we and the named former directors and
officers failed to disclose or misrepresented certain information concerning our
company in violation of federal securities laws. We believe that the suit is
without merit and have vigorously defended the matter.
We have consented to a settlement of this litigation negotiated by our insurance
carrier. The settlement is covered by insurance and involves no cash or other
payment obligation by us, and no admission of liability or wrongdoing by us. The
settlement is not expected to have any impact on our results of operations or
financial condition. On December 13, 2002, the settlement agreement received
preliminary approval from the U.S. District Court for the District of Minnesota.
The Court issued an order setting February 28, 2003 for a hearing for final
approval of the settlement agreement. At the hearing for final approval, the
Court will hear any objections to the settlement or its terms.
We are involved in other various claims, legal actions, sales tax disputes and
other complaints arising in the ordinary course of business. In the opinion of
management, any losses that may occur from these other matters are adequately
covered by insurance or are provided for in our consolidated financial
statements and the ultimate outcome of these other matters will not have a
material effect on our consolidated financial position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
30
PART II
--------------------
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock trades on the Nasdaq Stock Market under the symbol "SCSS". The
following table sets forth the quarterly high and low sales prices per share of
our common stock as reported by the Nasdaq National Market for the two most
recent fiscal years. These quotations reflect inter-dealer prices, without
retail mark-up, mark-down or commission, and may not necessarily represent
actual transactions.
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
--------- --------- -------- ---------
FISCAL 2002
High $10.20 $6.22 $6.99 $4.57
Low $5.29 $3.81 $3.77 $1.93
--------- --------- -------- ---------
FISCAL 2001
High $2.11 $1.71 $1.68 $2.44
Low $0.89 $0.81 $0.45 $1.13
--------- --------- -------- ---------
NUMBER OF RECORD HOLDERS; DIVIDENDS
As of February 14, 2003, there were 189 record holders of our common stock. We
did not declare or pay any cash dividends on the common stock during the fiscal
years ended December 28, 2002 or December 29, 2001 and do not anticipate paying
any cash dividends on our common stock in the foreseeable future.
31
ITEM 6. SELECTED FINANCIAL DATA
The data presented below have been derived from our Consolidated Financial
Statements and should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and our Consolidated
Financial Statements and Notes thereto included in this Annual Report on Form
10-K:
YEAR
------------------------------------------------------
2002 2001 2000 1999 1998
--------- -------- -------- -------- --------
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net sales.................................................$ 335,795 $261,687 $270,077 $273,767 $246,269
Gross profit.............................................. 209,999 154,477 154,476 163,847 147,884
Operating expenses:
Sales and marketing.................................... 155,890 138,417 149,283 147,929 116,696
General and administrative............................. 32,854 25,296 29,211 29,213 19,723
Store closings and asset impairments................... 233 1,366 1,952 1,498 20
--------- -------- -------- -------- --------
Operating income (loss)(1)................................ 21,022 (10,602) (25,970) (14,793) 11,445
Net income (loss)......................................... 37,122 (12,066) (37,214) (8,204) 5,195
========= ======== ======== ======== ========
Net income (loss) per share:
Basic.................................................. $ 1.51 $ (0.66) $ (2.09) $ (0.45) $ 0.74
========= ======== ======== ======== ========
Diluted................................................ $ 1.09 $ (0.66) $ (2.09) $ (0.45) $ 0.19
========= ======== ======== ======== ========
Pro forma (2).......................................... $ 0.37 $ (0.41) $ (0.89) $ (0.45) $ 0.19
========= ======== ======== ======== ========
Shares used in calculation of net income (loss)
per share (2):
Basic.................................................. 24,549 18,157 17,848 18,300 4,114
========= ======== ======== ======== ========
Diluted and pro forma (2).............................. 34,532 18,157 17,848 18,300 15,928
========= ======== ======== ======== ========
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and marketable securities.......... $ 40,824 $ 16,375 $ 5,448 $ 27,570 $ 45,561
Working capital........................................... 26,765 (3,739) (12,431) 14,470 42,249
Total assets.............................................. 108,331 67,436 64,672 95,363 106,234
Long-term debt, less current maturities................... 2,991 17,109 2,322 36 29
Total shareholders' equity................................ 54,515 6,772 16,600 52,872 70,691
SELECTED OPERATING DATA:
Stores open at period-end (3)............................. 322 328 333 341 264
Stores opened during period............................... 15 11 19 79 65
Stores closed during period............................... 21 16 27 2 1
Average net sales per store (000's) (4)................... $ 817 $ 626 $ 636 $ 644 $ 664
Percentage of stores with more than $1.0 million in net
sales(4)................................................ 24.1% 9.8% 11.8% 12.6% 12.6%
Comparable store sales increase (decrease) (5)............ 26.8% (3.8)% 0.2% 4.7% 23.5%
Average square footage per store open during period (4)... 972 941 913 893 894
Net sales per square foot (4)............................. $ 841 $ 666 $ 697 $ 721 $ 743
Average store age (in months at period end)............... 61 51 41 31 26
EBITDA (6)................................................ $ 30,449 $ 334 $(15,628) $ (6,600) $ 16,816
- ----------
(1) Includes charges for store closings and asset impairments of $0.2 million,
$1.4 million, $2.0 million, $1.5 million and $0.0 million for 2002, 2001,
2000, 1999 and 1998, respectively. See Note 4 to our Consolidated Financial
Statements.
(2) Pro forma net income (loss) per share reflects the effects on net income
from specific non-recurring items and from the recognition of an income tax
benefit (provision) for years where a regular tax provision, at a rate of
38%, was not recorded. Generally accepted accounting principles (GAAP)
did not allow us to reduce net income for income tax expense in 2002 or to
provide an income tax benefit in 2001 or 2000. Because we expect to record
income tax in future periods, we believe pro forma net income (loss) per
share provides a more meaningful comparison than GAAP net income (loss) per
share for the periods presented and future periods. In addition, we
excluded the effect of the extraordinary after-tax, non-cash charges
associated with early repayment of our $5.0 million of 12% senior secured
debt in December 2002. A reconciliation of diluted net income (loss) per
share (as determined in accordance with GAAP) to pro forma net income
(loss) per share is as follows:
32
2002 2001 2000
-------- -------- --------
GAAP diluted net income (loss) per share..................... $ 1.09 $(0.66) $(2.09)
Effect of:
Income tax benefit (provision) at 38% of income before tax (0.22) 0.25 0.55
Extraordinary loss........................................ 0.02 -- --
(Restoration) write-off of deferred tax asset............. (0.52) -- 0.65
------ ------ ------
Pro forma diluted net income (loss) per share............... $ 0.37 $(0.41) $(0.89)
====== ====== ======
(3) Includes stores operated in leased departments within other retail stores
(13, 22, 25, 45 and 14 at the end of 2002, 2001, 2000, 1999 and 1998,
respectively).
(4) For stores open during the entire period indicated.
(5) Stores enter the comparable store calculation in the 13th full month of
operation. The number of comparable stores used to calculate such data was
307, 317, 314, 262 and 199 for 2002, 2001, 2000, 1999 and 1998,
respectively. Our 1998 comparable store sales increase reflects adjustments
for an additional week of sales in 1997. Without adjusting for the
additional week, comparable store sales would have been 17.9% in 1998.
(6) Earnings before interest, income taxes, depreciation, amortization and
other non-cash charges, including non-cash compensation (EBITDA) is a key
financial measure but should not be construed as an alternative to
operating income or cash flows from operating activities (as determined in
accordance with GAAP). We believe that EBITDA is a useful supplement to net
income and other income statement data in understanding cash flows
generated from operations that are available for taxes, debt service and
capital expenditures. A reconciliation of operating income (loss) to EBITDA
for each of the fiscal years indicated is as follows:
2002 2001 2000 1999 1998
-------- ---------- ---------- ---------- --------
Operating income (loss)................. $ 21,022 $ (10,602) $ (25,970) $ (14,793) $ 11,445
Store closings and asset impairments. 233 1,366 1,952 1,498 20
Depreciation and amortization........ 9,194 9,570 8,390 6,695 5,351
-------- ------ --------- -------- --------
EBITDA $ 30,449 $ 334 $ (15,628) $ (6,600) $ 16,816
======== ====== ========= ======== ========
33
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ WITH THE CONSOLIDATED
FINANCIAL STATEMENTS AND RELATED NOTES. THIS DISCUSSION 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," "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 DEPENDING ON
A VARIETY OF FACTORS INCLUDING THOSE SET FORTH ABOVE IN PART I, ITEM 1 UNDER THE
HEADING TITLED "CERTAIN RISK FACTORS."
OVERVIEW AND CRITICAL ACCOUNTING POLICIES
We are 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.
Our critical accounting policies relate to revenue recognition, accrued sales
returns, accrued warranty costs and impairment of long-lived assets and
long-lived assets to be disposed of by us. The effect of these policies on our
financial statements is incorporated in the discussion below.
Net sales
We generate revenue by selling our products through four complementary
distribution channels. Three of these channels, retail, direct marketing and
e-commerce, are company-controlled and sell directly to consumers. Our wholesale
channel sells to leading home furnishings retailers, specialty bedding retailers
and the QVC shopping channel.
Revenue recognition. We record revenue at the time product is shipped to our
customer, except when beds are delivered and set up by our home delivery
employees, in which case revenue is recorded at the time the bed is delivered
and set up in the home.
Accrued sales returns. We reduce sales at the time revenue is recognized for
estimated returns. This estimate is based on historical return rates, which are
reasonably consistent from period to period. If actual returns vary from
expected rates, revenue in future periods is adjusted, which could have a
material adverse effect on future results of operations.
Channel Sales. The proportion of our total net sales, by dollar volume, from
each of our channels during the last three years is summarized as follows:
2002 2001 2000
------ ------ ------
Retail 77% 78% 79%
Direct marketing 14% 15% 18%
E-commerce 4% 3% 3%
Wholesale 5% 4% 0%
The number of company-operated retail locations during the last three years is
summarized as follows:
2002 2001 2000
------ ------ ------
Beginning of year 328 333 341
Opened 15 11 19
Closed (21) (16) (27)
---- ---- ----
End of year 322 328 333
==== ==== ====
We anticipate opening 20 to 30 new retail stores and expect to close
approximately five stores in 2003. Company-operated stores included leased
departments within 13, 22 and 25 Bed, Bath &
34
Beyond stores as of 2002, 2001 and 2000, respectively.
Comparable store sales increased (decreased) by 26.8%, (3.8)% and 0.2% in 2002,
2001 and 2000, respectively. In 2002, total net sales and comparable store sales
were positively affected by the increased investment in advertising and improved
product mix that resulted from improvements in our product line, the design of
our promotional programs and improvements in our selling process.
Cost of sales
Cost of sales includes costs associated with purchasing materials, manufacturing
costs and delivering our products to our customers. In 2002, we elected to
reclassify costs associated with the delivery of our products to customers from
sales and marketing expenses to cost of sales. As a result of this change, cost
of sales increased and sales and marketing expenses decreased. This change in
classification does not affect operating income or net income.
Accrued warranty costs. Cost of sales also includes estimated costs to service
warranty claims of customers. This estimate is based on historical claim rates
during the warranty period. Because this estimate covers an extended period of
time, a revision of estimated claim rates could result in a significant
adjustment of estimated future costs of fulfilling warranty commitments. An
increase in estimated claim rates could have a material adverse effect on future
results of operations.
Gross profit
Our gross profit margin is dependent on a number of factors and may fluctuate
from quarter to quarter. These factors include the mix of products sold, the
level at which we offer promotional discounts to purchase our products, the cost
of materials and manufacturing and the mix of sales between wholesale and
company-controlled distribution channels. Sales directly to consumers through
company-controlled channels generally generate higher gross margins than sales
through our wholesale channels because we capture both the manufacturer's and
retailer's margin.
Sales and marketing expenses
Sales and marketing expenses include advertising and media production, other
marketing and selling materials such as brochures, videos, customer mailings and
in-store signage, sales compensation, store occupancy costs and customer
service. In 2002, we elected to reclassify costs associated with the delivery of
our products to customers from sales and marketing expenses to cost of sales. As
a result of this change, cost of sales increased and sales and marketing
expenses decreased. This change in classification does not affect operating
income or net income. Store opening costs are expensed as incurred and
advertising costs are expensed the first time the advertisement is aired.
Advertising expense was $39.5 million in 2002, $29.5 million in 2001 and $31.3
million in 2000. Future advertising expenditures will depend on the
effectiveness and efficiency of the advertising in creating awareness of our
products and brand name, generating consumer inquiries and driving consumer
traffic to our points of sale. We anticipate that full year advertising
expenditures in 2003 will approximate $50 million.
General and administrative expenses
General and administrative expenses include costs associated with management of
functional areas, including information technology, investor relations, risk
management and research and development. Costs include salary, bonus and
benefits, information hardware, software and maintenance, office facilities,
insurance and shareholder relations costs and other overhead.
Store closing and asset impairment expenses
35
We evaluate our long-lived assets, including leaseholds and fixtures in
existing stores and stores expected to be remodeled, based on expected cash
flows through the remainder of the lease term after considering the potential
impact of planned operational improvements and marketing programs. Expected cash
flows may not be realized, which could cause long-lived assets to become
impaired in future periods and could have a material adverse effect on future
results of operations. Store assets are written off when we believe these costs
will not be recovered through future operations.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, our results of
operations expressed as percentages of net sales.
PERCENTAGE OF NET SALES
-------------------------
2002 2001 2000
----- ----- -----
Net sales 100.0% 100.0% 100.0%
Cost of sales 37.5 41.0 42.8
----- ----- -----
Gross profit 62.5 59.0 57.2
Operating expenses:
Sales and marketing 46.4 52.9 55.3
General and administrative 9.8 9.7 10.8
Store closings and asset
impairments 0.1 0.5 0.7
----- ----- -----
Total operating
expenses 56.3 63.1 66.8
----- ----- -----
Operating income (loss) 6.3 (4.0) (9.6)
Other income (expense), net (0.4) (0.6) 0.1
----- ----- -----
Income (loss) before income
taxes and extraordinary loss 5.9 (4.6) (9.5)
Income tax (benefit) expense (5.3) 0.0 4.3
----- ----- -----
Income (loss) before
extraordinary loss 11.2 (4.6) (13.8)
----- ----- -----
Extraordinary loss, net
of tax (0.1) 0.0 0.0
----- ----- -----
Net income (loss) 11.1% (4.6)% (13.8)%
===== ===== =====
Quarterly and annual operating results may fluctuate significantly as a result
of a variety of factors, including increases or decreases in comparable store
sales, the timing, amount and effectiveness of advertising expenditures, any
changes in sales return rates or warranty experience, the timing of new store
openings and related expenses, net sales contributed by new stores, competitive
factors, any disruptions in supplies or third-party service providers and
general economic conditions and consumer confidence. Furthermore, a substantial
portion of net sales is often realized in the last month of a quarter, due in
part to our promotional schedule and commission structure. As a result, we may
be unable to adjust spending in a timely manner, and our business, financial
condition and operating results may be significantly harmed. Our historical
results of operations may not be indicative of the results that may be achieved
for any future period.
COMPARISON OF 2002 AND 2001
Net sales
Net sales in 2002 increased 28% to $335.8 million from $261.7 million in 2001
due to a 15% increase in mattress unit sales and higher average selling prices
resulting primarily from improvements in product mix and lower return rates. The
increase in net sales by sales channel was attributable to (i) a $54.9 million
increase in sales from company-controlled retail stores, including an increase
in comparable store sales of $52.9 million, (ii) a $7.9 million increase in
direct marketing sales, (iii) a $5.9 million increase in sales from our
wholesale channel and (iv) a $5.4 million increase in sales from our e-commerce
channel.
Gross profit
Gross profit margin increased to 62.5% in 2002 from 59.0% in 2001 primarily due
to improved product sales mix, savings in processing returned product, reduced
product delivery costs, reduced warranty claim rates resulting from improved
product quality and greater manufacturing leverage.
Sales and marketing expenses
36
Sales and marketing expenses in 2002 increased 13% to $155.9 million from $138.4
million in 2001, but decreased as a percentage of net sales to 46.4% in 2002
from 52.9% in 2001. The $17.5 million increase was primarily due to additional
media investments, sales-based compensation and retail occupancy costs. The
decrease as a percentage of net sales was attributable to greater leverage in
fixed selling expenses and lower cost promotional offerings.
General and administrative expenses
General and administrative (G&A) expenses increased 30% to $32.9 million in 2002
from $25.3 million in 2001. Of the increase, $5.9 million was due to additional
incentive compensation costs resulting from our improved performance, with the
remaining increase primarily resulting from an increased investment in
information technology. We expect G&A growth rates to be lower in the future due
to planned lower incentive compensation costs.
Store closing and asset impairment expenses
Store closing and asset impairment expenses in 2002 were $0.2 million compared
to $1.4 million in 2001. In 2002, the entire amount represented impairments
related to store closures. In 2001, the expenses included $1.0 million related
to store closures and $0.4 million related primarily to the write-off of
unusable fixtures for the merchandising of our sleeper sofa products.
Other income (expense), net
Other expense decreased $0.2 million to approximately $1.3 million in 2002 from
$1.5 million in 2001. The decrease was primarily due to an increase in interest
income from our improved cash position, partially offset by increased interest
expense associated with our senior secured debt. This debt was paid off in
December 2002.
Income tax (benefit) expense
Income tax benefit was $17.8 million in 2002 as compared to zero in 2001. The
$17.8 million income tax benefit for 2002 was the result of recording a
non-recurring, non-operating, non-cash addition to earnings due to the expected
realization of tax benefits from net operating loss carryforwards and other
deferred tax assets. We expect to begin recording income tax expense at an
estimated rate of 38% during 2003.
COMPARISON OF 2001 AND 2000
Net sales
Net sales in 2001 decreased 3% to $261.7 million from $270.1 million in 2000 due
primarily to a decrease in mattress unit sales and lower average selling prices.
The average selling price per mattress set declined slightly as a result of
lower selling prices for products sold to QVC and wholesale customers, slightly
offset by higher average selling prices in our company-controlled distribution
channels. The change in net sales was attributable to (i) an $8.5 million
decrease in sales from company-controlled retail stores, including a decrease in
comparable store sales of $7.7 million, (ii) an $8.6 million decrease in direct
marketing sales, (iii) a $9.1 million increase in sales from our wholesale
channel and (iv) a $0.1 million increase in sales from our e-commerce channel.
Gross profit
Gross profit margin in 2001 increased to 59.0% from 57.2% in 2000 primarily due
to reduced warranty claim rates resulting from improved product quality, savings
in processing returned product and improved product sales mix, partially offset
by increased product delivery costs.
Sales and marketing expenses
Sales and marketing expenses in 2001 decreased 7% to $138.4 million from $149.3
million in 2000 and decreased as a percentage of net sales
37
to 52.9% in 2001 from 55.3% in 2000. The $10.9 million decrease in expenses and
the decrease as a percentage of net sales were primarily due to reductions in
promotional and fulfillment materials, reduced sales support staffing and lower
retail occupancy costs, partially offset by increases in media production
expense.
General and administrative expenses
General and administrative expenses decreased 13% to $25.3 million in 2001 from
$29.2 million in 2000. The $3.9 million decrease was primarily due to staffing
reductions and reduced occupancy expense resulting from the consolidation of our
two corporate offices.
Store closings and asset impairment expenses
Store closing and asset impairment expenses in 2001 were $1.4 million compared
to $2.0 million in 2000. In 2001, the expenses included $1.0 million related to
store closures and $0.4 million related primarily to the write-off of unusable
fixtures for merchandising of our sleeper sofa products. In 2000, the expenses
included $1.4 million related to the write-off of assets associated with the
relocation of our headquarter offices, the write-off of web development costs
and $0.6 million related to store closures.
Other income (expense), net
Other expense changed $1.8 million to approximately $1.5 million in 2001 from
$0.3 million of other income in 2000. The change was primarily due to $1.4
million of interest expense from long-term debt and lower interest income due to
lower cash levels in 2001.
Income tax (benefit) expense
Income tax expense decreased $11.6 million to $0.0 million in 2001 from $11.6
million in 2000. Income tax expense decreased as a result of not recognizing an
income tax benefit from operating losses in 2001 and from the write-off of $21.6
million of net deferred tax assets in 2000.
38
QUARTERLY RESULTS OF OPERATIONS
The following table sets forth, by quarter, statement of operations and
percentage of net sales data for the two most recent years. Sales are subject to
some seasonal influences, with lower sales in the second quarter and higher
sales during the fourth quarter holiday season due primarily to increased mall
traffic. Results of any period are not necessarily indicative of results for a
full year (in thousands, except per share amounts).
2002 2001
------------------------------------- ---------------------------------------
QUARTER QUARTER
------------------------------------- ---------------------------------------
DEC. SEPT. JUNE MAR. DEC. SEPT. JUNE MAR.
------- ------- ------- ------- -------- ------- ------- -------
STATEMENT OF OPERATIONS
Net sales $92,263 $85,056 $77,281 $81,195 $69,341 $64,148 $62,742 $65,456
Cost of sales 34,584 30,915 29,340 30,957 26,965 25,434 26,800 28,011
------- ------- ------- ------- ------- ------- ------- -------
Gross profit 57,679 54,141 47,941 50,238 42,376 38,714 35,942 37,445
Operating expenses:
Sales and marketing 40,309 39,199 36,774 39,608 32,815 32,806 33,022 39,774
General and administrative 8,534 9,085 8,026 7,209 7,044 5,285 5,954 7,013
Store closings and asset
impairments - 24 157 52 858 20 142 346
------- ------- ------- ------- ------- ------- ------- -------
Total operating expenses 48,843 48,308 44,957 46,869 40,717 38,111 39,118 47,133
------- ------- ------- ------- ------- ------- ------- -------
Operating income (loss) 8,836 5,833 2,984 3,369 1,659 603 (3,176) (9,688)
Other income (expense), net (268) (120) (421) (473) (709) (376) (354) (25)
------- ------- ------- ------- ------- ------- ------- -------
Income (loss) before income taxes
and extraordinary loss 8,568 5,713 2,563 2,896 950 227 (3,530) (9,713)
Income tax benefit (expense) (477) 17,891 - 348 115 - - (115)
------- ------- ------- ------- ------- ------- ------- -------
Income (loss) before extraordinary
loss 8,091 23,604 2,563 3,244 1,065 227 (3,530) (9,828)
Extraordinary loss, net of tax (380) - - - - - - -
------- ------- ------- ------- ------- ------- ------- -------
Net income (loss) $ 7,711 $23,604 $ 2,563 $ 3,244 $ 1,065 $ 227 $(3,530) $(9,828)
======= ======= ======= ======= ======= ======= ======= =======
Net income (loss) per share:
Basic $ 0.25 $ 0.80 $ 0.13 $ 0.18 $ 0.06 $ 0.01 $ (0.19) $ (0.54)
Diluted $ 0.21 $ 0.69 $ 0.08 $ 0.11 $ 0.04 $ 0.01 $ (0.19) $ (0.54)
Pro forma $ 0.15 $ 0.10 $ 0.05 $ 0.06 $ 0.03 $ 0.01 $ (0.12) $ (0.34)
Weighted average common shares:
Basic 30,488 29,634 19,690 18,386 18,274 18,179 18,119 18,056
Diluted and pro forma 36,636 34,203 34,415 33,059 30,869 18,953 18,119 18,056
PERCENTAGE OF NET SALES:
Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of sales 37.5 36.3 38.0 38.1 38.9 39.6 42.7 42.8
------- ------- ------- ------- ------- ------- ------- -------
Gross profit 62.5 63.7 62.0 61.9 61.1 60.4 57.3 57.2
Operating expenses:
Sales and marketing 43.7 46.1 47.6 48.8 47.3 51.1 52.6 60.8
General and administrative 9.2 10.7 10.4 8.9
Store closings and asset 10.2 8.2 9.5 10.7
impairments 0.0 0.0 0.2 0.1 1.2 0.0 0.2 0.5
------- ------- ------- ------- ------- ------- ------- -------
Total operating expenses 52.9 56.8 58.2 57.8 58.7 59.4 62.3 72.0
======= ======= ======= ======= ======= ======= ======= =======
Operating income (loss) 9.6 6.9 3.8 4.1 2.4 1.0 (5.0) (14.8)
Other income (expense), net (0.3) (0.1) (0.5) (0.6) (1.0) (0.6) (0.6) (0.0)
------- ------- ------- ------- ------- ------- ------- -------
Income (loss) before income taxes
and extraordinary loss 9.3 6.8 3.8 3.6 1.4 1.0 (5.0) (14.8)
Income tax benefit (expense) (0.5) 21.0 0.0 0.4 0.2 0.0 0.0 (0.2)
------- ------- ------- ------- ------- ------- ------- -------
2002 2001
------------------------------------- ---------------------------------------
QUARTER QUARTER
------------------------------------- ---------------------------------------
DEC. SEPT. JUNE MAR. DEC. SEPT. JUNE MAR.
------- ------- ------- ------- -------- ------- ------- -------
Income (loss) before extraordinary
loss 8.8 27.8 3.3 4.0 1.5 0.4 (5.6) (15.0)
Extraordinary loss, net of tax (0.4) 0.0 0.0 0.0 0.0 0.0 0.0 0.0
------- ------- ------- ------- ------- ------- ------- -------
Net income (loss) 8.4% 27.8% 3.3% 4.0% 1.5% 0.4% (5.6)% (15.0)%
======= ======= ======= ======= ======= ======= ======= =======
Sales are subject to some seasonal influences, with lower sales in the
second quarter and higher sales during the fourth quarter holiday season due to
increased mall traffic.
Pro forma diluted net income (loss) per share reflects the effects on
net income from specific non-recurring items and from the recognition of an
income tax benefit (provision) for years where a regular tax provision, at a
rate of 38%, was not recorded. Generally accepted accounting principles (GAAP)
did not allow us to reduce net income for income tax expense in 2002 or to
provide an income tax benefit in 2001. Because we expect to record income tax
expense in future periods, we believe pro forma diluted net income (loss) per
share provides a more meaningful comparison than GAAP net income (loss) per
share for the periods presented and for future periods. In addition, we excluded
the effect of the extraordinary after tax, non-cash charges associated with
early repayment of our $5.0 million of 12% senior secured debt in December 2002.
A reconciliation of diluted net income (loss) per share (as determined in
accordance with GAAP) to pro forma diluted net income (loss) per share is as
follows:
2002 2001
------------------------------------- ---------------------------------------
QUARTER QUARTER
------------------------------------- ---------------------------------------
DEC. SEPT. JUNE MAR. DEC. SEPT. JUNE MAR.
------- ------- ------- ------- -------- ------- ------- -------
GAAP diluted net income (loss) per
share $ 0.21 $ 0.69 $ 0.08 $ 0.11 $ 0.04 $ 0.01 $ (0.19) $ (0.54)
Effect of:
Income tax benefit (provision) at
38% of income before tax $ (0.08) $ (0.07) $ (0.03) $ (0.05) $ (0.01) $ (0.00) $ 0.07 $ 0.20
Extraordinary loss $ 0.02 - - - - - - -
(Restoration) of deferred tax asset - $ (0.52) - - - - - -
------- ------- ------- ------- ------- ------- ------- -------
Pro forma diluted net income (loss)
per share $ 0.15 $ 0.10 $ 0.05 $ 0.06 $ 0.03 $ 0.01 $ (0.12) $ (0.34)
======= ======= ======= ======= ======= ======= ======= =======
40
LIQUIDITY AND CAPITAL RESOURCES
We generated cash from operations of $36.1 million in 2002 ($28.3 million of
cash was generated after our $7.8 million investment in property and equipment).
Historically, our primary source of capital has been from external sources, most
recently from the completion of our $11.0 million convertible debt offering in
June 2001 and our $5.0 million senior secured term debt financing in September
2001. The $11.0 million in convertible debt was converted to equity in the
second quarter of 2002 and the $5.0 million of senior debt was prepaid in
December 2002 with cash generated from operations. In February 2003, our board
of directors approved an expanded share repurchase program of up to $12.5
million. We are currently pursuing a new bank revolving line of credit. While it
is not currently anticipated that this line will be necessary for short- or
long-term liquidity needs, the line would provide additional cash flexibility.
Barring any unexpected significant external or internal developments, we expect
current cash balances on hand and free cash flow generated from operations to be
sufficient to meet our short-term and long-term liquidity needs.
Net cash provided by (used in) operating activities in 2002, 2001 and 2000 was
$36.1 million, $0.4 million and ($10.3) million, respectively. Net cash provided
by operating activities in 2002 consisted primarily of net income adjusted for
non-cash expenses and an increase in accrued compensation and benefits,
partially offset by an increase in prepaid expenses. The increase in accrued
compensation and benefits was due primarily to higher incentive compensation
costs resulting from improved company performance, which were paid in early
2003. Prepaid expenses increased in 2002 primarily due to the timing of payments
related to marketing and advertising expenditures.
Net cash provided by operating activities in 2001 consisted primarily of a
decrease in inventories and prepaid expenses, partially offset by the net loss
adjusted for non-cash expenses and a decrease in accounts payable and accrued
sales returns. Inventory levels were reduced in 2001 as a result of two primary
activities: (i) the closure of one of our manufacturing plants and (ii) a focus
on reducing supplier lead-times, resulting in lower in-stock raw material levels
required at our manufacturing plants. Prepaid expenses were reduced in 2001 as a
result of lower prepaid advertising levels, consistent with the timing and form
of media placements at the end of 2001 versus those in place at the end of 2000.
The decrease in accounts payable in 2001 was due primarily to a decrease in the
number of stores open at the end of 2001 and to extended payment terms being in
place with some of our key suppliers at the end of 2000. The terms with those
key suppliers had normalized at the end of 2001. The balance in our accrued
sales returns in 2001 decreased as a result of the change in our sales return
policy from 90 days at the end of 2000 to 30 days at the end of 2001. The
shorter return period resulted in a smaller balance of sales that had not yet
been returned at the end of 2001.
Net cash used in 2000 operating activities consisted primarily of the net loss
adjusted for non-cash expenses and an increase in accounts receivable, partially
offset by an increase in accounts payable. The increase in accounts receivable
at the end of 2000 was primarily due to the timing of credit card settlements.
Payables increased at the end of 2000 due to additional retail stores being open
as of year-end and extended payment terms with suppliers.
Net cash provided by (used in) investing activities for 2002, 2001 and 2000 was
($21.5) million, ($0.9) million and $3.7 million, respectively. Investing
activities consisted of purchases of property and equipment related to
investment in information technology and the opening of new retail stores in all
periods. In 2002, we made investments of $24.8 million in marketable securities
and had $11.1 million of marketable securities mature. In 2001 and 2000 we
liquidated $4.0 million and $16.2 million, respectively, of marketable
securities to support our continuing operations. In 2003, we expect
41
to open 20 to 30 new retail stores and to remodel approximately 100 stores. Our
anticipated capital investment related to our new stores and remodeling is
expected to be approximately $11.0 million. Total capital expenditures are
expected to be approximately $18.0 million in 2003. We expect our new stores to
be cash flow positive within the first 12 months of operation, and as a result,
are not expected to have a significant negative effect on net cash provided by
operations.
Net cash provided by (used in) financing activities for 2002, 2001 and 2000 was
($3.9) million, $15.4 million and $0.6 million, respectively. Net cash used in
financing activities in 2002 resulted primarily from the repayment of our $5.0
million of senior secured debt. The total cash used in financing activities in
2002 was partially offset by cash received from the issuance of common stock
related to the exercise of options and warrants. Net cash provided by financing
activities in 2001 resulted from the issuance of common stock and from the
financing of $11.0 million of convertible debt and $5.0 million of senior
secured term debt. Fees and expenses of $1.0 million were netted against the
proceeds from debt issuances. Net cash provided by financing activities in 2000
resulted from cash received from the issuance of common stock.
Our liquidity is impacted by minimum cash payment commitments resulting from
long-term debt outstanding and operating leases. The table below outlines those
minimum cash commitments, during the periods indicated (in thousands):
PAYMENTS DUE BY PERIOD
----------------------------------------
< 1 1 - 3 3 - 5 > 5
TOTAL YEAR YEARS YEARS YEARS
------ ------ ------- ------- -------
Long-term debt $ 4,011 11 4,000 - -
Operating leases 76,519 15,641 27,853 21,037 11,988
------ ------ ------ ------ ------
Total $80,530 15,652 31,853 21,037 11,988
======= ====== ====== ====== ======
In addition, we have secured a $1.0 million stand-by letter of credit with cash.
At December 28, 2002, we had net operating loss carryforwards for federal income
tax purposes of approximately $20.9 million, of which $103,000 will expire
between 2003 and 2006 and the remainder will expire between 2020 and 2021. We
have recorded a valuation allowance of $641,000 for capital loss carryforwards
that are not likely to be utilized within the applicable carryforward periods.
42
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Our debt obligations consist of a $4 million non-interest bearing subordinated
convertible debenture. As a result, we do not believe we have significant
exposure to interest rate risk.
Other financial instruments that potentially subject us to concentrations of
credit risk consist principally of investments. The counterparties to the
agreements consist of government agencies and various major corporations of
investment grade credit standing. We do not believe there is significant risk of
non-performance by these counterparties because we limit the amount of credit
exposure to any one financial institution and any one type of investment.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our Consolidated Financial Statements are listed under Item 15 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
43
PART III
--------------------
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS
Our executive officers and directors are as follows:
SLEEP
NAME AGE NUMBER POSITION
- ----------------------------------- --- ------ -----------------------------------------------
William R. McLaughlin............... 46 55 Director, President and Chief Executive Officer
Keith C. Spurgeon................... 48 90 Senior Vice President, Sales
Noel F. Schenker.................... 49 35 Senior Vice President, Marketing and New Business
Development
Gregory T. Kliner................... 65 35 Senior Vice President, Operations
James C. Raabe...................... 42 25 Senior Vice President and Chief Financial Officer
Mark A. Kimball..................... 44 35 Senior Vice President, Human Resources and Legal,
General Counsel and Secretary
Michael J. Thyken................... 41 45 Senior Vice President and Chief Information Officer
Tracey T. Breazeale................. 36 25 Senior Vice President, Special Projects
Patrick A. Hopf (1)................. 53 35 Chairman of the Board
Thomas J. Albani (2)................ 60 90 Director
Christopher P. Kirchen (3).......... 60 35 Director
David T. Kollat (2)................. 64 40 Director
Michael A. Peel (2)................. 53 45 Director
Trudy A. Rautio (3)................. 50 45 Director
Ervin R. Shames (2)(1).............. 62 35 Director
Jean-Michel Valette (3)............. 42 35 Director
- --------------
(1) Member of the Corporate Governance and Nominating Committee
(2) Member of the Compensation Committee
(3) Member of the Audit Committee
44
EXECUTIVE OFFICERS
William R. McLaughlin joined our company in March 2000 as President and Chief
Executive Officer. 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.
Keith C. Spurgeon joined our company as Senior Vice President, Sales in February
2002. From September 2000 to February 2002, Mr. Spurgeon served as an
independent business consultant. From 1996 to September 2000 he was Chairman of
the Board and Chief Executive Officer of Zany Brainy, Inc., a retailer of
educational toys and books for children.. Zany Brainy filed for Chapter 11
bankruptcy protection in May 2001. He served as Vice President-Asia/Australia at
Toys "R" Us, Inc. from 1991 to 1996 after holding various management positions
from 1986 to 1991. Mr. Spurgeon began his career at Jewel Food Stores.
Noel F. Schenker joined our company as Senior Vice President, Marketing and New
Business Development in November 2000. Ms. Schenker served as Senior Vice
President of Marketing and Strategic Planning at Rollerblade, Inc., a sporting
goods company, from 1992 to 1996, and as an independent consultant from 1996 to
2000. She was with The Pillsbury Company from 1981 to 1992, serving as Vice
President of Marketing for the Green Giant business.
Gregory T. Kliner joined our company as Senior Vice President, Operations in
August 1995. From October 1986 to August 1995, Mr. Kliner served as Director of
Operations of the Irrigation Division for The Toro Company, a manufacturer of
lawn care, snow removal products and irrigation systems.
James C. Raabe 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.
Mark A. Kimball has served as Senior Vice President, Human Resources and Legal,
General Counsel and Secretary since July 2000. 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.
Michael J. Thyken has served as Senior Vice President and Chief Information
Officer since July 2001. From July 2000 to July 2001, Mr. Thyken served as Vice
President and Chief Information Officer. During 1999, he was Group Director of
Application Development at Jostens, a manufacturer of scholastic recognition
products. From 1994 to 1999, Mr. Thyken was Director of Technical Services for
Target Stores, then a division of Dayton Hudson Corporation, a department store
retailer. From 1984 to 1994, Mr. Thyken served in various positions with IBM
Corporation.
Tracey T. Breazeale has served as Senior Vice President, Special Projects since
February 2001. From July 1999 to February 2001, Ms. Breazeale served as our
Senior Vice President of Strategic Planning and Branding. In February 2001, Ms.
Breazeale's work schedule was reduced to 25% of full time and her title was
changed to Senior Vice President, Special Projects. She was with the Boston
Consulting Group from October 1993 to July 1999, initially as a consultant and
the last three years as a manager, where Ms. Breazeale specialized in strategic
and marketing oriented projects for retail and consumer product companies.
45
Patrick A. Hopf has served as Chairman of the Board of Directors since April
1999 and has served as a member of our board of directors since December 1991.
Mr. Hopf also served as our Chairman of the Board of Directors from August 1993
to April 1996. Since April 2002, Mr. Hopf has been the President of Symmetry
Growth Capital LLC, a venture capital firm. From August 1988 to February 2002,
he was President of St. Paul Venture Capital, Inc., a venture capital firm, and
from February 2002 to December 2002, he was Executive Vice President of St. Paul
Venture Capital, Inc. From August 1988 to January 1999, Mr. Hopf served as Vice
President of St. Paul Fire and Marine Insurance Company. Mr. Hopf also serves as
a director of a number of privately held companies.
Thomas J. Albani has served as a member of our board of directors since February
1994. Mr. Albani served as President and Chief Executive Officer of Electrolux
Corporation, a manufacturer of premium floor care machines, from June 1991 to
May 1998. From September 1984 to April 1989, he was employed by Allegheny
International Inc., a home appliance manufacturing company, in a number of
positions, most recently as Executive Vice President and Chief Operating
Officer. Mr. Albani also serves as a director of Igloo Products Corporation.
Christopher P. Kirchen has served as a member of our board of directors since
December 1991. Mr. Kirchen is currently Managing General Partner of BEV Capital,
a venture capital partnership that he co-founded in March 1997. From 1986 to
December 2002, he was a General Partner of Consumer Venture Partners, a former
investor in our company. Mr. Kirchen also serves as a director of a number of
privately held companies.
David T. Kollat has served as a member of our board of directors since February
1994. Mr. Kollat has served as President and Chairman of 22 Inc., a research and
consulting company for retailers and consumer goods manufacturers, since 1987.
From 1976 until 1987, he served in various capacities for The Limited, a women's
apparel retailer, including Executive Vice President of Marketing and President
of Victoria's Secret Catalogue. Mr. Kollat also serves as a director of The
Limited, Inc., Wolverine World Wide, Inc., Big Lots, Inc. and Cone Mills
Corporation, as well as a number of privately held companies.
Michael A. Peel has served as a member of our board of directors since February
19, 2003. Mr. Peel has served as Senior Vice President, Human Resources and
Corporate Services of General Mills, Inc., a manufacturer and marketer of
packaged consumer foods, since 1991. From 1977 to 1991, Mr. Peel served in
various capacities for PepsiCo, Inc., including as Senior Vice President, Human
Resources for PepsiCo Worldwide Foods from 1987 to 1991.
Trudy A. Rautio has served as a member of our board of directors since December
2002. Ms. Rautio has served as Executive Vice President and Chief Financial
Officer of Carlson Consumer Group, a division of Carlson Companies, Inc., a
marketing, business and leisure travel and hospitality company, since 1997. From
1993 until 1997, she served in various capacities for Jostens, Inc., including
as Senior Vice President Finance from 1994 until 1997. From 1982 until 1993, Ms.
Rautio served in various capacities for The Pillsbury Company, including as Vice
President Finance from 1992 until 1993.
Ervin R. Shames has served as a member of our board of directors since April
1996. From April 1996 to April 1999, Mr. Shames served as our Chairman of the
Board of Directors. Since January 1995, Mr. Shames has served as an independent
management consultant to consumer goods and services companies, advising on
management and marketing strategy. Since 1996, he has been a visiting lecturer
at the University of Virginia's Darden Graduate School of Business. From
December 1993 to January 1995, he served as the Chief Executive Officer of
Borden, Inc. and was President and Chief Operating Officer of Borden, Inc. from
July 1993 until
46
December 1993. Mr. Shames serves as a director of Online Resources Corporation
and Choice Hotels.
Jean-Michel Valette has served as a member of our board of directors since
October 1994. Mr. Valette is an independent adviser to branded consumer
companies. From August 1998 to May 2000, Mr. Valette served as President and
Chief Executive Officer of Franciscan Estates, Inc., a Napa Valley winery. He
was a Managing Director of Hambrecht & Quist LLC, an investment banking firm,
from October 1994 to August 1998 and served as a Senior Analyst at Hambrecht &
Quist LLC from November 1992 to October 1994. Hambrecht & Quist LLC was one of
the underwriters of our initial public offering. Mr. Valette also serves as a
director of The Boston Beer Company, Peet's Coffee and Tea, Inc. and Golden
State Vintners, Inc., as well as a number of privately held companies.
BOARD COMPOSITION
Our board of directors is divided into three classes, each of whose members
serve for a staggered three-year term. The terms of Patrick A. Hopf, Trudy A.
Rautio and Ervin R. Shames expire at our 2003 annual meeting of shareholders.
The terms of Thomas J. Albani, David T. Kollat and William R. McLaughlin expire
at our 2004 annual meeting of shareholders. The terms of Christopher P. Kirchen,
Michael A. Peel and Jean-Michel Valette expire at our 2005 annual meeting of
shareholders.
INFORMATION ABOUT THE BOARD AND ITS COMMITTEES
Our board of directors met five times and took action by written consent on four
occasions during 2002. All of the current directors attended 75% or more of the
meetings of the board and all such committees on which they served during 2002.
Our board of directors has an Audit Committee, a Compensation Committee and a
Corporate Governance and Nominating Committee.
The Audit Committee provides assistance to our board of directors in satisfying
its fiduciary responsibilities relating to our accounting, auditing, operating
and reporting practices, and reviews our annual financial statements, the
selection and work of our independent certified public accountants and the
adequacy of internal controls for compliance with corporate policies and
directives. The Audit Committee consists of Messrs. Valette and Kirchen and Ms.
Rautio.
The Compensation Committee reviews general programs of compensation and benefits
for all of our employees, makes recommendations to our board of directors
concerning such matters as compensation to be paid to our officers and
directors, and administers our stock option and incentive plans, pursuant to
which stock options and other incentive awards may be granted to eligible
employees, officers, directors and consultants. The Compensation Committee
consists of Messrs. Albani, Kollat, Peel and Shames.
The Corporate Governance and Nominating Committee develops and recommends
Corporate Governance Principles to our board of directors to govern our board,
its committees, our company and our employees, identifies and recommends to our
board individuals qualified to become members of our board, and develops and
oversees the annual board and board committee evaluation process. The Corporate
Governance and Nominating Committee consists of Messrs. Hopf and Shames.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and
executive officers and all persons who beneficially own more than 10% of our
common stock to file with the Securities and Exchange Commission initial reports
of ownership and reports of changes in ownership of our common stock.
Executive officers, directors and greater than 10% beneficial owners are also
required to
47
furnish us with copies of all Section 16(a) forms they file.
To our knowledge, based upon a review of the copies of such reports furnished to
us during the fiscal year ended December 28, 2002 and written representations by
such persons, all transactions were reported on a timely basis in 2002.
48
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY OF CASH AND CERTAIN OTHER COMPENSATION
The following table provides summary information concerning cash and non-cash
compensation paid to or earned by our Chief Executive Officer and our four most
highly compensated executive officers other than the CEO serving as executive
officers at the end of 2002 (the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
LONG-TERM
ANNUAL COMPENSATION COMPENSATION
--------------------------------- ------------
SECURITIES ALL OTHER
UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY($) BONUS($) OPTIONS(#) ($)(1)
- --------------------------- ---- --------- -------- ---------- -------------
William R. McLaughlin 2002 $ 500,000 $ 937,500 (2) 250,000 $ 1,462
President and Chief Executive Officer 2001 500,000 281,250 375,000 --
2000 390,372 161,028 600,000 123,428 (3)
Noel F. Schenker 2002 250,000 281,250 (2) 50,000 135,182 (4)
Senior Vice President, Marketing and 2001 250,000 84,375 115,000 --
New Business Development 2000 41,346 20,466 100,000 577
Keith C. Spurgeon (5) 2002 206,731 237,981 (2) 100,000 165,930 (6)
Senior Vice President of Sales 2001 -- -- -- --
2000 -- -- -- --
Gregory T. Kliner 2002 192,400 216,450 (2) 50,000 50,125 (4)
Senior Vice President of Operations 2001 192,400 64,935 112,500 --
2000 186,992 46,281 28,000 2,400
Mark A. Kimball 2002 200,000 225,000 (2) 50,000 2,423
Senior Vice President, Human 2001 201,923 68,149 115,000 --
Resources and Legal, General Counsel 2000 201,243 49,808 36,000 --
and Secretary
- -----------------
(1) Except as noted, the amounts disclosed for each individual represent our
contributions to the accounts of the named individuals in our 401(k)
defined contribution plan.
(2) Represents bonuses accrued in 2002, the payment of which occurred in
February 2003.
(3) Includes $2,106 in contributions to the account of Mr. McLaughlin in our
defined contribution plan and $121,322 in payment for reimbursement of
relocation expenses.
(4) $132,158 relates to the exercise of non-statutory stock options.
(5) Mr. Spurgeon joined us on February 25, 2002.
(6) Includes payment for reimbursement of Mr. Spurgeon's relocation expenses
totalling $163,218.
49
OPTION GRANTS AND EXERCISES
The following tables summarize option grants and aggregated option exercises
during the fiscal year ended December 28, 2002 to or by the Named Executive
Officers.
OPTION GRANTS IN LAST FISCAL YEAR
INDIVIDUAL GRANTS (1)
-------------------------------------------------------
PERCENT OF POTENTIAL REALIZABLE VALUE
TOTAL AT ASSUMED ANNUAL RATES
NUMBER OF OPTIONS OF STOCK PRICE
SECURITIES GRANTED TO EXERCISE APPRECIATION
UNDERLYING EMPLOYEES OR BASE FOR OPTION TERM (2)
OPTIONS IN FISCAL PRICE EXPIRATION --------------------------
NAME GRANTED (#) YEAR ($/SH) DATE 5% 10%
- ---------------------- ------------- ---------- -------- ------------ ---------- -----------
William R. McLaughlin 250,000 (3) 26.2% $2.73 01/30/12 $429,221 $1,087,729
Noel F. Schenker 50,000 (3) 5.2% 2.73 01/30/12 85,844 217,546
Keith C. Spurgeon 75,000 (3) 7.9% 3.13 02/25/12 147,633 374,131
25,000 (4) 2.6% 3.13 02/25/12 49,211 124,710
Gregory T. Kliner 50,000 (3) 5.2% 2.73 01/30/12 85,844 217,546
Mark A. Kimball 50,000 (3) 5.2% 2.73 01/30/12 85,844 217,546
(1) All of the options granted to the Named Executive Officers were granted
under our 1997 Stock Incentive Plan.
(2) In accordance with the rules of the Securities and Exchange Commission, the
amounts shown on this table represent hypothetical gains that could be
achieved for the respective options if exercised at the end of the option
term. These gains are based on assumed rates of stock appreciation of 5%
and 10% compounded annually from the date the respective options were
granted to their expiration date and do not reflect our estimates or
projections of future common stock prices. The gains shown are net of the
option price, but do not include deductions for taxes or other expenses
associated with the exercise. Actual gains, if any, on stock option
exercises will depend upon the future performance of the common stock, the
executive's continued employment with us or our subsidiaries and the date
on which the options are exercised. The amounts represented in this table
might not necessarily be achieved.
(3) These options become exercisable in as nearly equal as possible monthly
installments over a 36-month period, so long as the executive remains
employed by us or one of our subsidiaries at that date. To the extent not
already exercisable, these options become immediately exercisable in full
upon certain changes in control of our company and remain exercisable for
the remainder of their term.
(4) These options become exercisable when the average of the high and low sales
prices of our common stock, as reported by the Nasdaq National Market
System, exceeds $12.00 per share for at least 30 consecutive trading days.
50
AGGREGATED OPTION EXERCISES IN
LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES
NUMBER OF SECURITIES VALUE OF UNEXERCISED
SHARES VALUE UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
ACQUIRED ON REALIZED OPTIONS AT DECEMBER 28, 2002 AT DECEMBER 28, 2002 (2)
-------- ---------------------------- ----------------------------
NAME EXERCISE (#) ($)(1) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- ------------ -------- ----------- ------------- ----------- -------------
William R. McLaughlin --- $ 519,444 705,556 $2,709,636 $3,770,114
---
Noel F. Schenker 40,700 192,078 80,272 144,028 554,311 1,034,161
Keith C. Spurgeon --- --- 45,833 54,167 271,331 320,669
Gregory T. Kliner --- --- 185,557 124,888 876,241 783,976
Mark A. Kimball --- --- 209,000 117,000 640,097 799,473
(1) Value based on the difference between the fair market value of one share of
common stock on the date of exercise and the exercise price of the option.
(2) Value based on the difference between the fair market value of one share of
common stock at December 28, 2002 ($9.05) and the exercise price of the
options ranging from $1.00 to $17.00 per share. Options are in-the-money if
the market price of the shares exceeds the option exercise price.
DIRECTOR COMPENSATION
All of our non-employee directors receive an annual retainer of $25,000, each
committee chair receives additional compensation of $5,000 per year and each
member of the Audit Committee receives additional compensation of $5,000 per
year.
Each of our newly elected non-employee directors is eligible for an initial
grant of options to purchase 20,000 shares of our common stock at an exercise
price equal to the fair market value of our common stock on the date of grant.
These initial options become exercisable in equal monthly increments over a
24-month period, so long as the director remains a director of our company.
After the vesting of this initial grant, each of our non-employee directors is
eligible for an annual grant, subject to action by our board of directors and
coincident with the annual meeting of shareholders, of options to purchase
10,000 shares of our common stock at an exercise price equal to the fair market
value of our common stock on the date of the annual meeting of shareholders.
These annual options become exercisable in equal monthly increments over a
36-month period, so long as the director remains a director of our company. All
of the options granted to our directors remain exercisable for a period of up to
10 years after the date of grant, subject to continuous service on our board of
directors.
All of our directors are reimbursed for travel expenses for attending meetings
of our board of directors and any board committees.
Our directors who are our employees do not receive additional compensation for
their services as directors.
51
EMPLOYMENT AGREEMENTS
William R. McLaughlin. We have entered into a letter agreement with William R.
McLaughlin pursuant to which he serves as President and CEO. Mr. McLaughlin
receives a base salary and is entitled to participate in our incentive
compensation plans. Upon involuntary termination of Mr. McLaughlin's employment
by the Board or constructive dismissal, Mr. McLaughlin is entitled to one year's
salary as severance compensation and the unvested portion of his initial grant
of 300,000 options would become fully vested. Upon an involuntary termination or
constructive dismissal of Mr. McLaughlin's employment following a change in
control of our company, Mr. McLaughlin would be entitled to two years' salary as
severance compensation and his stock options would become fully vested.
Keith C. Spurgeon. We have entered into a letter agreement with Keith C.
Spurgeon pursuant to which he serves as Senior Vice President of Sales. Mr.
Spurgeon's receives a base salary and is entitled to participate in our
incentive compensation plans. Upon the involuntary termination of Mr. Spurgeon's
employment following a change in control, a termination without cause or a
constructive dismissal, Mr. Spurgeon is entitled to one year's salary as
severance and the unvested portion of his initial grant of 100,000 options would
become fully vested.
Noel F. Schenker. We have entered into a letter agreement with Noel F. Schenker
pursuant to which she serves as Senior Vice President, Marketing and New
Business Development. Ms. Schenker receives a base salary and is entitled to
participate in our incentive compensation plans. Upon the involuntary
termination of Ms. Schenker's employment following a change in control, a
termination without cause or a constructive dismissal, Ms. Schenker is entitled
to one year's salary as severance and the unvested portion of her initial grant
of 100,000 options would become fully vested.
Gregory T. Kliner. We have entered into a letter agreement with Gregory T.
Kliner pursuant to which he serves as Senior Vice President of Operations. Mr.
Kliner receives a base salary and is entitled to participate in our incentive
compensation plans.
James C. Raabe. We have entered into a letter agreement with James C. Raabe
pursuant to which he serves as Senior Vice President and Chief Financial
Officer. Mr. Raabe receives a base salary and is entitled to participate in our
incentive compensation plans.
Mark A. Kimball. We have entered into a letter agreement with Mark A. Kimball
pursuant to which he serves as Senior Vice President, Human Resources and Legal,
General Counsel and Secretary. Mr. Kimball receives a base salary and is
entitled to participate in our incentive compensation plans. Upon termination of
Mr. Kimball's employment without cause, Mr. Kimball is entitled to one year's
salary as severance compensation.
Michael J. Thyken. We have entered into a letter agreement with Michael J.
Thyken pursuant to which he serves as Senior Vice President and Chief
Information Officer. Mr. Thyken receives a base salary and is entitled to
participate in our incentive compensation plans.
Tracey T. Breazeale. We have entered into a letter agreement with Tracey T.
Breazeale pursuant to which she serves as a Senior Vice President. Ms. Breazeale
receives a base salary and is entitled to participate in our incentive
compensation plans. In February 2001, Ms. Breazeale's work schedule was reduced
to 25% of full time, with a proportionate reduction in salary.
52
CHANGE IN CONTROL ARRANGEMENTS
Under our 1990 Omnibus Stock Option Plan and the 1997 Stock Incentive Plan, if a
"change in control" of our company occurs, then, unless the Compensation
Committee decides otherwise either at the time of grant of an incentive award or
at any time thereafter, all outstanding options will become immediately
exercisable in full and will remain exercisable for the remainder of their
terms, regardless of whether the participant to whom such options have been
granted remains in the employ or service of our company or any subsidiary.
In addition, under the 1997 Stock Incentive Plan, if a "change in control" of
our company occurs, then, unless the Compensation Committee decides otherwise
either at the time of grant of an incentive award or at any time thereafter:
o all outstanding stock appreciation rights will become immediately
exercisable in full and will remain exercisable for the remainder of their
terms, regardless of whether the participant to whom such stock
appreciation rights have been granted remains in the employ or service of
our company or any subsidiary;
o all outstanding restricted stock awards will become immediately fully
vested and non-forfeitable; and
o all outstanding performance units and stock bonuses will vest and/or
continue to vest in the manner determined by the Compensation Committee and
set forth in the agreement evidencing such performance units or stock
bonuses.
There are presently no outstanding stock appreciation rights, restricted stock
awards, performance units or stock bonuses.
In addition, the Compensation Committee may pay cash for all or a portion of the
outstanding options. The amount of cash the participants would receive will
equal (a) the fair market value of such shares immediately prior to the change
in control minus (b) the exercise price per share and any required tax
withholding. The acceleration of the exercisability of options under both plans
may be limited, however, if the acceleration would be subject to an excise tax
imposed upon "excess parachute payments."
Under the both plans, a "change in control" will include any of the following:
o the sale, lease, exchange or other transfer of all or substantially all of
our assets to a corporation not controlled by us;
o the approval by our shareholders of a plan or proposal for the liquidation
or dissolution of our company;
o any change of control that is required by the Securities and Exchange
Commission to be reported;
o any person who was not a shareholder of our company on the effective date
of the plan becomes the beneficial owner of 50% or more of the voting power
of our outstanding common stock; or
o the "continuity" directors (directors as of the effective date of the plan
and their future nominees) ceasing to constitute a majority of the board of
directors.
Notwithstanding anything in the foregoing to the contrary, solely for purposes
of options granted under such plans prior to July 27, 1999, no change in control
will be deemed to have occurred for purposes of both plans by virtue of any
transaction which was approved by the affirmative vote of at least a majority of
the "continuity" directors, as defined above. For options granted on or after
July 27, 1999, each of the transactions constituting a change in control as
defined above will constitute a change in control for purposes of the plans
regardless of whether the transaction was approved by the continuity directors.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Messrs. Albani and Kollat served as members of the Compensation Committee of the
Board of Directors throughout 2002. Messrs. Shames and
53
Peel joined the Compensation Committee of the Board of Directors in 2003. Except
for any transactions described below under "Certain Relationships and Related
Transactions," no other relationships existed during 2002 with respect to
members of the Compensation Committee that would be required to be disclosed.
COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
Responsibilities of the Compensation Committee. The Compensation Committee of
the Board of Directors (the "Committee") is comprised entirely of independent,
non-employee directors. The primary purpose of the Committee is to discharge the
responsibilities of our Board relating to compensation of our executive
officers. The responsibilities of the Committee include:
o Establishing corporate goals and objectives with respect to compensation
for our CEO and other executive officers.
o Reviewing and approving salaries and other compensation applicable to our
CEO and other executive officers.
o Administering our incentive compensation plans applicable to executive
officers.
o Administering our stock option and stock purchase plans applicable to all
employees.
Compensation Philosophy. The decisions of the Committee and our compensation
programs are based on the following principles:
o As a performance-driven growth company, we favor variable compensation tied
to results and achievement over fixed, base compensation.
o As a growth company, we need to attract, retain and motivate executives and
key employees with the capability to enable us to achieve significantly
greater scale. We therefore benchmark our compensation against larger
companies.
o We seek to provide a compensation program that is competitive, motivating
and predictable, with base pay targeted at the mid-point of our benchmarks.
o We seek to reward achievement of aggressive performance objectives that are
aligned with the interests of our shareholders. Our incentive compensation
programs are designed to provide significant earnings potential as
aggressive performance targets are met or surpassed.
In discharging its responsibilities, the Committee considers factors such as our
company's performance, both in isolation and in comparison to other companies;
the individual performance of our executive officers; historical compensation
levels; the overall competitive environment for executives; and the level of
compensation necessary to attract and retain the talent necessary to achieve our
objectives. The Committee places primary emphasis on our company's performance
(rather than individual performance) as measured against goals approved by the
Committee. In analyzing these factors, the Committee from time to time reviews
competitive compensation data gathered in comparative surveys or collected by
independent consultants.
Executive Compensation Program Elements. Our executive compensation program
comprises base salary, annual incentive compensation, and long-term incentive
compensation under our stock option plans.
Base Salary. The Committee's recommendations regarding the base salary of
our executive officers, including the compensation of our CEO, are based on a
number of factors, including: the level of skill and responsibility required to
fulfill each executive's responsibilities; each executive's experience and
qualifications; each executive's performance and the impact of such performance
on our results; and competitive compensation data. Base salaries are reviewed
54
annually, and the Committee seeks to set executive officer base salaries at
competitive levels in relation to the companies with which we compete for
executives. Base salaries for our executive officers were increased at the
beginning of 2000 in order to retain key members of the management team to
pursue our turnaround plans. For 2001 and 2002, base salaries for our executive
officers were essentially maintained at the same levels as in 2000, except that
two members of our executive management team received modest increases in 2002
to bring their salaries in line with internal and external comparable positions.
For 2003, base salaries of our senior vice presidents were increased modestly,
at an average of approximately 3%, consistent with our philosophy of favoring
variable, performance-based compensation over fixed, base compensation.
Annual Incentive Compensation. We provide annual incentive cash
compensation for executive officers and other employees under our Executive and
Key Employee Incentive Plan. This plan is designed to provide a direct financial
incentive to our executive officers and other employees for achievement of
specific performance goals of our company. Consistent with the requirements of
this plan, at the beginning of each fiscal year, the Committee determines:
o The employees by grade level that are eligible to participate in the plan
for the year;
o The quarterly and/or annual performance goal or goals for the year (from
among sales growth and volume, net operating profit, cash flow, earnings
per share, return on capital, and/or return on assets);
o For each eligible employee, (A) the target bonus level as a percentage of
base compensation, (B) the portion of the target bonus level that is based
on achievement of objective company performance goals, and (C) the portion
of the target bonus level, if any, that is based on achievement of
objective individual performance goals; and
o The range of actual bonus payment levels, expressed as percentages of the
target bonus levels, to be paid based on various levels of achievement of
the performance goal or goals for the year.
For each of the fiscal years 2002 and 2003, the Committee has established
company-wide net operating profit as the exclusive performance goal for
determining annual incentive compensation for executive officers. The target
bonus level for senior vice presidents was set at 45% of base salary for 2002
and at 55% of base salary for 2003. The target bonus level for the CEO was set
at 75% of base salary for each of 2002 and 2003. The actual bonus payment may
range from 0% to 250% of the target bonus level, depending on the level of
achievement versus company-wide net operating profit targets.
Long-Term Incentive Compensation. We make long-term incentive compensation
available to our executive officers, as well as to many other of our employees,
in the form of stock option awards. Through the grant of stock options, we seek
to align the long-term interests of our executives and other employees with the
long-term interests of our shareholders by creating a strong and direct nexus
between compensation and shareholder return, and to enable significant ownership
in our company by executive officers and key managers. Executive officers and
other employees are eligible for stock option grants when they join us, and are
also eligible for annual stock option grants. The total size of our annual stock
option awards is reviewed against benchmark data. Individual awards are based on
levels of responsibility and potential impact on the our results, individual
performance and benchmark data.
All stock option grants have an exercise price equal to 100% of the fair market
value of the common stock on the date of grant. In the past, stock option grants
typically have become exercisable in 36 equal monthly installments over a
36-month period from the date of grant. Stock option grants awarded in 2003 will
become exercisable in equal annual installments over three years from the date
of grant. Options
55
typically remain exercisable for a period of 10 years from the date of grant,
provided the individual continues to be employed by us during such period.
Alternatively, some option grants have been "performance-based" and become fully
exercisable upon the trading price of our common stock reaching or exceeding
certain levels for at least 30 days or upon the end of a five-year period from
the date of grant.
Chief Executive Officer Compensation. William R. McLaughlin was hired as
President and CEO in March 2000. The principal terms of Mr. McLaughlin's
compensation package include: (A) an annual base salary of $500,000; (B) a cash
bonus at a target level of 75% of base salary (which bonus may range from 0% to
250% of such target amount, depending on company performance); and (C) long-term
incentive stock options. When hired in March 2000, Mr. McLaughlin received
options to purchase an aggregate of 600,000 shares of common stock exercisable
at a price of $5.91 per share, including (i) 300,000 shares vesting in equal
monthly increments over 36 months, (ii) 50,000 shares vesting upon the earlier
of such time that the trading price of our common stock exceeds $12.00 per share
for 30 consecutive trading days or five years from the date of grant, (iii)
100,000 shares vesting upon the earlier of such time that the trading price of
our common stock exceeds $24.00 per share for 30 consecutive trading days or
five years from the date of grant, and (iv) 150,000 shares vesting upon the
earlier of such time that the trading price of our common stock exceeds $36.00
per share for 30 consecutive trading days or five years from the date of grant.
Mr. McLaughlin is also eligible for additional annual stock option grants, and
received stock option grants of 375,000 shares in 2001 and 250,000 shares in
2002, in each case vesting over a period of three years from the date of grant.
In addition to the foregoing, Mr. McLaughlin (i) is entitled to participate in
standard employee benefit plans offered by us, (ii) was entitled to and received
reimbursement of relocation and temporary living expenses aggregating $121,322
in 2000, (iii) is entitled to severance compensation in certain circumstances.
See "Executive Compensation and Other Benefits - Employment and Consulting
Agreements."
The terms of Mr. McLaughlin's compensation were determined in part on the basis
of a survey completed by an independent consultant of compensation and benefits
payable to CEOs for companies of comparable size and complexity to Select
Comfort.
SECTION 162(m)
Section 162(m) of the Internal Revenue Code requires that we meet specific
criteria, including stockholder approval of certain stock and incentive plans,
in order to deduct, for federal income tax purposes, compensation over $1
million per individual paid to our CEO and each of our four other most highly
compensated executives. Our 1997 Stock Incentive Plan and the Executive and Key
Employee Incentive Plan are designed to permit stock awards or cash incentive
awards granted under the respective plans to qualify as deductible
performance-based compensation under the Internal Revenue Code. In reviewing and
adopting other executive compensation programs, the Committee plans to continue
to consider the impact of Section 162(m) limitations in light of the materiality
of the deductibility of potential benefits and the impact of such limitations on
other compensation objectives. Because the Committee seeks to maintain
flexibility in accomplishing our company's compensation goals, however, it has
not adopted a policy that all compensation must be fully deductible.
Compensation Committee
Thomas J. Albani, Chair
David T. Kollat
Michael A. Peel
Ervin R. Shames
56
COMPARATIVE STOCK PERFORMANCE
The graph below compares, for the period from December 3, 1998 through December
28, 2002, the total cumulative shareholder return on our common stock to the
total cumulative return on The Nasdaq Stock Market (U.S.) Index and the Standard
& Poor's 400 Retail (Specialty) Index. The graph assumes a $100 investment in
our common stock, The Nasdaq Stock Market (U.S.) Index and the Standard & Poor's
400 Retail (Specialty) Index on December 3, 1998 and the reinvestment of all
dividends.
COMPARISON OF 49 MONTH CUMULATIVE TOTAL RETURN*
AMONG SELECT CONFORM CORPORATION, THE NASDAQ STOCK MARKET (U.S.) INDEX
AND THE S&P MIDCAP 400 SPECIALTY STORES INDEX
[COMPARISON OF 49 MONTH CUMULATIVE TOTAL RETURN GRAPH]
<Table>
<Caption>
12/3/98 1/2/99 1/1/00 12/30/00 12/29/01 12/28/02
------- ------ ------ -------- -------- --------
Select Comfort Corporation 100.00 155.51 23.90 8.46 11.94 53.24
Nasdaq Stock Market (U.S.) 100.00 112.65 208.92 125.77 101.73 69.67
S&P Midcap 400 Specialty
Stores 100.00 127.04 103.79 93.89 146.83 130.80
</Table>
*$100 invested on 12/03/98 in stock or index-including reinvestment of
dividends. Fiscal year ended December 28.
Copyright (C) 2002, Standard & Poor's, a division of The McGraw-Hill Companies,
Inc. All rights reserved. www.researchdatagroup.com/S&P.htm
57
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information regarding the beneficial ownership of
our common stock as of February 14, 2003 by each person who was known by us to
be the beneficial owner of more than 5% of our common stock, by each director,
by each executive officer named in the Summary Compensation Table under the
heading "Executive Compensation and Other Benefits" and by all directors and
executive officers as a group.
SHARES OF COMMON STOCK
BENEFICIALLY OWNED (1)
-------------------------------
NAME AMOUNT PERCENT OF CLASS
- --------------------------- ------------ ----------------
St. Paul Companies, Inc. (2) 12,928,304 38.5%
NorthBay Partners, L.L.C. (3) 2,535,000 8.0%
William R. McLaughlin (4) 653,515 2.1%
Mark A. Kimball (5) 255,033 *
Gregory T. Kliner (6) 209,588 *
Noel F. Schenker (7) 127,118 *
Keith C. Spurgeon (8) 27,562 *
Patrick A. Hopf (9) 13,036,320 38.8%
Thomas J. Albani (10) 130,651 *
Christopher P. Kirchen (11) 271,541 *
David T. Kollat (12) 90,651 *
Michael A. Peel (13) 833 *
Trudy A. Rautio (14) 3,333 *
Ervin R. Shames (15) 338,056 1.1%
Jean-Michel Valette (16) 114,156 *
All directors and executive officers as a group (16 persons) (17) 15,700,344 44.2%
- ------------
* Less than 1% of the outstanding shares.
1) Except as otherwise indicated in the footnotes to this table, the persons
named in the table have sole voting and dispositive power with respect to
all shares of common stock indicated as beneficially owned. Shares of
common stock subject to options or warrants currently exercisable or
exercisable within 60 days are deemed
58
outstanding for computing the percentage of the person or group holding
such options or warrants but are not deemed outstanding for computing the
percentage of any other person or group.
2) Includes 4,886,022 shares held by St. Paul Fire and Marine Insurance
Company, 321,017 shares held by St. Paul Venture Capital IV, LLC, 955,900
shares held by St. Paul Venture Capital V, LLC, 4,100,000 shares held by
St. Paul Venture Capital VI, LLC and 275 shares held by St. Paul Venture
Capital Affiliates Fund I, LLC. Includes (i) 97,753 shares issuable upon
exercise of outstanding warrants held by St. Paul Fire and Marine Insurance
Co., (ii) 18,009 shares issuable upon exercise of outstanding warrants and
options held by St. Paul Venture Capital IV, LLC., (iii) 173,444 shares
issuable upon exercise of outstanding options held by St. Paul Venture
Capital V, LLC., (iv) 727,272 shares issuable upon conversion of a
convertible debenture held by St. Paul Venture Capital V, LLC., and (v)
1,648,612 shares issuable upon exercise of outstanding warrants and options
held by St. Paul Venture Capital VI, LLC. The St. Paul Companies, Inc. owns
all of the issued and outstanding shares of capital stock of St. Paul Fire
and Marine Insurance Co. St. Paul Fire and Marine Insurance Co. owns 99% of
the membership interests in St. Paul Venture Capital IV, LLC, St. Paul
Venture Capital V, LLC and St. Paul Venture Capital VI, LLC. Patrick A.
Hopf, Chairman of the Board of Directors of Select Comfort, is a member of
the investment committee responsible for the voting and acquisition and
disposition of Select Comfort shares held by each of the St. Paul entities.
The address of St. Paul Companies, Inc. is 385 Washington Street, St. Paul,
MN 55102.
3) Includes 1,301,250 outstanding shares and 600,000 shares issuable upon
exercise of an outstanding warrant held by NorthBay Opportunities, L.P. and
433,750 outstanding shares and 200,000 shares issuable upon exercise of an
outstanding warrant held by NorthBay International Opportunities, Ltd.
Northbay Partners, L.L.C. is the sole member of NorthBay Management, LLC
which serves as the general partner of NorthBay Opportunities, L.P. and the
sole member of NorthBay International Management, LLC, which serves as the
investment manager of NorthBay International Opportunities, Ltd. The
address for NorthBay Partners, L.L.C. is 1500 West Market Street, Suite
200, Mequon, WI 53092.
4) Includes 605,555 shares issuable upon exercise of outstanding options. Does
not include 1,000,000 outstanding shares held and 400,000 shares issuable
upon exercise of an outstanding warrant by BWSJ Corporation, for which Mr.
McLaughlin serves as a director and is a shareholder.
5) Includes 226,555 shares issuable upon exercise of outstanding options.
6) Includes 201,667 shares issuable upon exercise of outstanding options.
7) Includes 105,272 shares issuable upon exercise of outstanding options.
8) Includes 27,083 shares issuable upon exercise of outstanding options.
9) Includes (i) 1,216 shares held by Mr. Hopf's wife and children and (ii) an
aggregate of (A) 10,263,214 outstanding shares, (B) 1,937,818 shares
issuable upon exercise of outstanding options and warrants, and (C) 727,272
shares issuable upon conversion of a convertible debenture, all of which
are beneficially owned by St. Paul Fire and Marine Insurance Company. . See
footnote (2). Mr. Hopf disclaims beneficial ownership of the shares held by
the St. Paul entities, except to the extent of any pecuniary interest
therein. Mr. Hopf's address is 775 Prairie Center Drive, Suite 210, Eden
Prairie, MN 55344.
10) Includes 43,056 shares issuable upon exercise of outstanding options and
warrants.
11) Includes 23,056 shares issuable upon exercise of outstanding options.
12) Includes 60,556 shares issuable upon exercise of outstanding options.
13) Includes 833 shares issuable upon exercise of outstanding options and
warrants.
14) Includes 3,333 shares issuable upon exercise of outstanding options.
59
15) Includes 138,056 shares issuable upon exercise of outstanding options and
warrants held by Mr. Shames and 100,000 shares issuable upon exercise of
outstanding options held by Louise G. Shames, Trustee of the Ervin R.
Shames Estate Reduction Family Trust U/A dated October 30, 1997.
16) Includes 43,056 shares issuable upon exercise of outstanding options and
warrants.
17) Includes an aggregate of (i) 3,891,952 shares issuable upon exercise of
outstanding options and warrants and (ii) 727,272 shares issuable upon
conversion of a convertible debenture held by officers, directors and their
affiliates. Also includes all shares beneficially owned by St. Paul Fire
and Marine Insurance Company, Inc. See footnote (2).
TABLE OF EQUITY COMPENSATION PLAN INFORMATION
NUMBER OF SECURITIES
REMAINING AVAILABLE FOR
NUMBER OF SECURITIES TO FUTURE ISSUANCE UNDER
BE ISSUED UPON EXERCISE WEIGHTED-AVERAGE EXERCISE EQUITY COMPENSATION PLANS
OF OUTSTANDING OPTIONS PRICE OF OUTSTANDING (EXCLUDING SECURITIES
EQUITY COMPENSATION PLANS AND WARRANTS OPTIONS AND WARRANTS REFLECTED IN COLUMN (A))
(A) (B) (C)
- -------------------------------------- --------------------------- --------------------------- ---------------------------
Approved by security holders 10,037,693 $3.26 1,355,658
Not approved by security holders 0 -- 0
---------- ------ ---------
Total 10,037,693 $3.26 1,355,658
========== ====== =========
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
DIRECTOR RELATIONSHIPS
Patrick A. Hopf, our Chairman of the Board of Directors, was an Executive Vice
President of St. Paul Venture Capital, Inc. from February 2002 to December 2002.
Mr. Hopf was a Managing Member of St. Paul Venture Capital IV, LLC from January
1997 to December 2002 and St. Paul Venture Capital V, LLC from January 1999 to
December 2002, and a Managing Director of SPVC Management VI, LLC, the Managing
Member of St. Paul Venture Capital VI, LLC from October 2000 to December 2002.
St. Paul Venture Capital IV, LLC, St. Paul Venture Capital V, LLC, St. Paul
Venture Capital VI, LLC, St. Paul Venture Capital Affiliates Fund I, LLC (each
of which funds is managed by St. Paul Venture Capital, Inc.) and St. Paul Fire
and Marine Insurance Co. (whose holdings are managed by St. Paul Venture
Capital, Inc.) are significant shareholders of ours. Mr. Hopf is a member of the
investment committee responsible for the voting and acquisition and disposition
of Select Comfort shares held by each of the St. Paul entities. Mr. Hopf has a
continuing financial interest in the funds managed by the investment committee.
Christopher P. Kirchen, a member of our board of directors, was a general
partner of Consumer Venture Associates II, L.P., which is the general partner of
Consumer Venture Partners II, L.P., a former significant shareholder of ours.
Ervin R. Shames serves on the Board of Advisors for Avenue A, Inc. We have
entered into an agreement with Avenue A pursuant to which Avenue A will provide
us with certain Internet advertising services for budgeted fees of up to
$100,000 in 2003.
REGISTRATION RIGHTS AGREEMENT
Several holders of our common stock and warrants to purchase shares of our
common stock, including certain directors and holders of more than 5% of our
common stock, have demand and incidental registration rights covering certain
such shares held by them pursuant to a
60
Registration Rights Agreement dated June 6, 2001 among us and the other parties
thereto.
PRIVATE PLACEMENT OF 8% SENIOR SECURED CONVERTIBLE NOTES AND WARRANTS
In June 2001, we completed a private placement of 8% senior secured convertible
notes in the aggregate principal amount of $11.0 million, convertible into an
aggregate of 11.0 million shares of our common stock, together with warrants to
purchase an aggregate of 4.4 million shares of our common stock at an exercise
price of $1.00 per share. St. Paul Venture Capital VI, LLC purchased $4.1
million of the 8% senior secured convertible notes. BWSJ Corporation, a company
in which William R. McLaughlin has an ownership interest, purchased $1.0 million
of the notes. Three of our independent directors, including Thomas J. Albani,
Ervin R. Shames and Jean-Michel Valette, each purchased $50,000 of the notes.
All of these notes were automatically converted into shares of our common stock
in June 2002.
ITEM 14. DISCLOSURE CONTROLS AND PROCEDURES
(a) Within 90 days prior to the filing of this Annual Report on Form 10-K, our
President and Chief Executive Officer ("CEO") and our Chief Financial Officer
("CFO") carried out an evaluation of the effectiveness of our disclosure
controls and procedures. Based upon this evaluation, the CEO and CFO concluded
that our disclosure controls and procedures are effective in:
o accumulating and communicating information to our management, including the
CEO and CFO, to allow timely decisions regarding required disclosure; and
o recording, processing, summarizing and reporting information required to be
included in our periodic reports filed with the SEC in a timely manner.
(b) There were no significant changes in our internal controls or in other
factors that could significantly affect internal controls subsequent to the date
of the evaluation described above.
61
PART IV
--------------------
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE NUMBER
IN THIS REPORT
--------------
Independent Auditors' Report.................................................... F-1
Consolidated Balance Sheets as of December 28, 2002 and December 29, 2001....... F-2
Consolidated Statements of Operations for the years ended December 28, 2002,
December 29, 2001 and December 30, 2000......................................... F-3
Consolidated Statements of Shareholders' Equity for the years ended December 28,
2002, December 29, 2001 and December 30, 2000................................... F-4
Consolidated Statements of Cash Flows for the years ended December 28, 2002,
December 29, 2001 and December 30, 2000......................................... F-5
Notes to Consolidated Financial Statements...................................... F-6 to F-156
2. INDEX TO CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
The following Report and financial statement schedule are included in this Part IV
and are found in this Report at the pages indicated.
Independent Auditors' Report on Financial Statement Schedule.................... S-1
Schedule II - Valuation and Qualifying Accounts................................. S-1
All other schedules are omitted because they are not applicable or the required
information is included in the consolidated financial statements or notes thereto.
62
3. EXHIBITS
The exhibits to this Report are listed in the Exhibit Index below.
We will furnish a copy of any of the exhibits referred to above at a
reasonable cost to any shareholder upon receipt of a written request therefor.
Requests should be sent to: Select Comfort Corporation, 6105 Trenton Lane North,
Minneapolis, Minnesota 55442; Attn: Shareholder Information.
The following is a list of each management contract or compensatory plan or
arrangement required to be filed as an exhibit to this Annual Report on Form
10-K pursuant to Item 15(c):
1. Form of Incentive Stock Option Agreement under the 1997 Stock Incentive
Plan
2. Form of Performance Based Stock Option Agreement under the 1997 Stock
Incentive Plan
3. Employment Letter dated July 11, 1995 between the Company and Gregory T.
Kliner
4. Select Comfort Profit Sharing and 401(K) Plan
5. Select Comfort Corporation 1999 Employee Stock Purchase Plan
6. Select Comfort Corporation 1990 Omnibus Stock Option Plan, as amended and
restated
7. Select Comfort Corporation 1997 Stock Incentive Plan, as amended and
restated
8. Employment Letter dated July 21, 1999 between the Company and Tracey T.
Breazeale
9. Employment Letter dated April 22, 1999 between the Company and Mark A.
Kimball
10. Executive and Key Employee Incentive Plan
11. Employment Letter dated March 3, 2000 between the Company and William R.
McLaughlin
12. Employment Letter dated July 11, 2000 between the Company and Michael J.
Thyken
13. Employment Letter dated October 27, 2000 between the Company and Noel F.
Schenker
14. Employment Letter dated February 1, 2002 between the Company and Keith C.
Spurgeon
15. Select Comfort Executive Investment Plan
63
(b) REPORTS ON FORM 8-K
During the quarter ended December 28, 2002, we furnished four Current
Reports on Form 8-K. The Reports consisted of the following:
(i) Current Report furnished under Item 9 of Form 8-K on October
3, 2002, announcing net sales and revised earnings guidance
for the third quarter ended September 29, 2002.
(ii) Current Report furnished under Item 9 of Form 8-K on October
15, 2002, announcing comments on unaudited results for the
third quarter ended September 29, 2002 and revised guidance
for the fourth quarter.
(iii) Current Report furnished under Item 9 of Form 8-K on December
16, 2002, announcing election of Trudy Rautio to the board of
directors.
(iv) Current Report furnished under Item 9 of Form 8-K on December
19, 2002, announcing $5 million debt repayment.
64
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
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
Dated: February 26, 2003 By: /s/ William R. McLaughlin
------------------------------------------
William R. McLaughlin
President and Chief Executive Officer
(principal executive officer)
By: /s/ James C. Raabe
------------------------------------------
James C. Raabe
Chief Financial Officer
(principal financial and accounting
officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the date or dates indicated.
NAME TITLE DATE
- ---- ----- ----
/s/ Patrick A. Hopf Chairman of the Board February 26, 2003
- --------------------------------------------
Patrick A. Hopf
/s/ William R. McLaughlin President and Chief Executive February 26, 2003
- -------------------------------------------- Officer, Director
William R. McLaughlin
/s/ Ervin R. Shames Director February 26, 2003
- --------------------------------------------
Ervin R. Shames
/s/ Thomas J. Albani Director February 26, 2003
- --------------------------------------------
Thomas J. Albani
/s/ Christopher P. Kirchen Director February 26, 2003
- --------------------------------------------
Christopher P. Kirchen
65
/s/ David T. Kollat Director February 26, 2003
- --------------------------------------------
David T. Kollat
/s/ Director February , 2003
- --------------------------------------------
Jean-Michel Valette
/s/ Trudy A. Rautio Director February 26, 2003
- --------------------------------------------
Trudy A. Rautio
/s/ Michael A. Peel Director February 26, 2003
- --------------------------------------------
Michael A. Peel
66
Certification by Chief Executive Officer
I, William R. McLaughlin, certify that:
1. I have reviewed this annual report on Form 10-K of Select Comfort
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the Evaluation Date); and
c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: February 26, 2003
/s/ William R. McLaughlin
--------------------------------------------
William R. McLaughlin
President and Chief Executive Officer
67
Certification by Chief Financial Officer
I, James C. Raabe, certify that:
1. I have reviewed this annual report on Form 10-K of Select Comfort
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
annual report (the Evaluation Date); and
c) Presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) All significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: February 26, 2003
/s/ James C. Raabe
---------------------------------------------
James C. Raabe
Senior Vice President and Chief
Financial Officer
68
SELECT COMFORT CORPORATION
EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 28, 2002
EXHIBIT
NO. DESCRIPTION METHOD OF FILING
- ------- ------------ ----------------
3.1 Restated Articles of Incorporation of the Company, as amended.. Incorporated by reference to Exhibit
3.1 contained in Select Comfort's
Annual Report on Form 10-K for the
fiscal year ended January 1, 2000
(File No. 0-25121)
3.2 Restated Bylaws of the Company................................. Incorporated by reference to Exhibit
3.2 contained in the Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
4.1 Form of Warrant issued in connection with the sale of Incorporated by reference to Exhibit
Convertible Preferred Stock, Series E.......................... 4.2 contained in Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
4.2 Form of Warrant issued in connection with the November 1996 Incorporated by reference to Exhibit
Bridge Financing............................................... 4.3 contained in the Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
4.3 Form of Warrant issued under the June 2001 Incorporated by reference to Exhibit
Note Purchase Agreement........................................ 10.3 contained in Select Comfort's
Quarterly Report on Form 10-Q
for the quarter ended June 30, 2001
(File No. 0-25121)
4.4 Registration Rights Agreement dated June 6, 2001 by and among Incorporated by reference to Exhibit
Select Comfort Corporation and the securityholders named 10.7 contained in Select Comfort's
therein........................................................ Quarterly Report on Form 10-Q for
the quarter ended June 30, 2001
(File No. 0-25121)
4.5 Common Stock Purchase Warrant issued to Medallion Capital, Inc. Incorporated by reference to Exhibit
under the Loan Agreement of September 28, 2001................. 10.3 contained in Select Comfort's
Quarterly Report on Form 10-Q for
the quarter ended September 29, 2001
(File No.0-25121)
69
10.1 Net Lease Agreement dated December 3, 1993 between the Company Incorporated by reference to Exhibit
and Opus Corporation........................................... 10.1 contained in Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.2 Amendment of Lease dated August 10, 1994 between the Company and Incorporated by reference to Exhibit
Opus Corporation............................................... 10.2 contained in the Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.3 Second Amendment to Lease dated May 10, 1995 between the Company Incorporated by reference to Exhibit
and Rushmore Plaza Partners Limited Partnership (successor to 10.3 contained in Select Comfort's
Opus Corporation).............................................. Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.4 Letter Agreement dated as of October 5, 1995 between Incorporated by reference to Exhibit
The Company and Rushmore Plaza Partners 10.4 contained in Select Comfort's
Limited Partnership............................................ Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.5 Third Amendment of Lease, Assignment and Assumption of Lease and Incorporated by reference to Exhibit
Consent dated as of January 1, 1996 among the Company, Rushmore 10.5 contained in Select Comfort's
Plaza Partners Limited Partnership and Select Comfort Direct Registration Statement on Form S-1, as
Corporation.................................................... amended (Reg. No. 333-62793)
10.6 Lease Agreement dated as of September 19, 2002 Filed electronically herewith
between the Company and Frastacky (US)
Properties Limited Partnership.................................
10.7 Supply Agreement dated October 18, 2002 between the Company and Filed electronically herewith
Supplier (1)...................................................
10.8 Major Merchant Agreement dated December 19, 1997 among First Incorporated by reference to Exhibit
National Bank of Omaha and the Company, Select Comfort SC 10.13 contained in Select Comfort's
Corporation, Select Comfort Retail Corporation and Select Registration Statement on Form S-1, as
Comfort Direct Corporation..................................... amended (Reg. No. 333-62793)
10.9 Form of Incentive Stock Option Agreement under the 1997 Stock Incorporated by reference to Exhibit
Incentive Plan................................................. 10.16 contained in the Company's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.10 Form of Performance Based Stock Option Agreement under the 1997 Incorporated by reference to Exhibit
Stock Incentive Plan........................................... 10.17 contained in Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
70
10.11 Employment Letter dated July 11, 1995 between the Company and Incorporated by reference to Exhibit
Gregory T. Kliner.............................................. 10.20 contained in Select Comfort's
Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.12 Lease Agreement dated September 30, 1998 between Incorporated by reference to Exhibit
the Company and ProLogis Development Services 10.28 contained in Select Comfort's
Incorporated................................................... Registration Statement on Form S-1, as
amended (Reg. No. 333-62793)
10.13 Revolving Credit Program Agreement by and between Green Tree Incorporated by reference to Exhibit
Financial Corporation and Select Comfort Corporation (2)....... 10.3 contained in Select Comfort's
Quarterly Report on Form 10-Q for
the quarter ended July 3, 1999
(File No. 0-25121)
10.14 Letter of Agreement by and between Bed, Bath & Beyond Inc. and Incorporated by reference to Exhibit
Select Comfort Retail Corporation (2).......................... 10.4 contained in Select Comfort's
Quarterly Report on Form 10-Q for
the quarter ended July 3, 1999
(File No. 0-25121)
10.15 Select Comfort Profit Sharing and 401(K) Plan.................. Filed electronically herewith
10.16 Select Comfort Corporation 1999 Employee Stock Purchase Plan, as Incorporated by reference to Exhibit
amended........................................................ 10.17 contained in Select Comfort's
Annual Report on Form 10-K for
the fiscal year ended December 30, 2000
(File No. 0-25121)
10.17 Select Comfort Corporation 1990 Omnibus Stock Option Plan, as Incorporated by reference to Exhibit
amended and restated........................................... 10.1 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended October 2, 1999 (File No.
0-25121)
10.18 Select Comfort Corporation 1997 Stock Inventive Plan, as amended Incorporated by reference to Exhibit
and restated through May 1, 2001............................... 10.8 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended June 30, 2001 (File No.
0-25121)
10.19 Employment Letter dated July 21, 1999 Incorporated by reference to Exhibit
between the Company and Tracey T. Breazeale.................... 10.24 contained in Select Comfort's
Annual Report on Form 10-K for the fiscal
year ended January 1, 2000 (File No.
0-25121)
71
10.20 Employment Letter dated April 22, 1999 between the Company and Incorporated by reference to Exhibit
Mark A. Kimball................................................ 10.25 contained in Select Comfort's
Annual Report on Form 10-K for the fiscal
year ended January 1, 2000 (File No.
0-25121)
10.21 Executive and Key Employee Incentive Plan...................... Incorporated by reference to Exhibit
10.22 contained in Select Comfort's
Annual Report on Form 10-K for the
fiscal year ended December 30, 2000
(File No. 0-25121)
10.22 Employment Letter dated March 3, 2000 between the Company and Incorporated by reference to Exhibit
William R. McLaughlin.......................................... 10.1 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended April 1, 2000 (File No.
0-25121)
10.23 Employment Letter dated July 11, 2000 between the Company and Incorporated by reference to Exhibit
Michael J. Thyken.............................................. 10.24 contained in Select Comfort's
Annual Report on Form 10-K for the fiscal
year ended December 30, 2000 (File No.
0-25121)
10.24 Employment Letter dated October 27, 2000 between the Company and Incorporated by reference to Exhibit
Noel F. Schenker............................................... 10.25 contained in Select Comfort's
Annual Report on Form 10-K for the fiscal
year ended December 30, 2000 (File No.
0-25121)
10.25 Employment Letter dated February 1, 2002 between the Company and Incorporated by reference to Exhibit
Keith C. Spurgeon.............................................. 10.1 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended March 30, 2002 (File No.
0-25121)
10.26 Amendment to Revolving Credit Program Agreement with Conseco Incorporated by reference to Exhibit
Bank, Inc. dated February 20, 2001............................. 10.1 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended March 31, 2001 (File No.
0-25121)
10.27 Second Amendment to Revolving Credit Program with Conseco Bank, Incorporated by reference to Exhibit
Inc. dated April 13, 2001...................................... 10.2 contained in Select Comfort's
Quarterly Report on Form 10-Q for the
quarter ended March 31, 2001 (File No.
0-25121)
72
10.28 Third Amendment to Revolving Credit Program Filed electronically herewith
Agreement with Conseco Bank, Inc. dated
June 19, 2002..................................................
10.29 Select Comfort Executive Investment Plan....................... Filed electronically herewith
21.1 Subsidiaries of the Company.................................... Filed electronically herewith
23.1 Independent Auditors' Consent.................................. Filed electronically herewith
99.1 Certification of Chief Executive Officer....................... Filed electronically herewith
99.2 Certification of Chief Financial Officer....................... Filed electronically herewith
- ------------
(1) Confidential treatment has been requested with respect to designated
portions of this document. Such portions have been omitted and filed separately
with the Securities and Exchange Commission pursuant to Rule 24b-2 of the
Securities Exchange Act of 1934, as amended.
(2) Confidential treatment has been granted by the Securities and Exchange
Commission with respect to designated portions contained within document. Such
portions have been omitted and filed separately with the Securities and Exchange
Commission pursuant to Rule 24b-2 of the Securities and Exchange Act of 1934, as
amended.
73
INDEX TO FINANCIAL STATEMENTS
<Table>
<Caption>
PAGE
----
Independent Auditors' Report................................ F-2
Consolidated Balance Sheets as of December 28, 2002 and
December 29, 2001......................................... F-3
Consolidated Statements of Operations for the Years Ended
December 28, 2002, December 29, 2001 and December 30,
2000...................................................... F-4
Consolidated Statements of Shareholders' Equity for the
Years Ended December 28, 2002, December 29, 2001 and
December 30, 2000......................................... F-5
Consolidated Statements of Cash Flows for the Years Ended
December 28, 2002, December 29, 2001 and December 30,
2000...................................................... F-6
Notes to Consolidated Financial Statements.................. F-7
</Table>
F-1
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
Select Comfort Corporation:
We have audited the accompanying consolidated balance sheets of Select
Comfort Corporation and subsidiaries (the Company) as of December 28, 2002 and
December 29, 2001 and the related consolidated statements of operations,
shareholders' equity, and cash flows for each of the fiscal years in the
three-year period ended December 28, 2002. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. 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 28, 2002 and December 29,
2001, and the results of their operations and their cash flows for each of the
fiscal years in the three-year period ended December 28, 2002 in conformity with
accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Minneapolis, Minnesota
January 31, 2003
F-2
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 28, 2002 AND DECEMBER 29, 2001
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<Table>
<Caption>
2002 2001
-------- --------
ASSETS
Current assets:
Cash and cash equivalents................................. $ 27,176 $ 16,375
Marketable securities -- current (note 2)................. 12,146 --
Accounts receivable, net of allowance for doubtful
accounts of $340 and $311, respectively................ 3,270 2,623
Inventories (note 3)...................................... 8,980 8,086
Prepaid expenses.......................................... 5,467 3,588
Deferred tax assets (note 8).............................. 12,955 --
-------- --------
Total current assets.............................. 69,994 30,672
-------- --------
Marketable securities -- non-current (note 2)............... 1,502 --
Property and equipment, net (note 4)........................ 28,977 30,882
Deferred tax assets (note 8)................................ 4,352 --
Other assets................................................ 3,506 5,882
-------- --------
Total assets...................................... $108,331 $ 67,436
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt (note 6)............. $ 11 $ 28
Accounts payable.......................................... 16,508 15,216
Accruals:
Sales returns.......................................... 3,181 3,624
Compensation and benefits.............................. 13,666 7,179
Taxes and withholding.................................. 2,779 3,032
Consumer prepayments................................... 1,964 1,263
Other.................................................. 5,120 4,069
-------- --------
Total current liabilities......................... 43,229 34,411
Long-term debt, less current maturities (note 6)............ 2,991 17,109
Warranty costs.............................................. 3,626 5,030
Other liabilities........................................... 3,970 4,114
-------- --------
Total liabilities................................. 53,816 60,664
-------- --------
Shareholders' equity (notes 6, 7 and 10):
Undesignated preferred stock; 5,000,000 shares authorized,
no shares issued and outstanding....................... -- --
Common stock, $0.01 par value; 95,000,000 shares
authorized, 30,727,101 and 18,302,307 shares issued and
outstanding, respectively.............................. 307 183
Additional paid-in capital................................ 92,184 81,687
Accumulated deficit....................................... (37,976) (75,098)
-------- --------
Total shareholders' equity........................ 54,515 6,772
-------- --------
Commitments and contingencies (notes 1, 5 and 11):
Total liabilities and shareholders' equity........ $108,331 $ 67,436
======== ========
</Table>
See accompanying notes to consolidated financial statements.
F-3
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 28, 2002, DECEMBER 29, 2001 AND DECEMBER 30, 2000
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Net sales................................................... $335,795 $261,687 $270,077
Cost of sales (note 1)...................................... 125,796 107,210 115,601
-------- -------- --------
Gross profit.............................................. 209,999 154,477 154,476
-------- -------- --------
Operating expenses:
Sales and marketing (note 1).............................. 155,890 138,417 149,283
General and administrative................................ 32,854 25,296 29,211
Store closings and asset impairments (note 4)............. 233 1,366 1,952
-------- -------- --------
Total operating expenses............................... 188,977 165,079 180,446
-------- -------- --------
Operating income (loss)..................................... 21,022 (10,602) (25,970)
-------- -------- --------
Other income (expense):
Interest income........................................... 571 237 1,082
Interest expense (note 6)................................. (1,655) (1,362) (26)
Equity in loss of affiliate............................... -- -- (642)
Other, net................................................ (198) (339) (66)
-------- -------- --------
Other income (expense), net............................ (1,282) (1,464) 348
-------- -------- --------
Income (loss) before income taxes and extraordinary loss.... 19,740 (12,066) (25,622)
Income tax (benefit) expense (note 8)....................... (17,762) -- 11,592
-------- -------- --------
Income (loss) before extraordinary loss..................... 37,502 (12,066) (37,214)
Extraordinary loss from early extinguishment of debt, net of
tax of $234 (note 6)...................................... (380) -- --
-------- -------- --------
Net income (loss)........................................... $ 37,122 $(12,066) $(37,214)
======== ======== ========
Basic net income (loss) per share (note 9):
Income (loss) before extraordinary loss................... $ 1.53 $ (0.66) $ (2.09)
Extraordinary loss from early extinguishment of debt...... (0.02) -- --
-------- -------- --------
Net income (loss) per share -- basic...................... $ 1.51 $ (0.66) $ (2.09)
======== ======== ========
Weighted average common shares -- basic..................... 24,549 18,157 17,848
======== ======== ========
Diluted net income (loss) per share (note 9):
Income (loss) before extraordinary loss................... $ 1.10 $ (0.66) $ (2.09)
Extraordinary loss from early extinguishment of debt...... (0.01) -- --
-------- -------- --------
Net income (loss) per share -- diluted.................... $ 1.09 $ (0.66) $ (2.09)
======== ======== ========
Weighted average common shares -- diluted................... 34,532 18,157 17,848
======== ======== ========
</Table>
See accompanying notes to consolidated financial statements.
F-4
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 28, 2002, DECEMBER 29, 2001 AND DECEMBER 30, 2000
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<Table>
<Caption>
ADDITIONAL
PAID-IN ACCUMULATED
SHARES AMOUNT CAPITAL DEFICIT TOTAL
---------- ------ ---------- ----------- --------
Balance at January 1, 2000.............. 17,713,247 $177 $78,513 $(25,818) $ 52,872
Exercise of common stock options (note
7)................................. 44,515 1 136 -- 137
Issuance of common stock warrants..... -- -- 278 -- 278
Employee stock purchases (note 10).... 204,927 2 525 -- 527
Net loss.............................. -- -- -- (37,214) (37,214)
---------- ---- ------- -------- --------
Balance at December 30, 2000............ 17,962,689 180 79,452 (63,032) 16,600
---------- ---- ------- -------- --------
Exercise of common stock options (note
7)................................. 694 -- 1 -- 1
Issuance of common stock warrants..... -- -- 1,868 -- 1,868
Employee stock purchases (note 10).... 338,924 3 366 -- 369
Net loss.............................. -- -- -- (12,066) (12,066)
---------- ---- ------- -------- --------
Balance at December 29, 2001............ 18,302,307 183 81,687 (75,098) 6,772
---------- ---- ------- -------- --------
Exercise of common stock options (note
7)................................. 166,238 2 279 -- 281
Exercise of common stock warrants..... 1,046,344 10 (10) -- --
Conversion of convertible debt (note
6)................................. 11,000,000 110 9,382 -- 9,492
Employee stock purchases (note 10).... 212,212 2 846 -- 848
Net income............................ -- -- -- 37,122 37,122
---------- ---- ------- -------- --------
Balance at December 28, 2002............ 30,727,101 $307 $92,184 $(37,976) $ 54,515
========== ==== ======= ======== ========
</Table>
See accompanying notes to consolidated financial statements.
F-5
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 28, 2002, DECEMBER 29, 2001 AND DECEMBER 30, 2000
(IN THOUSANDS)
<Table>
<Caption>
2002 2001 2000
-------- -------- --------
Cash flows from operating activities:
Net income (loss)......................................... $ 37,122 $(12,066) $(37,214)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization.......................... 9,194 9,570 8,390
Amortization of debt discount and deferred finance
fees................................................. 1,279 512 19
Loss on disposal of assets and impaired assets......... 548 1,687 2,167
Deferred tax (benefit) expense......................... (17,307) -- 10,887
Change in operating assets and liabilities:
Accounts receivable.................................. (647) 70 (1,637)
Inventories.......................................... (894) 2,926 640
Prepaid expenses..................................... (1,879) 2,023 80
Other assets......................................... 1,441 (2,244) 535
Accounts payable..................................... 1,292 (2,055) 1,360
Accrued compensation and benefits.................... 6,487 1,154 (182)
Other accruals and liabilities....................... (492) (1,163) 4,669
-------- -------- --------
Net cash provided by (used in) operating
activities...................................... 36,144 414 (10,286)
-------- -------- --------
Cash flows from investing activities:
Purchases of property and equipment....................... (7,802) (4,859) (12,084)
Investments in marketable securities...................... (24,780) -- --
Proceeds from maturity of marketable securities........... 11,132 3,950 16,179
Investment in affiliate................................... -- -- (400)
-------- -------- --------
Net cash (used in) provided by investing
activities...................................... (21,450) (909) 3,695
-------- -------- --------
Cash flows from financing activities:
Principal payments on long-term debt...................... (5,022) (38) (16)
Proceeds from issuance of common stock.................... 1,129 370 664
Net proceeds from long-term debt.......................... -- 15,040 --
-------- -------- --------
Net cash (used in) provided by financing
activities...................................... (3,893) 15,372 648
-------- -------- --------
Increase (decrease) in cash and cash equivalents............ 10,801 14,877 (5,943)
Cash and cash equivalents, at beginning of year............. 16,375 1,498 7,441
-------- -------- --------
Cash and cash equivalents, at end of year................... $ 27,176 $ 16,375 $ 1,498
======== ======== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest............................................... $ 585 $ 182 $ 7
Income taxes........................................... 495 188 175
Non-cash impact of conversion of debt to equity........... 9,492 -- --
</Table>
See accompanying notes to consolidated financial statements.
F-6
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Business
Select Comfort Corporation and its wholly-owned subsidiaries (the Company)
is the leading developer, manufacturer and marketer of premium quality,
adjustable-firmness beds. The Company's fiscal year ends on the Saturday closest
to December 31.
Financial Statement Presentation
Fiscal years 2002, 2001 and 2000 each had 52 weeks. Certain prior-year
amounts have been reclassified to conform to the current-year presentation. In
particular, the Company has elected to reclassify costs associated with delivery
of its products to customers, from sales and marketing expense to cost of sales.
As a result of this change in presentation, cost of sales increased and sales
and marketing expenses decreased by $17,134,000 and $16,677,000 in 2001 and
2000, respectively. This change in classification does not affect operating
income or net income.
Principles of Consolidation
The consolidated financial statements include the accounts of Select
Comfort Corporation and its subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.
Cash and Cash Equivalents
Cash and cash equivalents include highly liquid investments with original
maturities of three months or less. The Company had $1,000,000 of its cash and
cash equivalents securing a standby letter of credit at December 28, 2002.
Marketable Securities
Investments with an original maturity of greater than 90 days are
classified as marketable securities. Marketable securities include highly liquid
investment grade debt instruments issued by the U.S. government and related
agencies and municipalities and commercial paper issued by companies with
investment grade ratings. The Company's investments have an original maturity of
up to 24 months. Marketable securities with a remaining maturity of greater than
one year are classified as long-term.
Inventories
Inventories include material, labor and overhead and are stated at the
lower of cost or market. Cost is determined by the first-in, first-out method.
Property and Equipment
Property and equipment, carried at cost, are depreciated using the
straight-line method over the estimated useful lives of the assets, which range
from three to seven years. Leasehold improvements are amortized over the shorter
of the life of the lease, 10 years or the date a store remodel is expected to be
completed.
Other Assets
Other assets include security deposits, patents, investments, trademarks,
debt issuance costs and goodwill. Patents and trademarks are amortized using the
straight-line method over periods ranging from 10 to 17 years. Debt issuance
costs are amortized using the straight-line method over the term of the debt.
F-7
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
Fair Value of Financial Instruments
The carrying value of cash and cash equivalents and accounts receivable
approximate fair value because of the short-term maturity of those instruments.
The fair value of long-term debt approximates carrying value based on the
Company's estimate of rates that would be available to it for debt of the same
remaining maturities.
Stock Compensation
The Company records compensation expense for option grants under its stock
option plan if the current market value of the underlying stock at the grant
date exceeds the stock option exercise price. Pro forma disclosure of the impact
on net earnings (loss) of applying an alternative method of recognizing stock
compensation expense over the vesting period based on the fair value of all
stock-based awards on the date of grant is presented in Note 7. If the Company
issues options to non-employees, compensation expense is recognized based on the
fair market value method.
Research and Development Costs
Costs incurred in connection with research and development are charged to
expense as incurred. Research and development expense was $936,000, $1,086,000
and $889,000 in 2002, 2001 and 2000, respectively.
Pre-opening Costs
Costs associated with the opening of new stores are expensed as incurred.
Advertising Costs
The Company incurs advertising costs associated with print and broadcast
advertisements. Such costs are charged to expense the first time the
advertisement airs. Advertising expense was $39,477,000, $29,451,000 and
$31,265,000 in 2002, 2001 and 2000, respectively.
Income Taxes
The Company recognizes deferred tax assets and liabilities for the future
tax consequences attributable to temporary differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
recognized against any portion of deferred tax assets when realization of the
deferred tax asset is not considered more likely than not.
Earnings Per Share
Basic earnings (loss) per share excludes dilution and is computed by
dividing the net income (loss) attributable to common shareholders by the
weighted average number of common shares during the period. Diluted earnings
(loss) per share includes potentially dilutive common shares consisting of stock
options and warrants determined by the treasury stock method and dilutive
convertible securities.
F-8
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
Accounting Estimates and Critical Accounting Policies
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates. Critical accounting policies consist
of the following:
Revenue Recognition
Revenue is recognized at the time of shipment to customers for products
shipped with outside, third party carriers. Revenue is recognized at the time of
delivery for products delivered through our company-controlled home delivery
system. In both cases, revenue is recognized net of estimated returns.
Impairment of Long-lived Assets and Long-lived Assets to be Disposed of
The Company reviews its long-lived assets, certain identifiable
intangibles, and goodwill for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to
sell.
The Company reviews store assets for possible impairment considering such
factors as estimated store cash flows, lease termination provisions, and
opportunities to impact future store operating results.
The test for goodwill impairment is a two-step process, and is performed on
at least an annual basis. The first step is a comparison of the fair value of
the reporting unit with its carrying amount, including goodwill. If this step
reflects impairment, then the loss would be measured as the excess of recorded
goodwill over its implied fair value. Implied fair value is the excess of fair
value of the reporting unit over the fair value of all identified assets and
liabilities.
Beginning in 2002, the Company stopped amortizing goodwill according to
SFAS Statement 142 "Goodwill and Other Intangible Assets." As a result, no
amortization expense for goodwill was recorded in 2002. The carrying value of
goodwill as of December 28, 2002 was $2,850,000. In 2001 and 2000, the Company
recorded goodwill amortization expense of $374,000 ($0.02 per share) and $22,000
($0.00 per share), respectively.
Accrued Warranty Costs
The Company provides a 20-year warranty on adjustable-firmness beds, the
last 18 years of which are on a pro rated basis. Estimated warranty costs are
expensed at the time of sale based on historical claims incurred by the Company.
Actual warranty claim costs could differ from these estimates. The Company
classifies as non-current those estimated warranty costs expected to be paid out
in greater than one year.
F-9
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED)
As of December 28, 2002, $3,626,000 of the accrued warranty costs was considered
long-term. The activity in the accrued warranty liability account is as follows
(in thousands):
<Table>
<Caption>
ADDITIONS
BALANCE AT CHARGED TO
BEGINNING OF COSTS AND DEDUCTIONS BALANCE AT
YEAR EXPENSES FROM RESERVES END OF YEAR
------------ ---------- ------------- -----------
2002.................................. $6,287 $2,433 $3,540 $5,180
2001.................................. 7,181 2,708 3,602 6,287
2000.................................. 5,841 5,397 4,057 7,181
</Table>
Accrued Sales Returns
Estimated sales returns are provided at the time of sale based upon
historical sales returns. Returns are allowed by the Company for 30 nights
following the sale.
New Accounting Pronouncements
The Financial Accounting Standards Board has issued statement SFAS 146
"Accounting for Costs Associated with Exit or Disposal Activities." Statement
146 revises the timing of when costs associated with an exit or disposal
activity are recognized. This statement requires that an entity recognize the
liability for a cost associated with an exit or disposal activity when the
liability is incurred, rather than at the date of an entity's commitment to an
exit plan as was previously allowed. The Company will account for any exit or
disposal activities after December 28, 2002 under SFAS 146.
(2) MARKETABLE SECURITIES
Securities classified as held to maturity, which consist of securities that
management has the ability and intent to hold to maturity, are carried at
amortized cost and are summarized as follows as of December 28, 2002 (in
thousands):
<Table>
<Caption>
EFFECTIVE AMORTIZED
INTEREST RATE COST FAIR VALUE
------------- --------- ----------
Corporate securities................................ 2.3% $ 501 $ 501
U.S. government agencies............................ 2.0 10,098 10,139
Commercial paper.................................... 1.4 3,049 3,052
------- -------
$13,648 $13,692
======= =======
</Table>
(3) INVENTORIES
Inventories consist of the following (in thousands):
<Table>
<Caption>
DECEMBER 28, DECEMBER 29,
2002 2001
------------ ------------
Raw materials............................................... $2,669 $1,824
Work in progress............................................ 88 26
Finished goods.............................................. 6,223 6,236
------ ------
$8,980 $8,086
====== ======
</Table>
F-10
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(4) PROPERTY AND EQUIPMENT
Property and equipment are summarized as follows (in thousands):
<Table>
<Caption>
DECEMBER 28, DECEMBER 29,
2002 2001
------------ ------------
Leasehold improvements...................................... $ 37,638 $ 36,551
Office furniture and equipment.............................. 4,083 3,496
Production machinery and computer equipment................. 25,827 21,256
Less accumulated depreciation and amortization.............. (38,571) (30,421)
-------- --------
$ 28,977 $ 30,882
======== ========
</Table>
Store Closings and Asset Impairment Charges
Store closings and write-off expense was $233,000, $1,029,000 and $565,000
in 2002, 2001 and 2000, respectively.
In 2001 and 2000, the Company incurred charges of $337,000 and $1,387,000,
respectively, related to the impairment of carrying values of certain non-store
assets. In 2001, these charges related primarily to the write-off of unusable
fixtures for merchandising of sleeper sofa products. In 2000, these charges
included $741,000 related to asset write-offs resulting from the relocation of
the Company's headquarters and $646,000 related to the write-off of web site
software design costs.
(5) LEASES
The Company rents office and manufacturing space under four operating
leases which, in addition to the minimum lease payments, require payment of a
proportionate share of the real estate taxes and building operating expenses.
The Company also rents retail space under operating leases which, in addition to
the minimum lease payments, require payment of percentage rents based upon sales
levels. Rent expense was as follows (in thousands):
<Table>
<Caption>
2002 2001 2000
------- ------- -------
Minimum rents........................................... $16,213 $16,069 $17,589
Percentage rents........................................ 3,085 1,561 1,835
------- ------- -------
Total................................................... $19,298 $17,630 $19,424
======= ======= =======
Equipment rent.......................................... $ 1,913 $ 2,003 $ 1,587
======= ======= =======
</Table>
The aggregate minimum rental commitments under operating leases for
subsequent years are as follows (in thousands):
<Table>
2003........................................................ $15,641
2004........................................................ 14,401
2005........................................................ 13,452
2006........................................................ 12,018
2007........................................................ 9,019
Thereafter.................................................. 11,988
-------
$76,519
=======
</Table>
F-11
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(6) LONG-TERM DEBT
Long-term obligations under notes and capital leases are as follows (in
thousands, except share and per share amounts):
<Table>
<Caption>
DECEMBER 28, 2002 DECEMBER 29, 2001
----------------- -----------------
8% senior subordinated convertible notes due June
2006 (the Notes). Face amount of $11,000 net of
$925 debt discount in 2001, with interest payable
annually. Convertible into 11,000,000 shares of
common stock at the rate of $1.00 per share....... $ -- $10,075
12% senior secured debt due September 2006 (the
Debt). Face amount of $5,000 net of $616 debt
discount in 2001, with interest payable monthly... -- 4,384
Non-interest bearing subordinated convertible
debenture due November 2005. Face amount of $4,000
net of $1,009 debt discount, with an effective
interest rate of 12% per annum. Convertible into
727,272 shares of common stock at the rate of
$5.50 per share................................... 2,991 2,645
Other............................................... 11 33
------ -------
3,002 17,137
Less current maturities............................. 11 28
------ -------
$2,991 $17,109
====== =======
</Table>
The Notes were converted to 11,000,000 shares of common stock at the rate of
$1.00 per share in 2002. The Debt was prepaid in 2002. All deferred financing
costs were written off in connection with the early repayment of the Debt and
have been reflected as an extraordinary loss.
The aggregate maturities of long-term debt for subsequent years are as
follows (in thousands):
<Table>
2003........................................................ $ 11
2004........................................................ --
2005........................................................ 4,000
------
$4,011
======
</Table>
(7) SHAREHOLDERS' EQUITY
Stock Options
The Board of Directors has reserved 9,300,000 shares of common stock for
options that may be granted to key employees, directors or others under the
Company's stock option plans. Options available for grant at December 28, 2002
were 1,365,846.
F-12
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(7) SHAREHOLDERS' EQUITY -- (CONTINUED)
A summary of the changes in the Company's stock option plans for each of
the years in the three-year period ended December 28, 2002 is as follows:
<Table>
<Caption>
WEIGHTED
AVERAGE
SHARES EXERCISE PRICE
--------- --------------
Outstanding at January 1, 2000 (including 1,311,133 shares
exercisable).............................................. 2,685,353 $9.92
Granted................................................... 1,307,700 4.64
Exercised................................................. (44,515) 3.09
Canceled.................................................. (429,267) 9.44
--------- -----
Outstanding at December 30, 2000 (including 1,726,097 shares
exercisable).............................................. 3,519,271 8.08
Granted................................................... 1,766,900 1.03
Exercised................................................. (694) 1.01
Canceled.................................................. (628,453) 8.74
--------- -----
Outstanding at December 29, 2001 (including 2,034,877 shares
exercisable).............................................. 4,657,024 5.32
Granted................................................... 952,600 3.26
Exercised................................................. (166,238) 1.69
Canceled.................................................. (123,267) 3.97
--------- -----
Outstanding at December 28, 2002 (including 2,980,786 shares
exercisable).............................................. 5,320,119 $5.09
========= =====
</Table>
The following table summarizes information about options outstanding at
December 28, 2002:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ----------------------------------------------------------------------- --------------------------
AVERAGE REMAINING WEIGHTED WEIGHTED
CONTRACTUAL LIFE AVERAGE AVERAGE
RANGE OF EXERCISE PRICE SHARES (YEARS) EXERCISE PRICE SHARES EXERCISE PRICE
- ----------------------- --------- ----------------- -------------- --------- --------------
$0.45 - 1.00.......... 398,887 7.79 $ 0.99 142,804 $ 0.97
1.01 - 2.75........... 2,107,216 8.59 1.75 898,538 1.64
2.76 - 7.00........... 1,798,796 6.52 5.22 1,164,224 5.23
7.01 - 14.00.......... 398,245 6.40 8.38 368,245 8.28
14.01 - 28.63......... 616,975 6.28 16.69 406,975 17.33
- ----------------------- --------- ----------------- -------------- --------- --------------
$0.45 - 28.63......... 5,320,119 7.40 $ 5.09 2,980,786 $ 5.97
========= =========
</Table>
No compensation cost has been recognized in the consolidated financial
statements for employee stock option grants or the discount feature of the
Company's employee stock purchase plan. Had the Company determined compensation
cost based on the fair value at the grant date for its stock options and
employee stock purchase plan under an alternative accounting method, the
Company's net income (loss) would have been adjusted as outlined below (in
thousands, except per share amounts):
<Table>
<Caption>
2002 2001 2000
------- -------- --------
Net income (loss): As reported.......... $37,122 $(12,066) $(37,214)
Pro forma............ $34,593 $(15,239) $(39,763)
Income (loss) per share -- basic: As reported.......... $ 1.51 $ (0.66) $ (2.09)
Pro forma............ $ 1.41 $ (0.84) $ (2.23)
Income (loss) per
share -- diluted: As reported.......... $ 1.09 $ (0.66) $ (2.09)
Pro forma............ $ 1.02 $ (0.84) $ (2.23)
</Table>
F-13
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(7) SHAREHOLDERS' EQUITY -- (CONTINUED)
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following assumptions:
<Table>
<Caption>
2002 2001 2000
----- ----- -----
Expected dividend yield..................................... 0% 0% 0%
Expected stock price volatility............................. 90% 90% 40%
Risk-free interest rate..................................... 2.0% 4.9% 5.9%
Expected life in years...................................... 3.6 3.5 3.6
Weighted-average fair value at grant date................... $2.02 $0.34 $1.87
</Table>
Warrants
The Company has issued warrants to various holders with outstanding
issuances at December 28, 2002 summarized below:
<Table>
<Caption>
WARRANTS
WARRANT TYPE EXERCISE PRICE OUTSTANDING EXPIRATION DATE
- ------------ -------------- ----------- ----------------
2001 Senior Secured Convertible Notes
Financing................................. 1.00 3,380,000 6/6/11
2001 Senior Secured Debt Financing.......... 1.02 922,819 9/26/06
Miscellaneous other warrants................ 1.20 - 5.56 562,256 5/17/04 - 6/6/11
------------ --------- ----------------
$1.00 - 5.56 4,865,075 5/17/04 - 6/6/11
=========
</Table>
The warrants issued in conjunction with the Notes and Debt were valued at
$1,100,000 and $600,000, respectively, and were reflected in additional paid-in
capital in the statement of shareholders' equity. The associated debt discount
was amortized as interest expense over the term of the debt until the related
debt was converted or was repaid (note 6).
Miscellaneous other warrants consist of warrants issued to various parties
in lieu of cash payments. The value of these warrants was recognized as
compensation expense with an offset to shareholders' equity utilizing the
Black-Scholes pricing model with assumptions reflecting the market rates at the
time of warrant issuance.
(8) INCOME TAXES
The (benefit) provision for income taxes consists of the following (in
thousands):
<Table>
<Caption>
2002 2001 2000
-------- ---- -------
Current:
Federal................................................ $ -- $-- $ --
State.................................................. (340) -- 705
-------- --- -------
(340) -- 705
-------- --- -------
Deferred:
Federal................................................ (12,739) -- 10,397
State.................................................. (4,683) -- 490
-------- --- -------
(17,422) -- 10,887
-------- --- -------
Income tax (benefit) expense........................... $(17,762) $-- $11,592
======== === =======
</Table>
F-14
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(8) INCOME TAXES -- (CONTINUED)
Effective tax rates differ from statutory federal income tax rates as
follows:
<Table>
<Caption>
2002 2001 2000
------ ----- -----
Statutory federal income tax rate.......................... 35.0% (35.0)% (35.0)%
Change in valuation allowance.............................. (123.3) 31.4 82.2
State income taxes, net of federal benefit................. (1.8) -- (1.1)
Other...................................................... 0.1 3.6 (0.9)
------ ----- -----
(90.0)% 0.0% 45.2%
====== ===== =====
</Table>
The tax effects of temporary differences that give rise to deferred tax
assets at December 28, 2002 and December 29, 2001 are as follows (in thousands):
<Table>
<Caption>
2002 2001
------- --------
Deferred tax assets:
Current:
Net operating loss carryforwards....................... $ 7,904 $ --
Inventory, warranty and returns reserves............... 3,208 3,849
Allowance for doubtful accounts........................ 129 118
Other.................................................. 2,164 2,409
Long term:
Net operating loss carryforwards....................... 29 15,662
Depreciation........................................... 3,765 2,624
Other.................................................. 749 516
------- --------
Total gross deferred tax assets...................... 17,948 25,178
Valuation allowance......................................... (641) (25,178)
------- --------
Total net deferred tax assets........................ $17,307 $ --
======= ========
</Table>
During 2002, the Company recorded a reduction in the valuation allowance of
$24,537,000. The reduction in the valuation allowance follows the Company's
return to profitability as a result of cost restructuring efforts in 2000 and
2001 and an increase in sales in 2002. The Company believes that it is more
likely than not that it will generate sufficient taxable income to utilize its
deferred tax assets, including net operating loss carryforwards, within any
applicable carryover periods.
At December 28, 2002, the Company had net operating loss carryforwards for
federal income tax purposes of approximately $20,900,000, of which $103,000 will
expire between 2003 and 2006, with the remainder expiring between 2020 and 2021.
The Company has recorded a valuation allowance of $641,000 for a capital loss
carryforward that likely will not be utilized within its applicable carryforward
period.
F-15
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(9) 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 share and per share
amounts).
<Table>
<Caption>
NET PER SHARE
2002 INCOME SHARES AMOUNT
- ---- ------- ---------- ---------
BASIC EPS
Net income:.......................................... $37,122 24,549,459 $1.51
=====
EFFECT OF DILUTIVE SECURITIES
Options............................................ -- 1,882,807
Common stock warrants.............................. -- 2,885,441
Convertible debt................................... 563 5,214,286
------- ----------
DILUTED EPS
Net income plus assumed conversions.................. $37,685 34,531,993 $1.09
======= ========== =====
</Table>
<Table>
<Caption>
NET PER SHARE
2001 AND 2000 LOSS SHARES AMOUNT
- ------------- -------- ---------- ---------
BASIC AND DILUTED EPS
Net loss:
2001.............................................. $(12,066) 18,157,005 $(0.66)
2000.............................................. $(37,214) 17,848,375 $(2.09)
</Table>
The following is a summary of those securities outstanding during the
respective periods which have been excluded from the calculations because the
effect on net income (loss) per common share would not have been dilutive:
<Table>
<Caption>
2002 2001 2000
--------- ---------- ---------
Options............................................ 1,870,220 4,657,024 3,519,271
Common stock warrants.............................. 40,000 6,124,529 1,344,378
Convertible debt................................... 727,272 11,727,272 727,272
</Table>
(10) EMPLOYEE BENEFIT PLANS
Under the Company's profit sharing and 401(k) plan eligible employees may
defer up to 15% of their compensation on a pre-tax basis. Each year, the Company
may make a discretionary contribution equal to a percentage of the employee's
contribution. During 2002, 2001 and 2000, the Company expensed $485,000,
$119,000 and $487,000, respectively, relating to its contribution to the 401(k)
plan. During 2002, the Company issued 81,778 shares for its discretionary
contribution.
Employee Stock Purchase Plan
Under the Company's Employee Stock Purchase Plan, employees can purchase
Company common stock at a discount of 15% based on the average price of the
stock on the last business day of the offering period (calendar-quarter.) The
Company issued 145,434, 338,924 and 204,927 shares during 2002, 2001 and 2000,
respectively.
(11) COMMITMENTS AND CONTINGENCIES
In June 1999, the Company and certain of its former officers and directors
were named as defendants in a class action lawsuit filed in U.S. District Court
in Minnesota. The suit, filed on behalf of purchasers
F-16
SELECT COMFORT CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(11) COMMITMENTS AND CONTINGENCIES -- (CONTINUED)
of the Company's common stock between December 4, 1998 and June 7, 1999, alleges
that the Company and the named former directors and officers failed to disclose
or misrepresented certain information concerning the Company in violation of
federal securities laws. The Company believes that the suit is without merit and
has vigorously defended the matter.
The Company has consented to a settlement of this litigation negotiated by
the Company's insurance carrier. The settlement is covered by insurance and
involves no cash or other payment obligation by the Company and no admission of
liability or wrongdoing by the Company. The settlement is not expected to have
any impact on the Company's results of operations or financial condition.
On December 13, 2002, the settlement agreement received preliminary
approval from the U.S. District Court for the District of Minnesota. The Court
issued an order setting February 28, 2003 for a hearing for final approval of
the settlement agreement. At the hearing for final approval, the Court will hear
any objections to the settlement or its terms.
The Company is involved in other various claims, legal actions, sales tax
disputes and other complaints arising in the ordinary course of business. In the
opinion of management, any losses that may occur from these other matters are
adequately covered by insurance or are provided for in the consolidated
financial statements and the ultimate outcome of these other matters will not
have a material effect on the consolidated financial position or results of
operations of the Company.
(12) SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a condensed summary of actual quarterly results for 2002
and 2001 (in thousands, except per share amounts):
<Table>
<Caption>
2002 DECEMBER SEPTEMBER JUNE MARCH
- ---- -------- --------- ------- -------
Net sales..................................... $92,263 $85,056 $77,281 $81,195
Gross profit.................................. 57,679 54,141 47,941 50,238
Operating income.............................. 8,836 5,833 2,984 3,369
Income before extraordinary loss.............. 8,091 23,604 2,563 3,244
Net income.................................... 7,711 23,604 2,563 3,244
Income per share before extraordinary
loss -- diluted............................. 0.22 0.69 0.08 0.11
Net income per share -- diluted............... 0.21 0.69 0.08 0.11
</Table>
<Table>
<Caption>
2001 DECEMBER SEPTEMBER JUNE MARCH
- ---- -------- --------- ------- -------
Net sales..................................... $69,341 $64,148 $62,742 $65,456
Gross profit.................................. 42,376 38,714 35,942 37,445
Operating income (loss)....................... 1,659 603 (3,176) (9,688)
Net income (loss)............................. 1,065 227 (3,530) (9,828)
Net income (loss) per share -- diluted........ $ 0.04 $ 0.01 $ (0.19) $ (0.54)
</Table>
F-17
INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULE
The Board of Directors and Stockholders
Select Comfort Corporation:
Under date of January 31, 2003 we reported on the consolidated balance
sheets of Select Comfort Corporation and subsidiaries as of December 28, 2002
and December 29, 2001 and the related statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended
December 28, 2002, as contained in the Annual Report on Form 10-K for the year
2002. In connection with our audits of the aforementioned consolidated financial
statements, we also audited the related financial statement schedule as listed
in the accompanying index. This financial statement schedule is the
responsibility of the Company's management. Our responsibility is to express an
opinion on this financial statement schedule based on our audits.
In our opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
/s/ KPMG LLP
Minneapolis, Minnesota
January 31, 2003
SELECT COMFORT CORPORATION AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
ADDITIONS
BALANCE AT CHARGED TO
BEGINNING COSTS AND DEDUCTIONS BALANCE AT END
DESCRIPTION OF PERIOD EXPENSES FROM RESERVES OF PERIOD
- --------------------------------- ----------- ---------- ------------- --------------
Allowance for doubtful accounts
- 2002 $ 311 $ 296 $ 267 $ 340
- 2001 264 582 535 311
- 2000 305 531 572 264
S-1