10-Q 1 a2ndqtr10q.txt 2ND QTR 2003 10Q 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 June 28, 2003 COMMISSION FILE NO. 0-25121 -------------------- SELECT COMFORT CORPORATION (Exact name of registrant as specified in its charter) MINNESOTA 41-1597886 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6105 TRENTON LANE NORTH MINNEAPOLIS, MINNESOTA 55442 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (763) 551-7000 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 whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES [X] NO [ ] As of June 28, 2003, 33,091,825 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 June 28, 2003 and December 28, 2002............................... 3 Consolidated Statements of Operations for the Three Months and Six Months ended June 28, 2003 and June 29, 2002................................... 4 Consolidated Statements of Cash Flows for the Six Months ended June 28, 2003 and June 29, 2002................................................. 5 Notes to Consolidated Financial Statements........................ 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................... 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk........ 15 Item 4. Disclosure Controls and Procedures................................ 15 PART II: OTHER INFORMATION Item 1. Legal Proceedings............................................... 16 Item 2. Changes in Securities and Use of Proceeds....................... 16 Item 3. Defaults Upon Senior Securities................................. 16 Item 4. Submission of Matters to a Vote of Security Holders............. 16 Item 5. Other Information............................................... 17 Item 6. Exhibits and Reports on Form 8-K................................ 17 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS SELECT COMFORT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) (UNAUDITED) JUNE 28, DECEMBER 28, 2003 2002 ----------------- ----------------- ASSETS Current assets: Cash and cash equivalents $ 32,702 $ 27,176 Marketable securities - current (note 2) 14,654 12,146 Accounts receivable, net of allowance for doubtful accounts of $375 and $340 6,170 3,270 Inventories (note 3) 10,846 8,980 Prepaid expenses 5,043 5,467 Deferred tax assets 7,119 12,955 ----------------- ----------------- Total current assets 76,534 69,994 Marketable securities - non-current (note 2) 1,983 1,502 Property and equipment, net 34,093 28,977 Deferred tax assets 5,382 4,352 Other assets 3,499 3,506 ----------------- ----------------- Total assets $121,491 $108,331 ================= ================= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt $ - $ 11 Accounts payable 20,655 16,508 Accruals: Sales returns 3,355 3,181 Compensation and benefits 10,514 13,666 Taxes and withholding 2,546 2,779 Customer prepayments 4,381 1,964 Other 5,624 5,120 ----------------- ----------------- Total current liabilities 47,075 43,229 Long-term debt, less current maturities (note 4) - 2,991 Accrued warranty costs 3,408 3,626 Other liabilities 3,911 3,970 ----------------- ----------------- Total liabilities 54,394 53,816 ----------------- ----------------- Shareholders' equity (notes 5 and 7): Undesignated preferred stock; 5,000,000 shares authorized, no shares issued and outstanding - - Common stock, $.01 par value; 95,000,000 shares authorized, 33,091,825 and 30,727,101 shares issued and outstanding, respectively 331 307 Additional paid-in capital 96,718 92,184 Unearned compensation (865) - Accumulated deficit (29,087) (37,976) ----------------- ----------------- Total shareholders' equity 67,097 54,515 ----------------- ----------------- Total liabilities and shareholders' equity $121,491 $108,331 ================= =================
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 SIX MONTHS ENDED ----------------------------------- ----------------------------------- JUNE 28, JUNE 29, JUNE 28, JUNE 29, 2003 2002 2003 2002 ----------------- ----------------- ----------------- ----------------- Net sales $101,993 $ 77,281 $203,951 $158,476 Cost of sales 38,920 29,340 76,977 60,297 ----------------- ----------------- ----------------- ----------------- Gross profit 63,073 47,941 126,974 98,179 ----------------- ----------------- ----------------- ----------------- Operating expenses: Sales and marketing 46,284 36,774 95,201 76,382 General and administrative 9,209 8,026 17,510 15,235 Store closings and asset impairments (15) 157 59 209 ----------------- ----------------- ----------------- ----------------- Total operating expenses 55,478 44,957 112,770 91,826 ----------------- ----------------- ----------------- ----------------- Operating income 7,595 2,984 14,204 6,353 ----------------- ----------------- ----------------- ----------------- Other income (expense): Interest income 137 37 250 104 Interest expense (53) (537) (141) (1,123) Other, net - 79 24 125 ----------------- ----------------- ----------------- ----------------- Other income (expense), net 84 (421) 133 (894) ----------------- ----------------- ----------------- ----------------- Income before income taxes 7,679 2,563 14,337 5,459 Income tax (expense) benefit (2,918) - (5,448) 348 ----------------- ----------------- ----------------- ----------------- Net income $ 4,761 $ 2,563 $ 8,889 $ 5,807 ================= ================= ================= ================= Net income per share (note 5 and 6) - basic $ 0.15 $ 0.13 $ 0.28 $ 0.31 ================= ================= ================= ================= Weighted average shares - basic 32,018 19,690 31,449 19,038 ================= ================= ================= ================= Net income per share (note 5 and 6) - diluted $ 0.12 $ 0.08 $ 0.23 $ 0.19 ================= ================= ================= ================= Weighted average shares - diluted 38,778 34,415 38,492 33,848 ================= ================= ================= =================
See accompanying notes to consolidated financial statements. 4 SELECT COMFORT CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) SIX MONTHS ENDED ----------------------------------- JUNE 28, JUNE 29, 2003 2002 ----------------- ----------------- Cash flows from operating activities: Net income $ 8,889 $ 5,807 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 5,155 4,368 Amortization of debt discount and deferred finance fees 130 416 Non-cash compensation 30 - Loss on disposal of assets 59 216 Deferred tax benefit 4,806 - Change in operating assets and liabilities: Accounts receivable, net (2,900) (81) Inventories (1,866) (2,881) Prepaid expenses 424 (586) Other assets (10) 1,264 Accounts payable 4,147 210 Accrued compensation and benefits (3,152) 1,613 Customer prepayments 2,417 2,884 Other accruals and liabilities 168 (960) ----------------- ----------------- Net cash provided by operating activities 18,297 12,270 ----------------- ----------------- Cash flows from investing activities: Purchases of property and equipment (10,313) (2,916) Investments in marketable securities (17,706) (12,596) Proceeds from maturity of marketable securities 14,717 1,957 ----------------- ----------------- Net cash used in investing activities (13,302) (13,555) ----------------- ----------------- Cash flows from financing activities: Principal payments on debt (11) (20) Repurchase of common stock (1,834) - Proceeds from issuance of common stock 2,376 286 ----------------- ----------------- Net cash provided by financing activities 531 266 ----------------- ----------------- Increase (decrease) in cash and cash equivalents 5,526 (1,019) Cash and cash equivalents, at beginning of period 27,176 16,375 ----------------- ----------------- Cash and cash equivalents, at end of period $ 32,702 $ 15,356 ================= =================
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 six months ended June 28, 2003 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 June 28, 2003 and December 28, 2002 and the results of operations and cash flows for the periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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 December 28, 2002. Operating results for the Company on a quarterly basis may not be indicative of operating results for the full year. No new accounting pronouncements have been issued that are expected to have a material effect on the Company's financial statements. (2) MARKETABLE SECURITIES The Company invests its cash in highly liquid debt instruments issued by the US government and related agencies, municipalities and in commercial paper issued by companies with investment grade ratings. The Company's investments have an original maturity of up to 17 months with an average time to maturity of 7 months as of June 28, 2003. Investments with an original maturity of greater than 90 days are classified as marketable securities. Marketable securities with a remaining maturity of greater than one year are classified as long-term. The Company's marketable securities are classified as held-to-maturity and are carried at amortized cost. Securities held at June 28, 2003 carried an amortized cost of $16.6 million and a fair value of $16.7 million. (3) INVENTORIES Inventories consist of the following (in thousands): JUNE 28, DECEMBER 28, 2003 2002 ----------------- ---------------- Raw materials $3,188 $2,669 Work in progress 41 88 Finished goods 7,617 6,223 ----------------- ---------------- $10,846 $8,980 ================= ================ (4) LONG-TERM DEBT In May 2003, the Company entered into an agreement with Bank of America, N.A. for a $15 million three-year senior secured revolving credit facility. The interest rate on borrowings will be calculated using LIBOR plus 2%. The additional rate can vary from 1.5% to 2.25% based on the Company's leverage ratio. The Company is subject to certain financial covenants under the agreement, principally consisting of minimum liquidity requirements, working capital and leverage ratios. The Company has remained in full compliance with the financial covenants from the time of the agreement through June 28, 2003. The Company has had no borrowings against the credit facility. 6 SELECT COMFORT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In November 2000, the Company completed the acquisition of certain assets of SleepTec, Inc. A portion of the purchase price was a non-interest-bearing subordinated convertible debenture ("debenture") with an original principal amount of $4,000,000, due November 10, 2005 and convertible at any time into 727,272 shares of the Company's common stock at the rate of $5.50 per share. In May 2003, the holder elected to convert the debt into the 727,272 shares of common stock. As a result of this conversion, $3.1 million ($4 million in debt net of $0.9 million unamortized debt discount) has been reclassified as common stock and additional paid-in capital. (5) NET INCOME PER COMMON SHARE The following computations reconcile net income with net income per common share-basic and diluted (in thousands, except per share amounts): THREE MONTHS ENDED SIX MONTHS ENDED ------------------------------------- ------------------------------------- JUNE 28, 2003 WEIGHTED WEIGHTED ------------- NET AVERAGE PER SHARE NET AVERAGE PER SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT ------------ ------------ ----------- ----------- ----------- ------------ Net income $ 4,761 $ 8,889 ------------ ----------- BASIC EPS Net income available to common shareholders 4,761 32,018 $ 0.15 8,889 31,449 $ 0.28 =========== ============ EFFECT OF DILUTIVE SECURITIES Options - 2,613 - 2,481 Common stock warrants - 3,787 - 4,019 Convertible debt 27 360 81 543 ------------ ------------ ----------- ----------- DILUTED EPS Net income available to common shareholders plus assumed conversions $ 4,788 38,778 $ 0.12 $ 8,970 38,492 $ 0.23 ============ ============ =========== =========== =========== ============ THREE MONTHS ENDED SIX MONTHS ENDED ------------------------------------- ------------------------------------- JUNE 29, 2002 WEIGHTED WEIGHTED ------------- NET AVERAGE PER SHARE NET AVERAGE PER SHARE INCOME SHARES AMOUNT INCOME SHARES AMOUNT ------------ ------------ ----------- ----------- ----------- ------------ Net income $ 2,563 $ 5,807 ------------ ----------- BASIC EPS Net income attributable to common 2,563 19,690 $ 0.13 5,807 19,038 $ 0.31 shareholders =========== ============ EFFECT OF DILUTIVE SECURITIES Options - 1,904 - 1,629 Common stock warrants - 2,964 - 2,752 Convertible debt 254 9,857 563 10,429 ------------ ------------ ----------- ----------- DILUTED EPS Net income attributable to common shareholders plus assumed conversions $ 2,817 34,415 $ 0.08 $ 6,370 33,848 $ 0.19 ============ ============ =========== =========== =========== ============
Additional potentially dilutive securities ("securities") totaling 643,000 and 631,000 for the three-and six-month periods ended June 28, 2003, have been excluded from diluted EPS because the securities' exercise price was greater than the average market price of the Company's common shares. 7 SELECT COMFORT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (6) PRO FORMA NET INCOME AND NET INCOME PER SHARE The Company's net income and net income per share under Generally Accepted Accounting Principles (GAAP) for 2003 should be compared to 2002 net income and net income per share on a pro forma, after-tax basis to improve comparability between the periods. GAAP did not allow the Company to reduce its income for income tax expense in 2002, while 2003 results reflect a reduction in income for income taxes. A reconciliation of net income and diluted net income per share (as determined in accordance with GAAP) to pro forma net income and diluted net income per share is as follows (in thousands, except per share amounts): THREE MONTHS ENDED SIX MONTHS ENDED JUNE 29, 2002 JUNE 29, 2002 ------------------- ------------------- RECONCILIATION OF GAAP NET INCOME AND PRO FORMA NET INCOME: GAAP net income $ 2,563 $ 5,807 Income taxes - adjusted to 38% effective rate (974) (2,207) ------------------- ------------------- Pro forma net income $ 1,589 $ 3,600 =================== =================== THREE MONTHS ENDED SIX MONTHS ENDED JUNE 29, 2002 JUNE 29, 2002 ------------------- ------------------- RECONCILIATION OF GAAP DILUTED NET INCOME PER SHARE TO PRO FORMA DILUTED NET INCOME PER SHARE: GAAP diluted net income per share $ 0.08 $ 0.19 Effect of income taxes at 38% (.03) (.08) ------------------- ------------------- Pro forma diluted net income per share $ .05 $ .11 =================== ===================
(7) STOCK AND STOCK OPTION INCENTIVES 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. The following pro forma information regarding net income and net income per share, required by SFAS No. 123 "Accounting for Stock Based Compensation", has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement (in thousands, except per share amounts): THREE MONTHS ENDED SIX MONTHS ENDED ----------------------------- ------------------------------ JUNE 28, JUNE 29, JUNE 28, JUNE 29, 2003 2002 2003 2002 ----------------------------- ------------------------------ Net income:............................As reported $ 4,761 $ 2,563 $ 8,889 $ 5,807 Pro forma 4,332 1,896 7,513 4,409 Income per share -- basic:.............As reported 0.15 0.13 0.28 0.31 Pro forma 0.14 0.10 0.24 0.23 Income per share -- diluted:...........As reported 0.12 0.08 0.23 0.19 Pro forma 0.11 0.06 0.20 0.15
8 SELECT COMFORT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: THREE MONTHS ENDED SIX MONTHS ENDED ------------------------------------------------------------- JUNE 28, JUNE 29, JUNE 28, JUNE 29, 2003 2002 2003 2002 ------------------------------------------------------------- Expected dividend yield..................... 0% 0% 0% 0% Expected stock price volatility............. 90% 90% 90% 90% Risk-free interest rate..................... 2.0% 2.0% 2.0% 2.0% Expected life in years...................... 3.6 3.6 3.6 3.6 Weighted-average fair value at grant date... $ 9.13 $ 3.83 $ 6.04 $ 1.89
On February 24, 2003 the Company issued 100,000 shares of restricted stock to certain key employees. The shares vest over ten years based on continued employment. There was no restricted stock forfeited for the six months ended June 28, 2003. Compensation expense related to restricted stock awards is based upon market prices at date of grant and is charged to earnings on a straight-line basis over the period of restriction. Total compensation expense related to restricted stock was $30,000 for the three and six months ended June 28, 2003. (8) LITIGATION The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, any losses that may occur from these matters are adequately covered by insurance or are provided for in the consolidated financial statements and the ultimate outcome of these matters will not have a material effect on the consolidated financial position or results of operations of the Company. 9 ITEM 2. 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. YOU CAN IDENTIFY FORWARD-LOOKING STATEMENTS BY THOSE THAT ARE NOT HISTORICAL IN NATURE, PARTICULARLY THOSE THAT USE TERMINOLOGY SUCH AS "MAY," "WILL," "SHOULD," "EXPECTS," "ANTICIPATES," "CONTEMPLATES," "ESTIMATES," "BELIEVES," "PLANS," "PROJECTS," "PREDICTS," "POTENTIAL" OR "CONTINUE" OR THE NEGATIVE OF THESE OR SIMILAR TERMS. THESE STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THE COMPANY'S HISTORICAL EXPERIENCE AND ITS PRESENT EXPECTATIONS OR PROJECTIONS. 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 DECEMBER 28, 2002, WHICH DISCUSSION IS INCORPORATED HEREIN BY REFERENCE. THESE IMPORTANT FACTORS INCLUDE: o GENERAL AND INDUSTRY ECONOMIC TRENDS, o UNCERTAINTIES ARISING FROM DOMESTIC AND GLOBAL EVENTS, o CONSUMER CONFIDENCE AND SPENDING, o THE EFFECTIVENESS OF OUR ADVERTISING AND PROMOTIONAL EFFORTS, o ADVERTISING RATES, o CONSUMER ACCEPTANCE OF OUR PRODUCTS AND SLEEP TECHNOLOGY, o INDUSTRY COMPETITION, o OUR ABILITY TO SECURE SUITABLE RETAIL LOCATIONS, o WARRANTY EXPENSES, o OUR DEPENDENCE ON SIGNIFICANT SUPPLIERS OR SINGLE SOURCES OF SUPPLY, o THE VULNERABILITY OF ANY SUPPLIERS TO RECESSIONARY PRESSURES, LIQUIDITY CONCERNS OR OTHER FACTORS, o GOVERNMENTAL REGULATION, INCLUDING ANTICIPATED FUTURE REGULATION OF DIRECT MARKETING TELEPHONE SOLICITATIONS AND BEDDING FLAMMABILITY STANDARDS, AND o RISKS AND UNCERTAINTIES DETAILED FROM TIME TO TIME IN THE COMPANY'S FILINGS WITH THE SEC, INCLUDING THE COMPANY'S ANNUAL REPORT ON FORM 10-K AND OTHER PERIODIC REPORTS FILED WITH THE SEC. THE COMPANY HAS NO OBLIGATION TO PUBLICLY UPDATE OR REVISE ANY OF THE FORWARD-LOOKING STATEMENTS CONTAINED IN THIS QUARTERLY REPORT ON FORM 10-Q. OVERVIEW AND CRITICAL ACCOUNTING POLICIES Select Comfort(R) is the leading developer, manufacturer and marketer of premium quality, adjustable-firmness beds. The air chamber technology of our proprietary Sleep Number bed allows adjustable firmness on each side of the mattress and provides a sleep surface that is clinically proven to provide better sleep quality and greater relief of back pain compared to traditional mattress products. 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 into 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 the 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. At the time revenue is recognized, we reduce sales 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. 10 The proportion of our total net sales, by dollar volume, from each distribution channel is summarized as follows: Three Months Ended Six Months Ended ----------------------- ----------------------- 6/28/03 6/29/02 6/28/03 6/29/02 ---------- ----------- ----------- ----------- Stores 77% 73% 78% 74% Direct Call Center 13% 15% 13% 15% E-commerce 4% 5% 4% 4% Wholesale 6% 7% 5% 7% The number of company-operated retail locations is summarized as follows: Three Months Ended Six Months Ended ----------------------- ----------------------- 6/28/03 6/29/02 6/28/03 6/29/02 ---------- ----------- ----------- ----------- Beginning of period 323 324 322 328 Opened 10 2 12 3 Closed (1) (5) (2) (10) ---------- ----------- ----------- ----------- End of period 332 321 332 321 ========== =========== =========== =========== We anticipate opening 16 new retail stores and closing three to five stores during the remainder of 2003. We remodeled 84 stores in the first half of 2003 and anticipate remodeling approximately 10 more stores throughout the balance of the year. Company-operated stores included leased departments within 13 Bed, Bath & Beyond stores as of June 28, 2003 and 20 at June 29, 2002. Comparable store sales, including remodeled stores as noted above, increased over prior year, for the three months ended June 28, 2003 and June 29, 2002 by 33.9% and 21.3%, respectively. Comparable store sales increased for the six months ended June 28, 2003 and June 29, 2002 by 32.1% and 18.6%, respectively. COST OF SALES Cost of sales includes costs associated with purchasing materials, manufacturing costs and costs to deliver our products to our customers. 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. Store opening costs are expensed as incurred and advertising costs are expensed from the first time the advertisement is aired. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses include costs associated with management of functional areas, including information technology, human resources, finance, sales and marketing administration, investor relations, risk 11 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. IMPAIRMENT OF LONG-LIVED ASSETS AND ASSETS TO BE DISPOSED OF. 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, the Company's results of operations expressed as percentages of net sales. THREE MONTHS ENDED SIX MONTHS ENDED ----------------------------------- ----------------------------------- JUNE 28, JUNE 29, JUNE 28, JUNE 29, 2003 2002 2003 2002 ----------------- ----------------- ----------------- ----------------- Net sales 100.0% 100.0% 100.0% 100.0% Cost of sales 38.2 38.0 37.7 38.0 ----------------- ----------------- ----------------- ----------------- Gross profit 61.8 62.0 62.3 62.0 ----------------- ----------------- ----------------- ----------------- Operating expenses: Sales and marketing 45.4 47.6 46.7 48.2 General and administrative 9.0 10.4 8.6 9.6 Store closings and asset impairments 0.0 0.2 0.0 0.1 ----------------- ----------------- ----------------- ----------------- Total operating expenses 54.4 58.2 55.3 57.9 ----------------- ----------------- ----------------- ----------------- Operating income 7.4 3.9 7.0 4.0 Other income (expense), net 0.1 (0.5) 0.1 (0.6) ----------------- ----------------- ----------------- ----------------- Income before income taxes 7.5 3.3 7.0 3.4 Income tax (expense) benefit (2.9) 0.0 (2.7) 0.2 ----------------- ----------------- ----------------- ----------------- Net income 4.7% 3.3% 4.4% 3.7% ================= ================= ================= =================
COMPARISON OF THREE MONTHS ENDED JUNE 28, 2003 WITH THREE MONTHS ENDED JUNE 29, 2002 NET SALES Net sales increased 32% to $102.0 million for the three months ended June 28, 2003 from $77.3 million for the three months ended June 29, 2002, due to a 17% increase in mattress unit sales, and higher average selling prices resulting primarily from improvements in product mix. The increase in net sales by sales channel was attributable to (i) a $21.6 million increase in sales from Company-controlled retail stores, including an increase in comparable store sales of $18.8 million, (ii) a $2.0 million increase in direct marketing sales, (iii) a $0.8 million increase in sales through the Company's e-commerce channel and (iv) a $0.3 million increase in sales from the Company's wholesale channel. GROSS PROFIT Gross profit decreased to 61.8% for the three months ended June 28, 2003 from 62.0% for the three months ended June 29, 2002, primarily due to the increased cost of product delivery partially offset by improved product cost as a result of mix improvements. SALES AND MARKETING Sales and marketing expenses increased 26% to $46.3 million for the three months ended June 28, 2003 from $36.8 million for the three months ended June 29, 2002 but decreased as a percentage of net sales to 45.4% from 47.6% for the comparable prior-year period. The increase in expense was primarily due to additional media investments, sales-based incentive compensation, and increased occupancy and financing costs. The decrease as a percentage of net sales was attributable to greater leverage in fixed selling expenses, partially offset by increases in advertising spending as a percent of net sales. 12 GENERAL AND ADMINISTRATIVE General and administrative expenses increased 15% to $9.2 million for the three months ended June 28, 2003 from $8.0 million for the three months ended June 29, 2002 but decreased as a percentage of net sales to 9.0% from 10.4% for the prior-year period. The increase in general and administrative expenses was due primarily to accrued incentive compensation as a result of Company performance and additional headcount. The decrease as a percentage of net sales was attributable to greater leverage of fixed costs. STORE CLOSINGS AND ASSET IMPAIRMENTS Store closing and asset impairment expense decreased $172,000 for the three months ended June 28, 2003 from $157,000 for the three months ended June 29, 2002. In 2003, the entire $15,000 benefit represents an adjustment to a previously reported store impairment charge. No store assets were impaired during the quarter ended June 28, 2003. OTHER INCOME (EXPENSE), NET Other income (expense) changed $505,000 to income of $84,000 for the three months ended June 28, 2003 from an expense of $421,000 for the three months ended June 29, 2002. The improvement is primarily due to reduced interest expense following the elimination of $16 million of debt in 2002, and an increase in interest income from the Company's improved cash position. INCOME TAX (EXPENSE) BENEFIT Income tax (expense) benefit changed $2.9 million to an income tax expense of $2.9 million for the three months ended June 28, 2003 from $0 in income tax expense for the three months ended June 29, 2002. The increase in income tax expense was due to recording income tax expense at an estimated rate of 38% in 2003 while no such tax was recorded for the three months ended June 29, 2002. COMPARISON OF SIX MONTHS ENDED JUNE 28, 2003 WITH SIX MONTHS ENDED JUNE 29, 2002 NET SALES Net sales increased 29% to $204.0 million for the six months ended June 28, 2003 from $158.5 million for the six months ended June 29, 2002, due to a 13% increase in mattress unit sales and higher average selling prices resulting primarily from improvements in sales channel and product mix. The sales channel mix improvement was a result of a 16% increase in Company-controlled channel mattress unit sales and a 6% decrease in mattress unit sales in the wholesale channel. The increase in net sales by sales channel was attributable to (i) a $40.9 million increase in sales from Company-controlled retail stores, including an increase in comparable store sales of $36.8 million, (ii) a $3.6 million increase in direct marketing sales and (iii) a $1.7 million increase in sales through the Company's e-commerce channel, offset by a decrease of $0.8 million in sales from the Company's wholesale channel. GROSS PROFIT Gross profit increased to 62.3% for the six months ended June 28, 2003 from 62.0% for the six months ended June 29, 2002, primarily due to improved sales channel mix and improved product mix, partially offset by the increased cost of product delivery. The improved channel mix was a result of a decrease in mattress units sold in the lower margin wholesale channel. The improved product mix occurred in our Company-controlled channels. SALES AND MARKETING Sales and marketing expenses increased 25% to $95.2 million for the six months ended June 28, 2003 from $76.4 million for the six months ended June 29, 2002 but decreased as a percentage of net sales to 46.7% from 48.2% for the comparable prior-year period. The increase was primarily due to additional media investments, sales-based incentive compensation, and increased occupancy and financing costs. The decrease as a percentage of net sales was attributable to greater leverage in fixed selling expenses, partially offset by increases in advertising spending as a percent of net sales. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 15% to $17.5 million for the six months ended June 28, 2003 from $15.2 million for the six months ended June 29, 2002 but decreased as a percentage of net sales to 8.6% from 9.6% for the prior-year period. The increase in general and administrative expenses was due primarily to accrued incentive compensation as a result of Company performance and additional headcount. The decrease as a percentage of net sales was attributable to greater leverage of fixed costs. 13 STORE CLOSINGS AND ASSET IMPAIRMENTS Store closing and asset impairment expense decreased $150,000 to $59,000 for the six months ended June 28, 2003 from $209,000 for the six months ended June 29, 2002. In 2003, the entire $59,000 represents store impairment charges. OTHER INCOME (EXPENSE), NET Other income (expense) changed $1.0 million to income of $133,000 for the six months ended June 28, 2003 from an expense of $894,000 for the six months ended June 29, 2002. The improvement is primarily due to reduced interest expense following the elimination of $16 million of debt in 2002, and an increase in interest income from the Company's improved cash position. INCOME TAX (EXPENSE) BENEFIT Income tax (expense) benefit changed $5.8 million to an income tax expense of $5.4 million for the six months ended June 28, 2003 from an income tax benefit of $0.4 million for the six months ended June 29, 2002. The increase in income tax expense was due to recording income tax expense at an estimated rate of 38% in 2003 while no such tax was recorded for the six months ended June 29, 2002. The $0.4 million income tax benefit for the six months ended June 29, 2002 was due to a federal tax law change in the first quarter of 2002 allowing for the carryback of certain losses to prior periods. LIQUIDITY AND CAPITAL RESOURCES We generated cash from operations of $18.3 million in the first six months of 2003. 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 repurchased $1.8 million of common stock in the first three months of 2003. We recently obtained a new $15 million 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 does provide additional cash flexibility. Barring any unexpected significant external or internal developments, we expect current cash balances on hand and cash flow generated from operations to be sufficient to meet our short-term and long-term liquidity needs. Net cash provided by operating activities for the six months ended June 28, 2003 was $18.3 million and consisted primarily of our net income adjusted for non-cash expenses and increases in accounts payable and accrued customer pre-payments. Cash increases were partially offset by decreases in accrued compensation and benefits and increases in accounts receivable and inventory. Accounts payable increased as a result of the additional commitments made to advertising in 2003 and timing of payments related thereto. The increase in accrued customer prepayments is related to the timing of cash received on customer orders in advance of customer shipments at the end of the quarter. The decrease in accrued compensation is a result of annual incentive compensation payments made during the first quarter. The increase in accounts receivable is related to timing primarily as it relates to QVC shows. The increase in inventory is primarily the result of purchases to mitigate the risk of a potential longshoreman's strike. Net cash provided by operating activities for the six months ended June 29, 2002 was approximately $12.3 million and consisted primarily of the net income adjusted for non-cash expenses, increases in accrued customer prepayments, accrued compensation and benefits, and decreases in other assets, partially offset by increases in inventories. The inventory increase is primarily a function of timing of purchases and size of QVC shows. The increase in accrued customer prepayments is related to the timing of cash received on customer orders in advance of customer shipments at the end of the quarter. The increase in accrued compensation and benefits is a result of increases in incentive pay accruals. Net cash used in investing activities was $13.3 million for the six months ended June 28, 2003. Investing activities consisted primarily of investments in marketable securities and purchases of property and equipment for 84 remodeled and 12 new retail stores, and development costs for information technology systems for the six months ended June 28, 2003. In 2003, we made net investments in marketable securities of $3.0 million. The net cash used in investing activities for the six months ended June 29, 2002 was $13.6 million. In 2002 we invested in $10.6 million of marketable securities, and we also invested $2.9 million in purchases of property and equipment. In the remaining six months of 2003, we expect to open 16 new retail stores and to remodel approximately 10 additional stores. Our anticipated capital expenditures are expected to be approximately $18 million in 2003. We expect our new stores to be cash flow positive within the first 12 months of operation and, as a result, do not expect a significant negative effect on net cash provided by operations from new stores. 14 Net cash provided by financing activities was $531,000 for the six months ended June 28, 2003 from the proceeds from the issuance of common stock from the exercise of various options and warrants, offset by the repurchase of common stock. Net cash provided by financing activities for the six months ended June 29, 2002 was $266,000. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Financial instruments that potentially subject the Company 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. The Company does not believe there is significant risk of non-performance by these counterparties because the Company limits the amount of credit exposure to any one financial institution and any one type of investment. ITEM 4. DISCLOSURE CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in the Company's internal control over financial reporting during the Company's most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 15 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, any losses that may occur from these matters are adequately covered by insurance or are provided for in the consolidated financial statements and the ultimate outcome of these matters will not have a material effect on the consolidated financial position or results of operations of the Company. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our Annual Meeting of Shareholders was held on May 15, 2003. The following individuals were elected as Directors of the Company at the Annual Meeting to serve for terms of three years expiring at the 2006 Annual Meeting of Shareholders or until their successors are elected and qualified. Shares voted in favor of these Directors and shares withheld were as follows: Patrick A. Hopf Shares For 26,746,588 Shares Withheld 261,718 Trudy A. Rautio Shares For 26,887,398 Shares Withheld 120,908 Ervin R. Shames Shares For 26,744,468 Shares Withheld 263,838 In addition to the Directors named above, the following Directors' terms continued after the Annual Meeting and will expire at the Annual Meeting of Shareholders in the year indicated below: TERM NAME EXPIRES ---- ------- Thomas J. Albani 2004 David T. Kollat 2004 William R. McLaughlin 2004 Christopher P. Kirchen 2005 Michael A. Peel 2005 Jean-Michel Valette 2005 Shareholders also approved the appointment of KPMG LLP, certified public accountants, as independent auditors for the fiscal year ending January 3, 2004. Shares voted in favor of this appointment and shares withheld were as follows: Shares For 26,929,969 Shares Withheld 17,467 16 ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS. EXHIBIT NUMBER DESCRIPTION 10.1 Credit Agreement dated as of May 23, 2003 between Select Comfort Corporation and Bank of America, N.A. 10.2 Fourth Amendment to Revolving Credit Program Agreement with Mill Creek Bank dated June 23, 2003. 31.1 Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. 32.2 Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. (b) REPORTS ON FORM 8-K During the quarter ended June 28, 2003, the Company filed three Current Reports on Form 8-K. The Reports consisted of the following: (i) Current Report furnished under Item 9 of Form 8-K on April 3, 2003, announcing net sales for the first quarter ended March 29, 2003. (ii) Current Report furnished under Item 9 of Form 8-K on April 15, 2003, announcing comments on results for the first quarter ended March 29, 2003. (iii) Current Report furnished under Item 9 of Form 8-K on May 9, 2003, announcing pricing of public offering. 17 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/William R. McLaughlin --------------------------------------- August 12, 2003 William R. McLaughlin President and Chief Executive Officer (principal executive officer) /s/James C. Raabe --------------------------------------- James C. Raabe Chief Financial Officer (principal financial and accounting officer) 18 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION LOCATION 10.1 Credit Agreement dated as of May 23, 2003 between Filed herewith. Select Comfort Corporation and Bank of America N.A. 10.2 Fourth Amendment to Revolving Credit Program Agreement with Filed herewith. Mill Creek Bank dated June 23, 2003. 31.1 Certification of CEO pursuant to Section 302 of the Filed herewith. Sarbanes-Oxley Act of 2002. 31.2 Certification of CFO pursuant to Section 302 of the Filed herewith. Sarbanes-Oxley Act of 2002. 32.1 Certification of CEO pursuant to Section 906 of the Furnished herewith. Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. 32.2 Certification of CFO pursuant to Section 906 of the Furnished herewith. Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350.
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