UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended October 2, 1999 COMMISSION FILE NO. 0-25121 -------------------- SELECT COMFORT CORPORATION (Exact name of registrant as specified in its charter) MINNESOTA 41-1597886 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10400 VIKING DRIVE, SUITE 400 MINNEAPOLIS, MINNESOTA 55344 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (612) 918-3000 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. X YES NO As of October 2, 1999, 18,037,043 shares of Common Stock of the Registrant were outstanding.
SELECT COMFORT CORPORATION AND SUBSIDIARIES INDEX Page No. PART I: FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets October 2, 1999 and January 2, 1999............................... 3 Consolidated Statements of Operations for the Three Months and Nine Months ended October 2, 1999 and October 3, 1998............................................... 4 Consolidated Statements of Cash Flows for the Nine Months ended October 2, 1999 and October 3, 1998............................................... 5 Notes to Consolidated Financial Statements........................ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................... 8 Item 3. Quantitative and Qualitative Disclosures about Market Risk........ 13 PART II: OTHER INFORMATION Item 1. Legal Proceedings............................................... 14 Item 2. Changes in Securities and Use of Proceeds....................... 14 Item 3. Defaults Upon Senior Securities................................. 14 Item 4. Submission of Matters to a Vote of Security Holders............. 14 Item 5. Other Information............................................... 14 Item 6. Exhibits and Reports on Form 8-K................................ 15
PART I: FINANCIAL INFORMATION SELECT COMFORT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) OCTOBER 2, JANUARY 2, ASSETS 1999 1999 ---------- ---------- Current assets: Cash and cash equivalents $13,321 $45,561 Marketable securities 24,250 - Accounts receivable, net of allowance for doubtful accounts of $399, and $2,750, respectively (note 3) 1,578 10,624 Inventories (note 4) 11,164 10,136 Prepaid expenses 3,798 4,048 Income taxes 2,780 - Deferred tax assets 6,039 5,448 ---------- ---------- Total current assets 62,930 75,817 ---------- ---------- Property and equipment, net 35,192 29,125 Deferred tax assets 1,154 440 Other assets 2,682 852 ---------- ---------- Total assets $101,958 $106,234 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt $253 $930 Accounts payable 17,097 12,079 Accruals: Sales returns 5,246 6,021 Warranty costs 5,645 4,486 Compensation, taxes and benefits 5,183 4,843 Income taxes - 648 Other 4,587 4,561 ---------- ---------- Total current liabilities 38,011 33,568 Long-term debt, less current maturities 42 29 Other liabilities 2,496 1,946 ---------- ---------- Total liabilities 40,549 35,543 ---------- ---------- Shareholders' equity: Undesignated preferred stock; 5,000,000 shares authorized, no shares issued and outstanding - - Common stock, $.01 par value; 95,000,000 shares authorized, 18,037,043 and 18,435,687 shares issued and outstanding, respectively 180 184 Additional paid-in capital 80,503 87,619 Accumulated deficit (19,274) (17,112) ---------- ---------- Total shareholders' equity 61,409 70,691 ---------- ---------- Total liabilities and shareholders' equity $101,958 $106,234 ========== ========== See accompanying notes to consolidated financial statements. 3
SELECT COMFORT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED) THREE MONTHS ENDED NINE MONTHS ENDED --------------------- --------------------- OCTOBER 2, OCTOBER 3, OCTOBER 2, OCTOBER 3, 1999 1998 1999 1998 ---------- ---------- ---------- ---------- Net sales $68,281 $60,035 $205,663 $178,835 Cost of sales 23,944 20,744 71,053 62,290 ---------- ---------- ---------- ---------- Gross margin 44,337 39,291 134,610 116,545 ---------- ---------- ---------- ---------- Operating expenses: Sales and marketing 42,816 31,640 120,705 95,596 General and administrative 7,871 4,972 18,677 13,567 ---------- ---------- ---------- ---------- Total operating expenses 50,687 36,612 139,382 109,163 ---------- ---------- ---------- ---------- Operating income (loss) (6,350) 2,679 (4,772) 7,382 ---------- ---------- ---------- ---------- Other income (expense): Interest income 537 166 1,496 548 Interest expense (10) (4,256) (61) (6,992) Other, net (47) 1 (94) (1) ---------- ---------- ---------- ---------- Other income (expense), net 480 (4,089) 1,341 (6,445) ---------- ---------- ---------- ---------- Income (loss) before income taxes (5,870) (1,410) (3,431) 937 Income tax expense (benefit) (2,172) 493 (1,269) 1,348 ---------- ---------- ---------- ---------- Net loss ($3,698) ($1,903) ($2,162) ($411) ========== ========== ========== ========== Net loss per share - basic and diluted $(0.20) $(0.72) $(0.12) $(0.40) ========== ========== ========== ========== Weighted average share - basic and diluted 18,148 2,939 18,348 2,746 See accompanying notes to consolidated financial statements. 4
SELECT COMFORT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) NINE MONTHS ENDED ---------------------- OCTOBER 2, OCTOBER 3, 1999 1998 ---------- ---------- Cash flows from operating activities: Net loss ($2,162) ($411) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation and amortization 4,616 3,909 Deferred tax assets (1,305) (388) Interest expense from put warrant valuation - 5,220 Change in operating assets and liabilities: Accounts receivable, net 9,046 (3,002) Inventories (1,028) (2,567) Prepaid expenses 250 (223) Income taxes (3,428) 29 Accounts payable 5,018 205 Accrued sales returns (775) 296 Accrued warranty costs 1,159 605 Accrued compensation, taxes and benefits 340 (100) Other accrued liabilities 26 (848) Other assets 150 (544) Other liabilities 550 455 ---------- ---------- Net cash provided by operating activities 12,457 2,636 ---------- ---------- Cash flows used in investing activities: Purchases of property and equipment (10,663) (6,660) Investment in marketable securities (24,250) - Investment in affiliate (2,000) - ---------- ---------- Net cash used in investing activities (36,913) (6,660) ---------- ---------- Cash flows from financing activities: Principal payments on debt (664) (739) Repurchase of common stock (10,438) - Proceeds from issuance of common 3,318 1,672 ---------- ---------- Net cash provided by (used in) financing activities (7,784) 933 ---------- ---------- Decrease in cash and cash equivalents (32,240) (3,091) Cash and cash equivalents, at beginning of period 45,561 12,670 ---------- ---------- Cash and cash equivalents, at end of period $13,321 $9,579 ========== ========== See accompanying notes to consolidated financial statements. 5
SELECT COMFORT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) BASIS OF FINANCIAL STATEMENT PRESENTATION The consolidated financial statements for the three months and nine months ended October 2, 1999 and October 3, 1998 of Select Comfort Corporation and subsidiaries ("Select Comfort" or the "Company"), have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the financial position of the Company as of October 2, 1999 and January 2, 1999 and the results of operations and cash flow for the periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although management believes the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the Company's most recent audited consolidated financial statements and related notes included in the Company's Annual Report to Shareholders and its Form 10-K for the fiscal year ended January 2, 1999. Operating results for the Company on a quarterly basis may not be indicative of operating results for the full year. (2) INVESTMENT In May 1999, the Company invested $2.0 million in a less than 20% owned affiliate that will be the provider of the Company's sofa sleeper product. This investment is accounted for under the cost method. (3) ACCOUNTS RECEIVABLE Effective July 1999, we terminated our revolving third-party credit arrangement with Monogram Bank, an affiliate of General Electric Capital Corporation ("GE") and entered into a third-party credit arrangement with Green Tree Financial Corporation ("Green Tree"). These arrangements have been used to provide financing for our customers' use in purchasing our products. In connection with all purchases financed under these arrangements, the provider pays an amount equal to the total amount of purchases net of promotional discounts. The provider sets the rate, annual fees and all other terms and conditions relating to the customers' accounts, including collection policies and procedures, and is the owner of the receivables. In July 1999, Green Tree purchased substantially all of the outstanding receivables from GE. As a result of this transaction, the Company received $9.8 million that had been retained by GE and which had been included in accounts receivable. There are no retainage requirements as part of the new agreement. (4) INVENTORIES Inventories consist of the following (in thousands): OCTOBER 2, 1999 JANUARY 2, 1999 --------------- --------------- Raw materials $7,004 $6,533 Work in progress 71 67 Finished goods 4,089 3,536 --------------- --------------- $11,164 $10,136 =============== =============== 6
SELECT COMFORT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (5) NET INCOME PER COMMON SHARE The following computations reconcile net loss with net loss per common share-basic and diluted (in thousands except per share amounts). <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED --------------------------------- --------------------------------- NET PER SHARE NET PER SHARE OCTOBER 2, 1999 LOSS SHARES AMOUNT LOSS SHARES AMOUNT --------------- ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Net loss ($3,698) ($2,162) BASIC AND DILUTED EPS Net loss available to common shareholders ($3,698) 18,148 ($0.20) ($2,162) 18,348 ($0.12) ========== ========== ========== ========== ========== ========== </TABLE> <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED --------------------------------- --------------------------------- NET PER SHARE NET PER SHARE OCTOBER 3, 1998 LOSS SHARES AMOUNT LOSS SHARES AMOUNT --------------- ---------- ---------- ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> <C> <C> Net loss ($1,903) ($411) Less: Cumulative preferred dividend (225) (675) ---------- ---------- BASIC AND DILUTED EPS Net loss available to common shareholders ($2,128) 2,939 ($0.72) ($1,086) 2,745 ($0.40) ========== ========== ========== ========== ========== ========== </TABLE> (6) STOCK REPURCHASE In May 1999, the Board of Directors authorized management to repurchase up to $10 million in shares of the Company's common stock in the open market. The Company subsequently repurchased 575,000 shares for approximately $8.5 million. In August 1999, the Board of Directors authorized management to repurchase up to $4 million in shares of the Company's common stock. As of October 2, 1999 the Company had repurchased 275,000 shares for approximately $1.9 million under this program. The Company believes cash generated from operations, together with existing cash balances, will be sufficient to satisfy anticipated short-term working capital requirements and long-term liquidity needs. $2.1 million remained available under the program as of October 2, 1999. (7) LITIGATION The Company and certain of its former officers and directors have been named as defendants in a class action lawsuit filed on behalf of Company shareholders in U.S. District Court in Minnesota. The named plaintiffs, who purport to act on behalf of a class of purchasers of the Company's common stock during the period from December 4, 1998 to June 7, 1999, charge the defendants with violations of federal securities laws. The suit alleges that the Company and the named directors and officers failed to disclose or misrepresented certain information concerning the Company during the class period. The complaint does not specify an amount of damages claimed. The Company believes that the complaint is without merit and intends to vigorously defend the claims. 7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO INCLUDED HEREIN. THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THE STATEMENTS REGARDING SELECT COMFORT CORPORATION CONTAINED IN THIS REPORT THAT ARE NOT HISTORICAL IN NATURE, PARTICULARLY THOSE THAT UTILIZE TERMINOLOGY SUCH AS "MAY," "WILL," "SHOULD," "EXPECTS," "ANTICIPATES," "ESTIMATES," "BELIEVES" OR "PLANS," OR COMPARABLE TERMINOLOGY, ARE FORWARD-LOOKING STATEMENTS BASED ON CURRENT EXPECTATIONS AND ASSUMPTIONS, AND ENTAIL VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED IN SUCH FORWARD-LOOKING STATEMENTS. IMPORTANT FACTORS KNOWN TO SELECT COMFORT THAT COULD CAUSE SUCH MATERIAL DIFFERENCES ARE IDENTIFIED AND DISCUSSED IN PART I, ITEM 1 OF OUR ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED JANUARY 2, 1999, WHICH DISCUSSION IS INCORPORATED HEREIN BY REFERENCE. SUCH IMPORTANT FACTORS INCLUDE OUR ABILITY TO CREATE PRODUCT AND BRAND NAME AWARENESS, THE EFFECTIVENESS AND EFFICIENCY OF OUR ADVERTISING, THE LEVEL OF CONSUMER ACCEPTANCE OF OUR PRODUCTS, THE NUMBER AND TIMING OF NEW RETAIL STORE OPENINGS, THE PERFORMANCE OF OUR EXISTING AND NEW RETAIL STORES, OUR ABILITY TO MANAGE OUR PLANNED RAPID STORE EXPANSION, OUR ABILITY TO MAINTAIN COST-EFFECTIVE PRODUCTION AND DELIVERY OF PRODUCTS, OUR ABILITY TO SUCCESSFULLY IDENTIFY AND RESPOND TO EMERGING TRENDS IN THE MATTRESS INDUSTRY, THE LEVEL OF COMPETITION IN THE MATTRESS INDUSTRY, AND GENERAL ECONOMIC CONDITIONS AND CONSUMER CONFIDENCE. OVERVIEW Select Comfort is the leading vertically integrated manufacturer, specialty retailer and direct marketer of innovative air beds and sleep-related products. Since the introduction of our first air bed product in 1987, management has focused on improving our product, expanding our product line, building manufacturing and distribution systems and growing our four sales channels: retail, direct marketing, event marketing and e-commerce. Vertically integrated operations and control over four separate but complementary sales channels enable us to develop and maintain direct customer relationships as well as leverage advertising dollars. Sales generation is driven primarily by targeted print, radio and television media that generate customer inquiries, as well as by our multiple, complementary distribution channels, which are designed to provide multiple opportunities for customers to purchase our products. Retail operations included 320 stores at October 2, 1999, including 32 leased departments within Bed Bath & Beyond stores, and 264 stores at January 2, 1999, including 14 leased departments. The Company plans to open a minimum of 20 retail stores during the remainder of 1999, including expansion of the leased department concept. Three of the 19 retail store openings in the third quarter of 1999 were in new markets. We have closed a total of six stores since inception. For the three months ended October 2, 1999, the Company reported comparable store sales growth of 3.6% as compared to 23.3% for the three months ended October 3, 1998. Comparable store sales increased by 7.9% for the nine months ended October 2, 1999 and 24.7% for the nine months ended October 3, 1998. Comparable store sales results have been and will continue to be influenced by a variety of factors, including levels of awareness of our products and brand name, levels of consumer acceptance of our existing and new products, our ability to successfully introduce new products and product line extensions, comparable store sales performance in prior periods, the maturation of our store base, the amount, effectiveness and efficiency of retail advertising expenditures and promotional activity, the amount of competitive activity, our ability to effectively integrate our direct and retail distribution channels, the evolution of store operations, including improvements in store design, the quality and tenure of store-level managers and sales professionals, and general economic conditions and consumer confidence. 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 return rates, the timing of new store openings and related expenses, net sales contributed by new stores, any disruptions in third-party delivery services, competitive factors and general economic conditions and consumer confidence. Our business is also subject to some seasonal influences, with heavier concentrations of sales during the fourth quarter holiday season due to increased mall traffic. 8
A substantial portion of operating expenses is related to sales and marketing expenses, including costs associated with opening new stores, operating existing stores, and advertising and marketing expenditures. The level of such spending cannot be adjusted quickly and is based, in significant part, on expectations of future customer inquiries and net sales. Furthermore, a substantial portion of net sales is often realized in the last month of a quarter, with such net sales frequently concentrated in the last weeks or days of a quarter, due in part to our promotional schedule. Should the Company experience a shortfall in expected net sales or in the conversion rate of customer inquiries, we may be unable to adjust spending in a timely manner and our business, financial condition and operating results may be materially adversely affected. Our historical results of operations may not be indicative of the results that may be achieved for any future fiscal period. Results of Operations The following table sets forth, for the periods indicated, our results of operations expressed as percentages of net sales. Percentage amounts may not total due to rounding. THREE MONTHS ENDED NINE MONTHS ENDED --------------------- --------------------- OCTOBER 2, OCTOBER 3, OCTOBER 2, OCTOBER 3, 1999 1998 1999 1998 ---------- ---------- ---------- ---------- Net sales 100.0% 100.0% 100.0% 100.0% Cost of sales 35.1 34.6 34.5 34.8 ---------- ---------- ---------- ---------- Gross margin 64.9 65.4 65.5 65.2 ---------- ---------- ---------- ---------- Operating expenses: Sales and marketing 62.7 52.7 58.7 53.5 General and administrative 11.5 8.3 9.1 7.6 ---------- ---------- ---------- ---------- Total operating expenses 74.2 61.0 67.8 61.0 ---------- ---------- ---------- ---------- Operating income (loss) (9.3) 4.5 (2.3) 4.1 Other income (expense), net 0.7 (6.8) 0.7 (3.6) ---------- ---------- ---------- ---------- Income (loss) before income taxes (8.6) (2.3) (1.7) 0.5 Income tax expense (benefit) (3.2) 0.8 (0.6) 0.8 ---------- ---------- ---------- ---------- Net loss (5.4)% (3.2)% (1.1)% (0.2)% ========== ========== ========== ========== The overall decrease in operating earnings for 1999 as compared to 1998 relates to increases in operating expenses, as a percentage of net sales, to support long-term growth plans. In addition, direct marketing sales declined by $1.8 million in the third quarter of 1999 compared to the third quarter of 1998. Retail sales, which were positively influenced in those markets in which retail advertising has been expanded, were lower than expected in those markets without increased advertising. A substantial portion of the Company's operating expenses is relatively fixed on a short-term basis and is necessary for long-term growth, including increased retail advertising, certain selling expenses associated with retail store operations, direct marketing selling expenses, and general and administrative costs. The Company has also initiated several strategic studies that have added to general and administrative costs. These studies are expected to be completed in the fourth quarter of 1999. COMPARISON OF THREE MONTHS ENDED OCTOBER 2, 1999 WITH THREE MONTHS ENDED OCTOBER 3, 1998 NET SALES Net sales increased 13.7% to $68.2 million for the three months ended October 2, 1999 from $60.0 million for the three months ended October 3, 1998 primarily due to an increase in unit sales. Net sales were favorably impacted by (i) an $8.5 million increase from the opening of 76 new retail stores during the past 12 months and (ii) a $1.3 million increase from a 3.6% increase in comparable store sales, primarily due to increased advertising in selected markets. These sales increases were offset by a $1.8 million decrease in direct marketing sales. 9
GROSS MARGIN Gross margin decreased to 64.9% for the three months ended October 2, 1999 from 65.4% for the three months ended October 3, 1998 primarily due to increased costs of promotional programs and a shift in product mix to lower margin products, partially offset by improved purchasing through volume discounts and better relationships with key suppliers and improved leverage of fixed manufacturing costs over higher unit volumes. SALES AND MARKETING Sales and marketing expenses increased 35.3% to $42.8 million for the three months ended October 2, 1999 from $31.6 million for the three months ended October 3, 1998, and increased as a percentage of net sales to 62.7% from 52.7% for the comparable prior-year period. The increase in the dollar amount of sales and marketing expenses for the three month period was primarily due to (i) the opening of 76 new retail stores during the last 12 months, (ii) an increase in advertising expenditures of $4.4 million to support the Company's growth and (iii) higher commissions, percentage rents and freight expense related to the higher net sales. Sales and marketing expenses increased as a percentage of net sales primarily due to (i) increased advertising focused on longer term sales growth through brand and retail store awareness, (ii) lower direct marketing sales and (iii) selling expenses in new stores increasing at a greater rate than net sales. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 58.3% to $7.9 million for the three months ended October 2, 1999 from $5.0 million for the three months ended October 3, 1998. The increase in general and administrative expenses was primarily due to increased spending on infrastructure to support long-term growth plans and strategic consulting studies undertaken to determine and refine ongoing business strategies. OTHER INCOME (EXPENSE), NET Other income increased $4.6 million to approximately $480,000 for the three months ended October 2, 1999 from ($4.1) million expense for the three months ended October 3, 1998. The increase was primarily due to (i) the inclusion of $3.7 million of non-cash interest expense in the three months ended October 3, 1998 relating to the change in the fair value of an outstanding put warrant and (ii) an increase in interest income due to the increase in cash obtained from the completion of our initial public offering in December 1998. The put provision associated with the warrant was eliminated effective on completion of the initial public offering. INCOME TAX EXPENSE (BENEFIT) Income tax benefit changed to a ($2.2) million benefit for the three months ended October 2, 1999 from $493,000 expense for the three months ended October 3, 1998 due to a decrease in taxable income in 1999, partially offset by the use of available net operating loss carryforwards in 1998. COMPARISON OF NINE MONTHS ENDED OCTOBER 2, 1999 WITH NINE MONTHS ENDED OCTOBER 3, 1998 NET SALES Net sales increased 15.0% to $205.6 million for the nine months ended October 2, 1999 from $178.8 million for the nine months ended October 3, 1998 primarily due to an increase in unit sales. Net sales were favorably impacted by (i) an $18.6 million increase from the opening of 76 new retail stores during the past 12 months and (ii) an $8.1 million increase from a 7.9% increase in comparable store sales, primarily due to the continuing maturation of stores and increased advertising in selected markets. These sales increases were offset by a $7.0 million decrease in direct marketing sales. GROSS MARGIN Gross margin increased to 65.5% for the nine months ended October 2, 1999 from 65.2% for the nine months ended October 3, 1998 due to improved purchasing through volume discounts and better relationships with key suppliers and improved leverage of fixed manufacturing costs over higher unit volumes, partially offset by an increase in costs of promotional programs. 10
SALES AND MARKETING Sales and marketing expenses increased 26.3% to $120.7 million for the nine months ended October 2, 1999 from $95.6 million for the nine-months ended October 3, 1998, and increased as a percentage of net sales to 58.7% from 53.5% for the comparable prior-year period. The increase in the dollar amount of sales and marketing expenses for the nine month period was primarily due to (i) the opening of 76 new retail stores during the last 12 months, (ii) an increase in advertising expenditures of $9.0 million to support the Company's growth and (iii) higher commissions, percentage rents and freight expense related to higher net sales. Sales and marketing expenses increased as a percentage of net sales primarily due to (i) increased advertising focused on longer term sales growth through brand and retail store awareness, (ii) lower direct marketing sales and (iii) selling expenses in new stores increasing at a greater rate than net sales. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 37.7% to $18.7 million for the nine months ended October 2, 1999 from $13.6 million for the nine months ended October 3, 1998. The increase in general and administrative expenses was primarily due to increased spending on infrastructure to support long-term growth plans and strategic consulting studies undertaken to determine and refine ongoing business strategies. OTHER INCOME (EXPENSE), NET Other income increased $7.7 million to approximately $1.3 million for the nine months ended October 2, 1999 from ($6.4) million expense for the nine months ended October 3, 1998. The increase was primarily due to (i) the inclusion of $5.2 million of non-cash interest expense in the nine months ended October 3, 1998 relating to the change in the fair value of an outstanding put warrant and (ii) an increase in interest income due to the increase in cash obtained from the completion of our initial public offering in December 1998. The put provision associated with the warrant was eliminated effective on completion of the initial public offering. INCOME TAX EXPENSE (BENEFIT) Income tax expense decreased to ($1.3) million benefit for the nine months ended October 2, 1999 from $1.3 million expense for the nine months ended October 3, 1998 due to a decrease in taxable income in 1999 partially offset by the use of available net operating loss carryforwards in 1998. LIQUIDITY AND CAPITAL RESOURCES Our primary source of liquidity has been the sale of equity securities. We completed our initial public offering in December 1998, resulting in net proceeds of $44.6 million, which have been partially used for (i) the repayment of $15.0 million of debt, (ii) expansion of retail stores, (iii) the build-out of our third manufacturing plant and (iv) the repurchase of 1,065,000 shares of Company common stock for $11.8 million. The Company had working capital of approximately $24.9 million at October 2, 1999 and $42.2 million at January 2, 1999. Net cash provided by operating activities for the nine months ended October 2, 1999 was approximately $12.5 million and consisted primarily of net loss adjusted for non-cash expenses, decreases in accounts receivable as a result of the GE revolving third party credit agreement and increases in accounts payable and accrued liabilities, partially offset by increases in inventories. Net cash provided by operating activities for the nine months ended October 3, 1998 was approximately $2.6 million and consisted primarily of cash flows from operations before non-cash expenses, partially offset by increases in accounts receivable and decreases in accounts payable. Effective as of July 1999, we terminated our revolving third-party credit arrangement with Monogram Bank, an affiliate of General Electric Capital Corporation ("GE") and entered into a third-party credit arrangement with Green Tree Financial Corporation ("Green Tree"). These arrangements have been used to provide financing for our customers' use in purchasing our products. In connection with all purchases financed under these arrangements, the provider pays an amount equal to the total amount of purchases net of promotional discounts. The provider sets the rate, annual fees and all other terms and conditions relating to the customers' accounts, including collection policies and procedures, and is the owner of the receivables. In July 1999, Green Tree purchased substantially all of the outstanding receivables from GE. As a result of this transaction, we received $9.8 million that had been retained by GE and included in our accounts receivable. There are no retainage requirements as part of this new agreement. 11
Net cash used in investing activities was approximately $36.9 million for the nine months ended October 2, 1999 and $6.7 million for the nine months ended October 3, 1998. Investing activities consisted of purchases of property and equipment for new retail stores in both periods, and the investment of excess cash in marketable securities with maturities in excess of 90 days in 1999. Net cash used in financing activities was approximately $7.8 million for the nine months ended October 2, 1999 and consisted primarily of $10.4 million used to repurchase Company common stock and $0.5 million used to repay debt, offset by stock option exercises. Net cash provided by financing activities was approximately $900,000 for the nine months ended October 3, 1998 which consisted of stock option exercises net of debt repayments. In August 1999, the Board of Directors authorized management to repurchase up to $4 million in shares of the Company's common stock due to the availability of excess cash and the valuation of the Company's shares in the market. As of November 9, 1999 we had repurchased 490,000 shares for approximately $3.3 million under this authorization. We believe that cash flow generated from operations and existing cash resources will be sufficient to meet working capital and liquidity requirements for the foreseeable future as we pursue our long-term growth strategy, described in greater detail below. During 1999, through November 9, 1999, we had repurchased 1,065,000 shares for approximately $11.8 million. LOOKING FORWARD We have continued our strategic analysis of the business and have retained several consulting groups to perform studies to evaluate product positioning, marketing efforts, logistics and product distribution to be completed in the fourth quarter. The results of these studies will be a significant consideration in the refinement of our long-term strategy. We currently are executing several strategic initiatives that we believe will accelerate sales growth and improve operating results. These initiatives include (i) developing a more integrated marketing approach that will concentrate a higher percentage of advertising expenditures in our retail and e-commerce channels, (ii) increasing the number of retail distribution points for our products and (iii) expanding our product line. Store sales in markets in which we have expanded our media advertising expenditures have outperformed store sales in non-media markets. We will continue to evaluate overall advertising effectiveness and spending levels. We expect to open a minimum of 20 stores during the fourth quarter of 1999. Beyond 1999, growth in retail stores, as well as expansion into different retail venues or formats, will be based in part on findings of the ongoing strategic studies. Store openings in future years will most likely include additional mall stores and leased departments, possibly with one or more partnerships in addition to our partnership with Bed Bath & Beyond, and may include different venues or formats, including possibly strip mall stores, furniture stores, department stores or sleep stores. Product line expansion will initially be achieved through test marketing of the sofa sleeper product as well as a portable air bed. We have elected to terminate, effective as of February 1, 2000, the license agreement under which we had developed and test-marketed our adjustable frame product. We will continue to explore alternatives for development and commercialization of an adjustable frame product for our air beds, but we currently do not anticipate a broad-based rollout of an adjustable frame product in 2000. The success of our strategy will depend on many factors including (i) the effectiveness and efficiency of our advertising in creating awareness of our products and brand name and generating sales, (ii) our ability to successfully open additional stores and leased departments in new and existing markets, as well as in both existing and new venues and formats, (iii) the level of consumer acceptance of our existing and new products, (iv) our ability to successfully commercialize significant product line extensions, (v) our ability to generate consumer inquiries and drive consumer traffic to retail stores, (vi) competition in the mattress industry and (vii) general economic factors and consumer confidence. The strategic initiatives and additional business analyses are directed toward improving our long-term performance and are not expected to contribute significantly to growth in sales and earnings for the remainder of 1999, and may negatively impact earnings in the remainder of 1999 and 2000. 12
IMPACT OF YEAR 2000 STATE OF READINESS Beginning in early 1996, we included certain Year 2000 initiatives and remediation plans in our broader information systems strategic plan. In early 1998 we retained an independent consultant to assess the adequacy of Year 2000 initiatives and remediation plans. All essential information technology ("IT") systems have been inventoried and remediation plans for any Year 2000 issues have been implemented. Remediation plans included the development of Year 2000 compliant applications for order entry, customer service and point of sale systems in fall 1996. In the third quarter of 1997, we purchased and implemented an enterprise information system used in manufacturing operations, material planning, inventory management, order processing, financial management and human resources applications, which was upgraded to be Year 2000 compliant in February 1999. We purchased Year 2000 compliant upgrades to our payroll applications in 1997 and our telephone system in 1998. Year 2000 compliant upgrades for software applications for processing and tracking warranty claims and returns were implemented in October 1999. Year 2000 compliant upgrades for our customer inquiries applications have been developed and will be implemented in November 1999. With the implementation of these applications and upgrades, we expect that all core applications and IT systems will be Year 2000 compliant by the end of the fourth quarter of 1999. In August 1998, we formed a Year 2000 project team ("Year 2000 Project Team") to identify and address Year 2000 compliance matters, including significant non-IT systems which are comprised of the embedded technology used in our buildings, plant, equipment and other infrastructure. All material Year 2000 issues in non-IT systems have been inventoried and remedial action has been completed. During the first quarter of 1998, we initiated discussions with significant suppliers regarding their plans to remediate Year 2000 issues. We sent each of the significant suppliers a questionnaire inquiring as to the magnitude of their Year 2000 issues and the status of their readiness. We have received assurances from a majority of these suppliers that they will become Year 2000 compliant in a timely manner. We have not received responses from all of the third parties with which we do business. In addition to the questionnaires, a supplier certification program has been established under which suppliers must meet rigorous standards relating to quality, service, the ability to deliver materials on a timely basis and Year 2000 compliance. To date, 12 key suppliers have been certified and other authorized suppliers are in the process of seeking certification. All key suppliers, including our Eastern European supplier of air chambers, have notified us that they are or will be Year 2000 compliant during 1999. In addition to suppliers, we also rely upon governmental agencies, utility companies, telecommunication service companies and other service providers outside of our control. There can be no assurance that such governmental agencies or other third parties will not suffer a Year 2000 business disruption that could have a material adverse effect on our business, financial condition or operating results. COSTS TO ADDRESS THE YEAR 2000 ISSUE We have incurred $165,000 in 1999 to complete our remediation plans required for IT systems, including systems software costs and consulting fees. We do not anticipate incurring future significant costs. RISKS PRESENTED BY THE YEAR 2000 ISSUE If any third party who provides goods or services essential to our business activities fails to appropriately address Year 2000 issues, such failure could have a material adverse effect on our business, financial condition or operating results. For example, a Year 2000 related disruption on the part of the financial institutions which process our credit card sales could have a material adverse effect on our business, financial condition or operating results. CONTINGENCY PLANS The Year 2000 Project Team's initiatives include the development of contingency plans in the event we have not completed all remediation plans in a timely manner. In addition, the Year 2000 Project Team is in the process of developing contingency plans in the event that any third party who provides goods or services essential to our business fails to appropriately address Year 2000 issues. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK No material changes. 13
PART II: OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS The Company and certain of its former officers and directors have been named as defendants in a class action lawsuit filed on behalf of Company shareholders in U.S. District Court in Minnesota. The named plaintiffs, who purport to act on behalf of a class of purchasers of the Company's common stock during the period from December 4, 1998 to June 7, 1999, charge the defendants with violations of federal securities laws. The suit alleges that the Company and the named directors and officers failed to disclose or misrepresented certain information concerning the Company during the class period. The complaint does not specify an amount of damages claimed. The Company believes that the complaint is without merit and intends to vigorously defend the claims. ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS In May 1999, the Board of Directors authorized management to repurchase up to $10 million in shares of the Company's common stock in the open market. The Company subsequently repurchased 575,000 shares for approximately $8.5 million. In August 1999, the Board of Directors authorized management to repurchase up to an additional $4 million in shares of the Company's common stock. Through November 9, 1999, the Company has repurchased 490,000 shares for approximately $3.3 million under this program. We believe cash generated from operations, together with existing cash balances, will be sufficient to satisfy anticipated short-term working capital requirements and long-term liquidity needs. ITEM 3 - DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 5 - OTHER INFORMATION In July 1999, the Board of Directors of the Company approved the amendment of the Company's 1990 Omnibus Stock Option Plan and 1997 Stock Incentive Plan (collectively, the "Plans") to modify the change in control provisions applicable to options granted on or after July 27, 1999. Under the Plans, a transaction constituting a "change in control" will result in the immediate vesting in full of options granted under the Plans and such options will continue to be exercisable for the remaining term of the options. Prior to the amendments approved in July 1999, the Plans provided that a transaction that would otherwise constitute a change in control would not constitute a change in control if the transaction was approved by at least a majority of the "continuity" Directors (which includes members of the Board of Directors on the effective date of the Plan and Directors nominated by such Directors for subsequent election to the Board). The foregoing provision will continue to be applicable to options issued and outstanding prior to July 27, 1999. As to options granted on or after July 27, 1999, a transaction constituting a change in control as defined under the Plans will constitute a change in control, resulting in acceleration of the vesting of options, regardless of whether the transaction has been approved by a majority of the continuity Directors. The foregoing description of the change in control provisions of the Plans is qualified in its entirety by reference to the complete text of the Plans, which are included in this filing as exhibits. 14
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. Exhibit Number Description ------- ----------- 10.1 1990 Omnibus Stock Option Plan, as amended and restated 10.2 1997 Stock Incentive Plan, as amended and restated 27.1 Financial Data Schedule (b) Reports on Form 8-K None. 15
SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SELECT COMFORT CORPORATION /s/Patrick A. Hopf ------------------------------------- November 15, 1999 Patrick A. Hopf Chairman and Interim President and Chief Executive Officer (principal executive officer) /s/James C. Raabe ------------------------------------- James C. Raabe Chief Financial Officer (principal financial and accounting officer) 16
EXHIBIT INDEX Exhibit Number Description Location -------------- ----------------------------- ----------------------------- 10.1 Select Comfort Corporation Filed herewith electronically 1990 Option Plan, as amended and restated 10.2 Select Comfort Corporation Filed herewith electronically 1997 Option Plan, as amended and restated 27.1 Financial Data Schedule Filed herewith electronically 17