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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 JANUARY 2, 1999
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
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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, SUITE 100
MINNEAPOLIS, MINNESOTA 55442
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (612) 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/
As of March 1, 1999, 18,568,471 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 directors and executive
officers, was $249,599,034.
DOCUMENTS INCORPORATED BY REFERENCE
Parts II and IV of this Annual Report on Form 10-K incorporate by
reference information (to the extent specific pages are referred to herein)
from the Registrant's Annual Report to Shareholders for the year ended
January 2, 1999 (the "1998 Annual Report"). Part III of this Annual Report on
Form 10-K incorporates by reference information (to the extent specific
sections are referred to herein) from the Registrant's Proxy Statement for
its 1999 Annual Meeting to be held June 8, 1999 (the "1999 Proxy Statement").
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TABLE OF CONTENTS
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PART I.............................................................. 2
ITEM 1. BUSINESS................................................. 2
General....................................................... 2
Business and Growth Strategy.................................. 2
Products...................................................... 3
Retail Stores................................................. 4
Direct Marketing Operations................................... 5
Road Show Events.............................................. 6
Marketing and Advertising..................................... 6
Consumer Education and Customer Service....................... 6
Research and Product Development.............................. 7
Manufacturing and Distribution................................ 7
Suppliers..................................................... 8
Intellectual Property......................................... 8
Competition................................................... 8
Consumer Credit Arrangements.................................. 9
Governmental Regulation....................................... 9
Employees.....................................................10
Certain Important Factors.....................................10
ITEM 2. PROPERTIES...............................................14
ITEM 3. LEGAL PROCEEDINGS........................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......15
ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY.......................17
PART II.............................................................18
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS......................................18
Number of Record Holders; Dividends...........................18
Previous Sales of Unregistered Securities.....................18
Use of Proceeds from Initial Public Offering..................18
ITEM 6. SELECTED FINANCIAL DATA..................................19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS..............................19
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK......................................................19
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..............19
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE..............................19
PART III............................................................20
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......20
Directors, Executive Officers, Promoters and Control Persons..20
Section 16(a) Beneficial Ownership Reporting Compliance.......20
ITEM 11. EXECUTIVE COMPENSATION..................................20
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT.......................................................20
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..........20
PART IV.............................................................21
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K......................................................21
(a) 1. Consolidated Financial Statements.....................21
2. Consolidated Financial Statement Schedules............21
3. Exhibits..............................................22
(b) Reports on Form 8-K...................................22
EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K.........................26
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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. ALL REFERENCES TO "SELECT COMFORT," "THE COMPANY," "WE" OR
"US" HEREIN INCLUDE OUR WHOLLY OWNED SUBSIDIARIES, SELECT COMFORT DIRECT
CORPORATION, SELECT COMFORT RETAIL CORPORATION, DIRECT CALL CENTERS, INC. AND
SELECT COMFORT SC CORPORATION.
SELECT COMFORT-Registered Trademark-, SLEEP NUMBER-Registered Trademark-,
COMFORT CLUB-Registered Trademark-, 90 NIGHT TRIAL, BETTER NIGHT'S SLEEP
GUARANTEE, THE AIR BED COMPANY and the Company's stylized logo are trademarks
of the Company.
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PART I
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THIS FORM 10-K CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS. FOR THIS
PURPOSE, ANY STATEMENTS CONTAINED IN THIS FORM 10-K THAT ARE NOT STATEMENTS
OF HISTORICAL FACT MAY BE DEEMED TO BE FORWARD-LOOKING STATEMENTS. WITHOUT
LIMITING THE FOREGOING, WORDS SUCH AS "MAY," "WILL," "EXPECT," "BELIEVE,"
"ANTICIPATE," "ESTIMATE" OR "CONTINUE" OR COMPARABLE TERMINOLOGY ARE INTENDED
TO IDENTIFY FORWARD-LOOKING STATEMENTS. THESE STATEMENTS BY THEIR NATURE
INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES, AND ACTUAL RESULTS MAY DIFFER
MATERIALLY DEPENDING ON A VARIETY OF FACTORS, INCLUDING THOSE SET FORTH UNDER
THE HEADING BELOW ENTITLED "CERTAIN IMPORTANT FACTORS."
ITEM 1. BUSINESS
GENERAL
Select Comfort, "The Air Bed Company," is the leading manufacturer, specialty
retailer and direct marketer of premium quality, premium priced, innovative air
beds and sleep-related products. We believe we are revolutionizing the mattress
industry by offering a differentiated product through a variety of
service-oriented distribution channels.
Our products address broad-based consumer sleep problems, resulting in a better
night's sleep. Our proprietary technology allows our air beds to more naturally
contour to the body, thereby generally providing:
- - better spinal alignment,
- - reduced pressure points,
- - greater relief of lower back pain,
- - greater overall comfort, and
- - better quality sleep
in comparison with traditional mattress products. A firmness control system
allows customers to independently customize the firmness on each side of the
Select Comfort air bed to their optimal level of comfort and support.
Unlike traditional mattress manufacturers, we sell our products directly to
consumers through three controlled, complementary and service-oriented
distribution channels, including Company-operated retail stores and leased
departments within larger retail stores, direct marketing operations and road
show events.
Our retail operations included 264 stores in 44 states, including 14 leased
departments (13 in Bed Bath & Beyond stores), at January 2, 1999. We plan to
open approximately 75 retail stores in 1999, including the expansion of our
leased department concept.
Select Comfort was incorporated in Minnesota in February 1987. Our principal
executive office is located at 6105 Trenton Lane North, Suite 100,
Minneapolis, Minnesota 55442. Our telephone number is (612) 551-7000.
BUSINESS AND GROWTH STRATEGY
We intend to leverage our position as the leading manufacturer, specialty
retailer and direct marketer of innovative air beds and sleep-related products
by increasing awareness of air bed technology and further establishing the
Select Comfort brand to be synonymous with a better night's sleep, premium
quality products and superior customer service.
Key elements of our business strategy are as follows:
- - PROVIDE A SUPERIOR PRODUCT. Our products differ from traditional mattresses
by addressing broad-based consumer sleep problems through the greater
comfort and support of sleeping on air and through the ability to customize
the firmness on each side of the mattress at the touch of a button.
- - EDUCATE CONSUMERS AND PROVIDE SUPERIOR CUSTOMER SERVICE. Since consumer
education and customer service are critical to convey the features and
benefits of our innovative air beds and to achieve high levels of customer
acceptance and
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satisfaction, we seek to provide a more friendly and informative sales
environment. In order to ensure superior customer satisfaction, retail,
direct marketing and road show sales professionals receive extensive
training in sleep technology and our proprietary technology and
products, including features and benefits, assembly and service procedures
and policies. We also maintain a customer service department of over 35
employees who receive similar training and respond to consumer questions.
- - INCREASE PRODUCT AWARENESS AND BRAND RECOGNITION. We believe that the
single most important factor in increasing sales is increasing consumer
awareness of the features and benefits of Select Comfort air beds. Our
highest brand awareness and market share is in Minneapolis, where we have
our largest advertising budget and largest number of retail stores. We plan
to increase product awareness and brand recognition nationwide through
continued investment in advertising and expansion of our retail store base.
- - LEVERAGE COMPLEMENTARY DISTRIBUTION CHANNELS. We distribute directly to
customers through Company-operated retail stores, direct marketing
operations and road show events. Our control over these three complementary
distribution channels provides significant competitive advantages,
including the ability to:
- leverage the Select Comfort brand name to generate inquiries and
convert inquiries to sales,
- leverage advertising and marketing programs across multiple markets
and distribution channels,
- interact directly with consumers to enhance customer satisfaction and
build brand loyalty,
- train sales professionals regarding Select Comfort's products and to
provide superior customer service, and
- utilize data from direct marketing operations to support retail and
road show site selection, new store openings and road show events.
- - CAPITALIZE ON VERTICALLY INTEGRATED OPERATIONS. We maintain control
over all phases of our business, including the design, manufacturing,
marketing, distribution and service of our air beds. This allows us to
maintain rigorous product quality standards, establish coordinated and
integrated sales and marketing efforts, carefully manage the
presentation and pricing of our products and focus on customer
satisfaction and service.
- - PURSUE ADDITIONAL GROWTH OPPORTUNITIES. We have begun testing an
in-home assembly service in selected markets through national
providers to enhance customer satisfaction by providing greater
convenience to the customer. We continue to evaluate product
enhancements and new accessory products, such as the recently
initiated test marketing of adjustable frames. There can be no
assurance that the level of sales from these growth opportunities will
justify the costs associated with their development and marketing.
PRODUCTS
AIR BEDS
Every Select Comfort air bed has a patented air chamber as its functioning core
and comes with a patented firmness control system ("FCS") that allows the
customer to easily and instantly customize the firmness of the mattress at the
touch of a button. All of our air beds, except twin size mattresses, are
available with independent air chambers for each side of the mattress, allowing
customized firmness for each sleep partner. Our Imperial and Ultra Series of air
beds feature a wireless remote control with a digital display of the user's
"Sleep Number," which reflects the level of firmness and allows the customer to
more easily adjust and readjust the firmness level to the customer's personal
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preference. Our air beds feature either a traditional cover or a pillowtop style
cover that provides extra cushioning. The covers are constructed with sanitized
and hypoallergenic Damask ticking made from blends of polyester/polypropylene or
cotton/rayon, or from 100% rayon. Our air beds are manufactured in a broad array
of sizes and styles, including all standard bed sizes and a waterbed replacement
size that fits into a customer's existing waterbed frame. We restaged our
product line in the spring of 1998 to include new cover designs as well as the
addition of a new zoned foam in our pillowtop models. This restaging also
included a newly redesigned, "whisper quiet" air pump for the Imperial and Ultra
Series and all new marketing materials.
Our air beds can be assembled by customers in a simple process requiring no
tools and can be moved more easily than a traditional mattress and box
spring. Furthermore, because air is the primary support material of the
mattress, Select Comfort air beds do not lose their shape or support over
time like traditional mattresses and box springs. Each air bed is accompanied
with instructional product brochures and easy to follow assembly
instructions, is certified by Underwriter's Laboratories and is backed by a
20-year limited warranty and our 90 Night Trial and Better Night's Sleep
Guarantee.
FOUNDATIONS AND ACCESSORY PRODUCTS
In addition to air beds, we offer matching foundations and a line of accessory
products, including a line of bed frames and high quality mattress pads with
zoned heating and specialty pillows, all of which are hypoallergenic and
designed to provide comfort and better quality sleep.
RETAIL STORES
Since our first retail stores were opened in 1992, an increasing percentage of
our net sales has occurred at our retail stores, and retail store sales now
account for a majority of our net sales. At January 2, 1999, we had 264 stores
in 44 states, including 14 leased departments (13 in Bed Bath & Beyond stores).
We plan to open approximately 75 retail stores in 1999, including the expansion
of our leased department concept.
STORE ENVIRONMENT. We seek to offer a unique and innovative store environment
that attracts consumers, showcases our products and encourages trial of our air
beds. Our retail store design is intended to convey a sense of innovation,
sophistication and quality that reinforces Select Comfort's brand image and
reputation as sleep experts. We are currently testing an updated store design
that we believe will further enhance our products to the consumer. Our retail
stores are principally showrooms, averaging approximately 900 square feet, with
several display models from our line of air beds and a full display of our
branded accessories.
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 proprietary technology and products
as well as on the overall importance of sleep quality. This enables them to more
effectively introduce consumers to our innovative air beds, emphasize the
features and benefits that distinguish Select Comfort air beds from traditional
mattresses, determine the consumers' needs, encourage consumers to experience
the comfort and support of the air beds and answer questions regarding our
products.
SITE SELECTION. In selecting new store sites, we generally seek high-traffic
mall locations of approximately 800 to 1,200 square feet within malls in major
metropolitan and regional areas. We conduct extensive analyses of potential
store sites and base our selection on a number of
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factors, including the location within the mall, 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 and the number of direct marketing inquiries
received from the area surrounding the mall. Clustering of retail stores
within a metropolitan retail market is also a key consideration in order to
leverage our advertising.
MARKETING AND ADVERTISING. We support new store openings with local print and
radio advertisements and mailings to direct response inquiries in the market. We
also use local radio personalities and newspaper advertising in certain of the
markets where we have multiple retail stores. We use local radio and print
advertisements and promotional offers during high mall traffic periods, such as
three-day holiday weekends, and in-store events, including live remote
broadcasts and promotional contests.
MANAGEMENT AND EMPLOYEES. Stores are currently organized into four regional
areas and 34 geographic districts, with approximately eight stores in each
district. Each regional sales director oversees approximately eight geographic
districts. Each district has a district sales manager who is responsible for the
sales and operations and who reports to a 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 a Select Comfort store consists of one store
manager and two full-time sales professionals. In order to maintain high
operating standards, we recruit store managers who typically have one to four
years of experience as a store manager in specialty retailing. The sales
professionals devote substantially all of their efforts to sales and customer
service, which includes helping customers and generating and responding to
inquiries. In addition, to promote consumer education, ensure customer
satisfaction and generate referrals, the sales professionals place follow-up
calls to customers who have made recent purchases or inquiries.
TRAINING AND COMPENSATION. All store personnel receive comprehensive on-site
training on our technology and sleep expertise, the features and benefits of our
air 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 based on
individual and store-wide performance. Regional sales directors and district
sales managers are eligible to receive, in addition to their base compensation,
incentive compensation for the achievement of performance objectives by the
stores within their respective regions and districts.
DIRECT MARKETING OPERATIONS
Many consumers' initial exposure to the Select Comfort air bed is through our
direct marketing operations. Typically, an interested consumer will respond to
one of our advertisements by calling our toll-free number. On this call, one of
our direct marketing sales professionals captures information from the consumer,
begins the consumer education process, takes orders, or, if appropriate, directs
the consumer to our other distribution channels. The direct marketing operations
are conducted by knowledgeable and well-trained sales professionals, including a
group of over 50 sales professionals who field incoming direct marketing
inquiries, and over 40 sales professionals who make outbound calls to consumers
who have previously contacted the Company. The direct marketing operations also
include a database marketing department that is responsible for mailings of
product and promotional information to direct response inquiries.
We maintain a database of information on approximately 4.0 million inquiries,
including customers who have purchased an air bed from
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us, from which the direct marketing channel is able to take orders, or, if
appropriate, direct the consumer to our other distribution channels.
In the direct marketing channel, our advertising message is communicated through
targeted print, radio, infomercials and television advertisements, as well as
through product brochures, videos and other product and promotional materials
mailed in response to consumer inquiries at various intervals. As our
advertising budget has expanded over the last few years, the direct marketing
channel has relied more heavily on nationally syndicated radio personalities,
such as Paul Harvey and Rush Limbaugh, and more recently on 60 and 120-second
television commercials and 30-minute infomercials. Our direct marketing
operations continually monitor the effectiveness and efficiency of our
advertising through tracking the cost per inquiry and cost per order of our
advertising, using focus groups to evaluate the effectiveness of our advertising
messages and using sophisticated media buying techniques.
Our direct marketing operations also support our retail and road show operations
through referrals, as well as mailings to direct marketing inquiries in selected
markets in advance of retail store openings and road shows. As our base of
retail stores has expanded, our direct marketing sales professionals have
increasingly been able to refer direct marketing inquiries to a convenient
retail store location, improving the process of converting inquiries into sales
and providing the consumer with a choice of service venues.
ROAD SHOW EVENTS
Our third distribution channel is road show events in selected markets where we
typically do not have a retail presence, as well as at home shows and consumer
product shows, state fairs and similar events. Select Comfort sales
professionals, supported by local print and radio advertising and advance
mailings to direct marketing inquiries, travel to various cities to demonstrate
our products in temporary showrooms or in booths at trade shows and educate
consumers about the benefits of Select Comfort air beds. We use inquiries
generated from our direct marketing channel to determine road show sites and
typically will have approximately 10 road show events, ranging from three days
to two weeks in duration, in process at any given time. We have found this
distribution channel to be very effective in converting direct response
customers who want to see the product before purchasing, but do not live close
to a retail store location.
MARKETING AND ADVERTISING
The primary objective of our marketing and advertising strategy is to create
awareness of the features and benefits of Select Comfort air beds and to build
recognition of the Select Comfort brand as the leader in innovative air beds,
sleep expertise, superior quality and excellent customer service. We continue to
spend the majority of our advertising budget on direct marketing, which
indirectly drives traffic to our expanding base of retail stores. As our base of
retail stores continues to grow, we plan to dedicate more of our advertising
budget in direct support of the retail stores.
The majority of our advertising budget is devoted to print and long and
short-form television advertising, with the balance primarily devoted to radio
advertising with well-known national personalities, as well as local radio
personalities in selected retail markets. We also intend to continue to pursue
various alternative channels, such as catalogs, and targeted marketing programs.
We believe the Internet may provide not only a fourth channel of distribution
but also may provide an inexpensive name source for our existing distribution
channels.
CONSUMER EDUCATION AND CUSTOMER SERVICE
We are committed to achieving our goal of world class customer satisfaction and
service. We intend to achieve this goal through a variety of means designed to:
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- - educate consumers on the benefits of Select Comfort products,
- - deliver superior quality products,
- - maximize our direct relationship with consumers,
- - maximize convenience for the consumer, and
- - respond quickly to consumer needs and inquiries.
We believe that educating consumers about the features and benefits of Select
Comfort air beds is critical to the success of our marketing and sales efforts,
and we devote considerable time and resources to training programs for our
retail, direct marketing and road show sales professionals. Our retail stores
also have displays that provide customers with the latest information on sleep
technology and the features and benefits of our air beds.
Our controlled distribution channels optimize our direct contact with customers
and allow us to respond quickly to customer service inquiries and enhance
customer satisfaction. Our multiple distribution channels also enhance the
convenience for the consumer to purchase products through a variety of venues.
In addition, we are currently testing the offering of in-home assembly services
in selected markets through national providers in order to increase overall
sales and enhance customer satisfaction by providing greater convenience to the
customer.
We maintain an in-house customer service department of over 35 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. The
customer service department makes outbound calls to new customers during the 90
Night Trial phase to answer questions and provide solutions to possible problems
in order to enhance customer education, build customer satisfaction and reduce
returns.
RESEARCH AND PRODUCT DEVELOPMENT
We maintain an active research and development department that continuously
seeks to enhance our knowledge of sleep dynamics and sleep technology, improve
current product performance and benefits and develop new products. Our research
and development department also conducts clinical studies and product tests to
measure the benefits of our air beds, enhance our sleep technology learning,
develop product improvements and establish quality and performance standards.
Through customer surveys and consumer focus groups, we seek feedback on a
regular basis to help enhance existing products and develop new products.
Since the introduction of our first air bed, we have continued to improve and
expand our product line, including quieter firmness control systems, remote
control gauges 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 $1.6 million for 1998, $1.8 million for
1997 and $1.5 million for 1996.
MANUFACTURING AND DISTRIBUTION
Our manufacturing operations are located in Minneapolis and in Columbia, South
Carolina and consist of quilting and sewing of the fabric covers for our air
beds, assembly of firmness control systems and final assembly and packaging of
air beds and foundations from contract manufactured components. We currently
conduct our manufacturing operations on two shifts and believe we have
sufficient capacity to meet anticipated increases in demand through the next 12
months. We plan to open a third manufacturing and distribution facility in Salt
Lake City in May 1999, primarily to serve West Coast and Southwest destinations.
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We manufacture air beds to meet orders rather than to stock inventory, which
enables us to maintain lower levels of inventory. Orders are currently shipped
from one of our two distribution centers, primarily via UPS, typically within 48
hours following order receipt, and are usually received by the customer within
five to seven business days after shipment. When our Salt Lake City distribution
center becomes operational, we believe we will be able to reduce the delivery
times to approximately three days. We are continually evaluating alternative
carriers on a national and regional basis, as well as testing providers of
in-home assembly services in selected markets.
SUPPLIERS
We currently obtain all of the materials and components used to produce our air
beds from outside sources. Components for the firmness control systems are
obtained from a variety of domestic sources. Quilting and ticking materials are
obtained from a supplier in Belgium and components for foundation systems are
obtained primarily from two domestic sources.
Our proprietary air chambers are produced to our specifications by one Eastern
European supplier under a supply contract expiring in August 1999 (subject to
automatic renewal if neither party gives 90 days' notice of non-renewal),
pursuant to which we are obligated to purchase certain minimum quantities. We
expect to continue the relationship with the Eastern European supplier for the
foreseeable future. We believe that we would be able to procure an adequate
supply of air chambers from other sources on a timely basis if the supply
contract is terminated or the Eastern European supplier is otherwise unable to
supply air chambers.
We completed the development of an air chamber designed with new materials that
will be manufactured by a U.S. based company at a foreign manufacturing
facility, subject to final testing. Full production of this new air chamber is
expected to commence in the first quarter of 2000. The Eastern European supplier
is expected to provide a second source of supply of this new air chamber during
the first half of 2000. We do not presently have any contract or commitment from
either supplier to manufacture the newly developed air chamber. We are
continuously searching for alternative designs and materials for all of our
components and materials, as well as alternative sources of supply.
INTELLECTUAL PROPERTY
Certain elements of the design and function of our air beds are the subject of
United States and foreign patents and patent applications owned by us. We have
16 U.S. issued patents and eight U.S. patent applications pending. We also held
22 foreign patents and had 20 foreign patent applications pending as of January
2, 1999.
The name "Select Comfort" and our logo are trademarks of the Company registered
with the United States Patent and Trademark Office. We have a number of other
registered marks, including the trademarks "Comfort Club" and "Sleep Number,"
the service mark "Comfort Club," and a number of unregistered marks, including
the trademarks "90 Night Trial," "Better Night's Sleep Guarantee" and "The Air
Bed Company." We have registered several of these trademarks in numerous foreign
countries and have approximately 41 trademarks registered, or the subject of
pending applications, in foreign countries. Each federally registered mark is
renewable indefinitely if the mark is still in use at the time of renewal. We
are not aware of any material claims of infringement or other challenges to our
right to use our marks.
COMPETITION
The mattress industry is highly competitive. Participants in the mattress
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 air beds compete with a number of
different types of mattress alternatives, including
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innerspring mattresses, waterbeds, futons and other air-supported mattresses
that are sold through a variety of channels, including furniture stores,
bedding specialty stores, department stores, mass merchants, wholesale clubs,
telemarketing programs, television infomercials and catalogs. We believe that
our success depends in part on increasing consumer acceptance of existing
products and the continuing introduction of products that have qualities and
benefits which differentiate our products from those offered by other
manufacturers.
The traditional mattress industry is characterized by a high degree of
concentration among the four largest manufacturers of innerspring mattresses
with nationally recognized brand names, including Sealy, which also owns the
Stearns & Foster brand name, Serta, Simmons and Spring Air. The balance of the
mattress market is served by over 700 manufacturers, primarily operating on a
regional basis. Many of these competitors, and in particular the four largest
manufacturers named above, have greater financial, marketing and manufacturing
resources and better brand name recognition than us, and sell their products
through broader and more established distribution channels.
We believe that a number of companies, including two of the four largest
manufacturers, have begun to offer air beds. There can be no assurance that
these or any other mattress manufacturer will not aggressively pursue the air
bed market. Any such competition by the established manufacturers or new
entrants into the market could have a material adverse effect on our business,
financial condition and operating results. In addition, should any of our
competitors reduce prices on premium mattress products, we may be required to
implement price reductions in order to remain competitive, which could have a
material adverse effect on our business, financial condition and operating
results.
CONSUMER CREDIT ARRANGEMENTS
In May 1997, we entered into an arrangement with Monogram Credit Card Bank of
Georgia (the "Bank"), an affiliate of General Electric Capital Corporation, a
creditor and warrantholder of the Company, pursuant to which the Bank offers to
our qualified customers an unsecured revolving credit arrangement to finance
purchases from us. The Bank sets the rate, annual fees, late fees and all other
terms and conditions relating to the customers' accounts, including collection
policies and procedures, and is the owner of the receivables. The effective
interest rate is comparable to rates generally available under similar consumer
revolving credit arrangements. The Bank's current commitment extends to a
maximum of $85 million of receivables outstanding. In 1998, approximately 51.4%
of the Company's net sales were financed by the Bank through these consumer
credit arrangements.
In March 1999, we notified the Bank of our intent to terminate this consumer
credit arrangement. In addition, we have signed a letter of intent with a third
party provider to replace the existing arrangement. We anticipate that a new
arrangement will be under terms that are no less favorable than under the
existing arrangement and that the transition to the new provider will occur
during the third quarter of 1999.
GOVERNMENTAL REGULATION
Our products and our marketing and advertising practices are subject to
regulation by various federal, state and local regulatory authorities, including
the Federal Trade Commission and the U.S. Food and Drug Administration. The
mattress industry also engages in advertising self-regulation through certain
voluntary forums, including the National Advertising Division of the Better
Business Bureau. We are also subject to various other federal, state and local
regulatory requirements, including federal, state and local environmental
regulation and regulations issued by the U.S. Occupational Safety and Health
Administration.
9
<PAGE>
EMPLOYEES
At January 2, 1999, we employed 1,520 persons, including 831 retail store
employees, 131 direct marketing employees, 41 customer service employees, 19
road show sales professionals, 347 manufacturing and distribution employees and
151 management and administrative employees. Approximately 88 of our employees
were employed on a part-time basis at January 2, 1999. 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 IMPORTANT FACTORS
There are several important factors that could cause our actual results to
differ materially from those anticipated by us or which are reflected in any of
our forward-looking statements. These factors, and their impact on the success
of our operations and our ability to achieve our goals, include the following:
HISTORY OF OPERATING LOSSES; UNCERTAIN PROFITABILITY
We have only recently achieved profitable operations and have incurred
substantial operating losses since our inception, and there can be no assurance
that we will sustain profitability on a quarterly or annual basis in future
periods. Our future operating results will depend upon a number of factors,
including:
- the level of consumer acceptance of our products,
- our ability to create product and brand name awareness,
- the effectiveness and efficiency of our advertising,
- 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 successfully identify and respond to emerging
trends in the mattress industry,
- the level of competition in the mattress industry,
- general economic conditions and consumer confidence, and
- our ability to maintain cost-effective production and delivery
of products.
LIMITED HISTORY OF RETAIL OPERATIONS; AGGRESSIVE GROWTH STRATEGY
Our net sales have grown significantly in the past several years primarily as
a result of the opening of new retail stores, increases in comparable store
sales from year to year, and growth of sales from our direct marketing
operations.
Our ability to continue our growth strategy will be dependent upon many factors,
including our ability to:
- - successfully open additional retail stores in existing
geographic markets,
- - successfully enter new geographic markets and store environments in
which we have no previous retail experience,
- - effectively integrate new retails stores into our existing operations,
- - negotiate acceptable lease terms for additional sites,
- - effectively hire, train, manage and retain qualified management and
other personnel,
- - generate additional direct marketing inquiries,
- - effectively develop strategic alliances with respect to product
development, marketing and distribution,
- - maintain a high level of manufacturing quality and efficiency, and
- - enhance our operational, financial and management systems.
10
<PAGE>
In addition, we plan to lease a third manufacturing and distribution center in
Salt Lake City, which is expected to be in operation in May 1999. There can be
no assurance that the costs for this new facility will not be greater than the
manufacturing costs at our current facilities in Minnesota and South Carolina.
In addition, delays or interruptions in the normal supply of products could
occur as we attempt to integrate a third manufacturing and distribution center.
Any such increases in costs or delays could have a material adverse effect on
our business, financial condition and operating results.
There can be no assurance that we will be able to grow at historical rates or
effectively manage this expansion in any one or more of these areas, and any
failure to do so could have a material adverse effect on our business, financial
condition and operating results.
EFFECTIVENESS AND EFFICIENCY OF ADVERTISING EXPENDITURES
Our advertising expenditures increased from $5.5 million in 1994 to $31.6
million in 1998, and are expected to continue to increase for the foreseeable
future. Our future growth and profitability will be dependent in part on the
effectiveness and efficiency of our advertising expenditures, including our
ability to:
- - create greater awareness of our products and brand name,
- - determine the appropriate creative message and media mix for future
advertising expenditures,
- - effectively manage advertising costs (including creative and media)
in order to maintain acceptable costs per inquiry, costs per
order and operating margins, and
- - convert inquiries into actual orders.
No assurance can be given that our planned increases in advertising expenditures
will result in increased sales, will generate sufficient levels of product and
brand name awareness or that we will be able to manage such advertising
expenditures on a cost effective basis.
FLUCTUATIONS IN COMPARABLE STORE SALES RESULTS
Our comparable store sales results have fluctuated significantly in the past and
such fluctuations are likely to continue. Stores enter the comparable store
calculation in their 13th full month of operation. Our comparable store sales
increases were 17.9% for 1998, 34.6% for 1997 and 26.1% for 1996.(*) Our
comparable store sales results have fluctuated significantly from quarter to
quarter with increases ranging from 8.2% to 62.0% on a quarterly basis for 1996
and 1998. There can be no assurance that our comparable store sales results will
not fluctuate significantly in the future. A variety of factors affect our
comparable store sales results, including:
- - the level of consumer awareness of our products and brand name,
- - the rate of consumer acceptance of our products,
- - the higher levels of sales in the first year of operations as each
successive class of new stores is opened,
- - the strong comparable store sales performance in recent periods,
- - the maturation of our store base,
- - the timing and relative success of promotional events, advertising
expenditures, new product introductions and product line extensions,
- - a change in the sales mix between our distribution channels, and
- - general economic conditions and consumer confidence.
Changes in comparable store sales results could cause the price of our common
stock to fluctuate substantially.
- -----------------------------
* Fiscal 1997 was a 53-week year versus 52 weeks for 1996 and 1998.
Comparable store sales for 1998 and 1997, adjusted to 52 weeks, would be
23.5% and 27.3%, respectively.
11
<PAGE>
QUARTERLY FLUCTUATIONS AND SEASONALITY
Our quarterly 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 increases in return rates,
- - the timing of new store openings and related expenses,
- - competitive factors,
- - net sales contributed by new stores,
- - any disruptions in third-party delivery services, 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 higher
mall traffic.
The level of spending related to sales and marketing expenses and new store
opening costs cannot be adjusted quickly and is based, in significant part, on
our expectations of future customer inquiries and net sales. 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 materially adversely affected.
Our results of operations of any quarter are not necessarily indicative of the
results that may be achieved for a full year or any future quarter.
RETURN POLICY AND PRODUCT WARRANTY
Part of our marketing and advertising strategy focuses on providing a 90 Night
Trial in which customers may return the air bed and obtain a refund of the
purchase price. An increase in return rates could have a material adverse effect
on our business, financial condition and operating results. We also provide our
customers with a limited 20-year warranty on our air beds. We have only been
selling air beds in significant quantities since 1992. There can be no assurance
that our warranty reserves will be adequate to cover future warranty claims, and
such failure could have a material adverse effect on our business, financial
condition and operating results.
PRODUCT DEVELOPMENT AND ENHANCEMENTS
Our growth and future success will depend 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. There can be no
assurance that we will be successful in developing or marketing enhanced or new
products, or that any such products will be accepted by the market. There can
also be no assurance that we will be able to establish and maintain profitable
strategic alliances. Further, there can be no assurance that the resulting level
of sales of any of our enhanced or new products will justify the costs
associated with their development and marketing.
MARKET ACCEPTANCE
The U.S. mattress market is dominated by four large manufacturers of innerspring
mattresses. Our air bed technology represents a significant departure from
traditional innerspring mattresses. The market for air beds is continuing to
evolve and the success of our products will be dependent upon both the continued
growth of this market and upon market acceptance of our air beds. The failure of
our air beds to achieve market acceptance for any reason would have a material
adverse effect on our business, financial condition and operating results.
RELIANCE UPON VENDORS; FOREIGN SOURCES OF SUPPLY
The inability of our suppliers to meet, for any reason, our requirement for air
chambers could have a material adverse effect on our business,
12
<PAGE>
financial condition and operating results. In addition, since our air
chambers and certain other supplies are manufactured outside the United
States, our operations could be materially adversely affected by the risks
associated with foreign sourcing of materials, including:
- - political instability resulting in disruption of trade,
- - existing or potential duties, tariffs or quotas that may limit
the quantity of certain types of goods that may be imported into the
United States or increase the cost of such goods, and
- - any significant fluctuation in the value of the
dollar against foreign currencies.
With the exception of our air chambers, we have no long-term purchase contracts
or other contractual assurances of continued supply, pricing or access to
components. The inability or failure of one or more key vendors to supply
components, the loss of one or more key vendors or a material change in our
purchase terms could have a material adverse effect on our business, financial
condition and operating results.
RELIANCE UPON CARRIERS
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, causing
delays in deliveries to customers and requiring us to use alternative carriers.
No assurance can be given that UPS will not experience difficulties in meeting
our requirements in the future. We continue to evaluate alternative carriers on
a national and regional basis, as well as providers of in-home assembly
services. There can be no assurance that alternative carriers will be able to
meet our requirements on a timely or cost-effective basis. Any significant delay
in deliveries to customers or increase in freight charges may have a material
adverse effect on our business, financial condition and operating results.
YEAR 2000 COMPLIANCE
There can be no assurance that we will be able to effectively address our Year
2000 issues in a timely and cost-efficient manner and without interruption to
our business. We have initiated discussions with our significant suppliers
regarding their plans to remediate Year 2000 issues where their systems
interface with our systems or otherwise impact our operations. There can be no
assurance that Year 2000 difficulties encountered by our suppliers and other
third parties with whom we do business will not have a material adverse impact
on our business, financial condition or operating results.
INTELLECTUAL PROPERTY PROTECTION
No assurance can be given that our current pending patents will provide
substantial protection or that others will not be able to develop products that
are similar to or competitive with our air beds. In addition, there can be no
assurance that copyright, trademark, trade secret, unfair competition and other
intellectual property laws, nondisclosure agreements and other protective
measures will preclude competitors from developing products similar to our
products or otherwise competing with us. In addition, the laws of certain
foreign countries may not protect our intellectual property rights and
confidential information to the same extent as the laws of the United States.
Although we are unaware of any basis for an intellectual property infringement
or invalidity claim against us, there can be no assurance that third parties,
including competitors, will not assert such claims against us or that, if
asserted, such claims will not be upheld. Intellectual property litigation,
which could result in substantial cost to and diversion of effort by management,
may be necessary to enforce our patents, to protect our trade secrets and
proprietary technology or to defend us against claimed infringement of the
rights of others and
13
<PAGE>
to determine the scope and validity of the proprietary rights of others.
There can be no assurance that we would prevail in any such litigation or
that, if it is unsuccessful, we would be able to obtain any necessary
licenses on reasonable terms or at all.
ITEM 2. PROPERTIES
We currently lease all of our existing retail store locations and expect that
our policy of leasing, rather than owning, will continue as we expand. Our store
leases generally provide for an initial lease term of 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.
We lease 125,000 square feet of space in Minneapolis for one of our
manufacturing and distribution centers, one of our direct marketing call
centers, a customer service center, a research and development center and
corporate offices, which lease expires in 2004. We also lease 105,000 square
feet of space in Columbia, South Carolina, for our other manufacturing and
distribution center and a direct marketing call center, which lease expires in
2003. We have agreed to lease approximately 100,800 square feet in Salt Lake
City for a third manufacturing and distribution center that we expect to open in
May of 1999, which lease expires in 2009.
ITEM 3. LEGAL PROCEEDINGS
We are involved in various legal proceedings incident to the ordinary course of
our business. We believe that the outcome of all pending legal proceedings in
the aggregate will not have a material adverse effect on our business, financial
condition or operating results.
14
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A Special Meeting of Shareholders of Select Comfort was held on November 30,
1998. The following matters were voted on and approved by our shareholders at
the Special Meeting. The tabulation of votes with respect to each of the
following matters voted on at the Special Meeting is set forth as follows:
1. Amendment to Article III of the Company's Articles of Incorporation to:
- - decrease the public offering price that would cause the automatic
conversion of the Series E preferred stock into common stock from $19.95
to $15.00 per share;
- - decrease the conversion price at which the Series E preferred stock was
converted into common stock from $8.82 to $8.20 per share upon a public
offering completed in 1998; and
- - decrease the conversion price at which the Series E preferred stock was
converted into common stock to the lower of $8.20 per share or 46.02%
of the mid-point of the filing range of initial public offering prices
upon a public offering completed after 1998.
All classes voting together on an as-if-converted basis:
<TABLE>
<CAPTION>
Broker
For Against Abstain Non-Vote
--- ------- ------- --------
<S> <C> <C> <C>
13,204,151 43,566 60,894 0
</TABLE>
Series E preferred stock voting as a separate class:
<TABLE>
<CAPTION>
Broker
For Against Abstain Non-Vote
--- ------- ------- --------
<S> <C> <C> <C>
706,177 0 0 0
</TABLE>
2. Amendment to Article III of the Company's Articles of Incorporation to
eliminate the preferred stock provisions and increase the number of authorized
shares of capital stock of the Company from 37,123,390 to 100,000,000 shares.
<TABLE>
<CAPTION>
Broker
For Against Abstain Non-Vote
--- ------- ------- --------
<S> <C> <C> <C>
13,244,151 3,566 60,894 0
</TABLE>
3. Amendment to the Company's Articles of Incorporation to provide for the
classification of the Board of Directors and related matters.
<TABLE>
<CAPTION>
Broker
For Against Abstain Non-Vote
--- ------- ------- --------
<S> <C> <C> <C>
13,306,611 0 2,000 0
</TABLE>
15
<PAGE>
4. Election of Directors.
FOR THREE-YEAR TERM EXPIRING AT THE 2001 ANNUAL MEETING OF SHAREHOLDERS
<TABLE>
<CAPTION>
Broker
Name of Nominee For Withheld Non-Vote
--------------- --- -------- --------
<S> <C> <C> <C>
Thomas J. Albani 13,306,611 2,000 0
H. Robert Hawthorne 12,757,611 551,000 0
David T. Kollat 13,306,611 2,000 0
</TABLE>
FOR TWO-YEAR TERM EXPIRING AT THE 2000 ANNUAL MEETING OF SHAREHOLDERS
<TABLE>
<CAPTION>
Broker
Name of Nominee For Withheld Non-Vote
--------------- --- -------- --------
<S> <C> <C> <C>
Patrick A. Hopf 13,306,611 2,000 0
Ervin R. Shames 12,757,611 551,000 0
</TABLE>
FOR ONE-YEAR TERM EXPIRING AT THE 1999 ANNUAL MEETING OF SHAREHOLDERS
<TABLE>
<CAPTION>
Broker
Name of Nominee For Withheld Non-Vote
--------------- --- -------- --------
<S> <C> <C> <C>
Christopher P. Kirchen 13,306,611 2,000 0
Kenneth A. Macke 12,757,611 551,000 0
Jean-Michel Valette 13,306,611 2,000 0
</TABLE>
5. Amendment to the Company's Articles of Incorporation to require the
affirmative vote of at least two-thirds of the outstanding voting power of the
Company entitled to vote for the approval of certain business combinations of
the Company.
<TABLE>
<CAPTION>
Broker
For Against Abstain Non-Vote
--- ------- ------- --------
<S> <C> <C> <C>
13,306,499 0 2,112 0
</TABLE>
16
<PAGE>
ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company, their ages and the offices held,
as of March 1, 1999, are as follows:
<TABLE>
<CAPTION>
NAME AGE TITLE
---- --- -----
<S> <C> <C>
H. Robert Hawthorne 53 President and Chief Executive Officer
Daniel J. McAthie 48 Executive Vice President, Chief Operating Officer,
Chief Financial Officer and Secretary
Charles E. Dorsey 48 Senior Vice President of Direct Marketing and President
of Select Comfort Direct Corporation
Ronald E. Mayle 40 Senior Vice President of Retail and President of Select
Comfort Retail Corporation
Gregory T. Kliner 60 Senior Vice President of Operations
</TABLE>
Information regarding the business experience of the executive officers
is set forth below.
H. ROBERT HAWTHORNE has served as the President, Chief Executive Officer and a
Director of the Company since April 1997. From February 1992 to April 1997, he
served as President of The Pillsbury Brands Group, a subsidiary of The Pillsbury
Company, which is a subsidiary of Diageo PLC. From June 1990 to January 1992, he
was President and Chief Executive Officer of Alpo Petfoods, then a subsidiary of
Grand Metropolitan PLC. Prior to joining Alpo Petfoods, Mr. Hawthorne was
President and Chief Executive Officer of Pillsbury Canada, a subsidiary of
Diageo PLC.
DANIEL J. MCATHIE has served as Executive Vice President, Chief Financial
Officer and Secretary since October 1995. Mr. McAthie also served as Chief
Administrative Officer from October 1995 to October 1998, at which time he was
named Chief Operating Officer. From May 1990 to April 1995, Mr. McAthie held the
positions of Senior Vice President, Chief Financial Officer, Vice President and
Treasurer of Fingerhut Companies, Inc., a mail order catalog company.
CHARLES E. DORSEY has served as Senior Vice President of Direct Marketing
since January 1992 and President of Select Comfort Direct Corporation since
March 1996. From March 1988 to December 1991, Mr. Dorsey served as Chief
Operating Officer for DM Shelter, Inc., a custom packaged home company.
RONALD E. MAYLE has served as Senior Vice President of Retail of the Company and
President of Select Comfort Retail Corporation since December 1997. From October
1996 to December 1997, Mr. Mayle served as Managing Member of Management &
Capital, a retail consulting firm. From May 1995 to October 1996, Mr. Mayle
served as an independent retail marketing consultant, primarily to a variety of
privately owned, start-up retail enterprises, advising on infrastructure and
sales and marketing strategies. From April 1992 to May 1995, Mr. Mayle was Vice
President of Operations of Petstuff, Inc., a subsidiary of PetsMart Inc.
GREGORY T. KLINER has served as Senior Vice President of Operations since 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 and snow removal products and irrigation systems.
17
<PAGE>
PART II
--------------------
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The information under the caption "Common Stock" on the inside back cover of the
Company's 1998 Annual Report is incorporated herein by reference.
NUMBER OF RECORD HOLDERS; DIVIDENDS
As of March 1, 1999, there were 157 record holders of the Company's common
stock. We did not declare or pay any cash dividends on the Common Stock
during the fiscal years ended January 3, 1998 or January 2, 1999.
PREVIOUS SALES OF UNREGISTERED SECURITIES
During the fiscal year ended January 2, 1999, we issued the following
securities without registration under the Securities Act:
1. From January 3, 1998 through January 2, 1999, we issued an aggregate of
526,880 shares of common stock to employees and directors of the Company
pursuant to the exercise of stock options and warrants by such individuals at
a weighted average exercise price of $3.23 per share.
2. In November 1998, we issued a warrant to General Electric Capital
Corporation to purchase 5,513 shares of common stock at an exercise price of
$8.82.
No underwriting commissions or discounts were paid with respect to the sales
of the unregistered securities described above. In addition, all of the above
sales were made in reliance on Rule 701, Regulation D and Section 4(2) under
the Securities Act. With regard to our reliance upon the exemptions set forth
in the previous sentence, we made certain inquiries to establish that such
sales qualified for such exemptions from the registration requirements. In
particular, we confirmed that:
- - all offers of sales and sales were made by personal contact from officers
or directors of the Company or other persons closely associated with
the Company;
- - each investor made representations that he or she was sophisticated in
relation to this investment (and we have no reason to believe such
representations were incorrect);
- - each purchaser gave assurance of investment intent and the certificates
for the shares bear a legend accordingly; and
- - offers and sales within any offering were made to a limited number of
persons.
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING
On September 3, 1998, we filed a Registration Statement on Form S-1 (File No.
333-62793) with the Securities and Exchange Commission (the "SEC"), pursuant
to which we registered the offer and sale under the federal securities laws
of 4,600,000 shares of common stock, including 1,677,650 shares sold by
certain selling shareholders. The SEC declared our Registration Statement
effective on December 3, 1998, and the closing of the initial public offering
was held on December 9, 1998. The managing underwriters were Hambrecht &
Quist LLC, BankBoston Robertson Stephens Inc., Piper Jaffray Inc. and Charles
Schwab & Co., Inc.
The aggregate offering price of the offering was $78,200,000. The net
proceeds to the Company from the sale of the shares of common stock offered
by the Company was $44,643,353, after deducting the underwriting discount of
$3,477,597 and the estimated offering expenses of approximately $1,559,000.
All of the expenses incurred in connection with the initial public offering
were paid to unrelated parties or entities, except for underwriting discount
which were given to, among others, Hambrecht &
18
<PAGE>
Quist LLC. Jean-Michel Valette, a director of the Company, is a member of the
general partner of H&Q Select Comfort Investors, L.P., a related party to
Hambrecht & Quist LLC.
From December 9, 1998 to January 2, 1999, we have spent the net proceeds from
the offering as follows:
<TABLE>
<S> <C>
Repayment of long-term debt $15,325,480
Fund the build-out, start-up and
leasing of our third manufacturing
and distribution facility 222,400
Fund expansion of our retail store base 2,760
-----------
$15,550,640
-----------
-----------
</TABLE>
ITEM 6. SELECTED FINANCIAL DATA
The financial information under the caption "Selected Consolidated Financial
Data" on page 16 of the Company's 1998 Annual Report is incorporated herein by
reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The information under the caption "Management's Discussion and Analysis of
Financial Condition and Results of Operations" on pages 17 to 22 of the
Company's 1998 Annual Report is incorporated herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Not Applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements and Independent Auditors' Report
thereon on pages 23 to 38 of the Company's 1998 Annual Report are incorporated
herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
19
<PAGE>
PART III
--------------------
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS
The information under the captions "Election of Directors -- Information
About Nominees and Directors" and "Election of Directors -- Other Information
About Nominees and Directors" in the Company's 1999 Proxy Statement is
incorporated herein by reference. The information concerning executive
officers of the Company is included in this Report under Item 4a, "Executive
Officers of the Company."
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
The information under the caption "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's 1999 Proxy Statement is incorporated herein by
reference.
ITEM 11. EXECUTIVE COMPENSATION
The information under the captions "Election of Directors -- Director
Compensation" and "Executive Compensation and Other Benefits" in the
Company's 1999 Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information under the caption "Principal Shareholders and Beneficial
Ownership of Management" in the Company's 1999 Proxy Statement is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information under the caption "Certain Transactions" in the Company's
1999 Proxy Statement is incorporated herein by reference.
20
<PAGE>
PART IV
--------------------
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. CONSOLIDATED FINANCIAL STATEMENTS
The following Consolidated Financial Statements of the Company and
its subsidiaries are incorporated herein by reference from the pages
indicated in the Company's 1998 Annual Report:
CONSOLIDATED FINANCIAL STATEMENTS:
<TABLE>
<S> <C>
Independent Auditors' Report................................................ 23
Consolidated Balance Sheets as of January 2, 1999 and January 3, 1998....... 24
Consolidated Statements of Operations for the years ended January 2, 1999,
January 3, 1998 and December 28, 1996....................................... 25
Consolidated Statements of Shareholders' Equity for the years ended
January 2, 1999, January 3, 1998 and December 28, 1996...................... 26
Consolidated Statements of Cash Flows for the years ended
January 2, 1999, January 3, 1998 and December 28, 1996...................... 27
Notes to Consolidated Financial Statements.................................. 28-38
</TABLE>
2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES
Attached to this Report on page 25 is the Independent Auditors'
report together with Schedule II--Valuation and Qualifying
Accounts.
21
<PAGE>
3. EXHIBITS
The exhibits to this Report are listed in the Exhibit Index on
pages 26 to 29 below.
We will furnish a copy of the exhibits referred to above at a
reasonable cost to any person who was a shareholder of Select Comfort
Corporation as of April 14, 1999, upon receipt from any such person of a
written request for any such exhibit. Such request should be sent to:
Select Comfort Corporation, 6105 Trenton Lane North, Suite 100,
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 13(a):
1. Omnibus Stock Option Plan, as amended
2. 1997 Stock Incentive Plan
3. Form of Incentive Stock Option Agreement under the 1997 Stock
Incentive Plan
4. Form of Performance Based Stock Option Agreement under the 1997 Stock
Incentive Plan
5. Employment Letter Agreement dated April 3, 1997 between the Company
and H. Robert Hawthorne
6. Employment Letter Agreement dated October 20, 1995 between the
Company and Daniel J. McAthie
7. Employment Letter Agreement dated July 11, 1995 between the Company
and Gregory T. Kliner
8. Consulting Agreement and Stock Option Agreement dated April 1, 1996
between the Company and Ervin R. Shames
9. Employment Letter Agreement dated November 12, 1997 between the
Company and Ronald E. Mayle
(b) REPORTS ON FORM 8-K
We did not file any Current Reports on Form 8-K during the quarter
ended January 2, 1999.
22
<PAGE>
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: March 25, 1999 By: /s/ H. Robert Hawthorne
---------------------------------------
H. Robert Hawthorne
President and Chief Executive Officer
(principal executive officer)
By: /s/ Daniel J. McAthie
-----------------------------------------
Daniel J. McAthie
Executive Vice President, Chief Operating
Officer, Chief Financial Officer and
Secretary (principal financial and
accounting officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below on March 25, 1999 by the following persons on
behalf of the Registrant and in the capacities and on the dates indicated.
NAME TITLE
- ---- -----
/s/ H. Robert Hawthorne President, Chief Executive Officer and
- ------------------------------- Director (principal executive officer)
H. Robert Hawthorne
/s/ Ervin R. Shames Chairman of the Board
- -------------------------------
Ervin R. Shames
/s/ Thomas J. Albani Director
- -------------------------------
Thomas J. Albani
/s/ Patrick A. Hopf Director
- -------------------------------
Patrick A. Hopf
/s/ Christopher P. Kirchen Director
- -------------------------------
Christopher P. Kirchen
23
<PAGE>
/s/ David T. Kollat Director
- -------------------------------
David T. Kollat
/s/ Kenneth A. Macke Director
- -------------------------------
Kenneth A. Macke
/s/ Jean-Michel Valette Director
- -------------------------------
Jean-Michel Valette
24
<PAGE>
Independent Auditors' Report on Financial Statement Schedule
The Board of Directors and Stockholders
Select Comfort Corporation
Under date of January 22, 1999 we reported on the consolidated balance sheets of
Select Comfort Corporation and subsidiaries as of January 2, 1999 and January 3,
1998, and the related statements of operations, stockholders' equity, and cash
flows for each of the years in the three-year period ended January 2, 1999, as
contained in the Annual Report on Form 10-K for the year 1998. 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 the all material aspects, the information set forth therein.
/s/ KPMG Peat Marwick LLP
Minneapolis, Minnesota
January 22, 1999
SELECT COMFORT CORPORATION AND SUBSIDIARIES
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
ADDITIONS
BALANCE AT CHARGED TO DEDUCTIONS BALANCE AT
BEGINNING COSTS AND FROM END OF
DESCRIPTION OF PERIOD EXPENSES RESERVES PERIOD
- ---------------------------- ---------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Allowance for doubtful
accounts - 1998 $1,901 $2,794 $1,945 $2,750
- 1997 200 2,101 400 1,901
- 1996 261 63 124 200
Accrued warranty
costs - 1998 $3,257 $4,807 $3,578 $4,486
- 1997 2,036 3,274 2,053 3,257
- 1996 1,390 1,936 1,290 2,036
</TABLE>
25
<PAGE>
SELECT COMFORT CORPORATION
EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED JANUARY 2, 1999
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION METHOD OF FILING
- ------- ----------- ----------------
<S> <C> <C>
3.1 Restated Articles of Incorporation of the Company.............. Incorporated by reference to Exhibit
3.1 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
3.2 Restated Bylaws of the Company................................. Incorporated by reference to Exhibit
3.2 contained in the Company's
Registration Statement on Form S-1, as
amended (File 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 the Company's
Registration Statement on Form S-1, as
amended (File 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 Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
4.3 Amended and Restated Registration Rights Agreement dated Incorporated by reference to Exhibit
December 28, 1995.............................................. 4.4 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
4.4 First Amendment to Series E Stock Purchase Agreement and Incorporated by reference to Exhibit
Amended and Restated Registration Rights Agreement dated 4.5 contained in the Company's
April 25, 1996................................................. Registration Statement on Form S-1, as
amended (File No. 333-62793)
4.5 Second Amendment to Amended and Restated Registration Rights Incorporated by reference to Exhibit
Agreement dated as of November 1, 1996........................ 4.6 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
4.6 Second (sic) Amendment to Amended and Restated Registration Incorporated by reference to Exhibit
Rights Agreement dated March 24, 1997......................... 4.7 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
26
<PAGE>
4.7 Series A Warrant effective as of March 31, 1998 issued to Incorporated by reference to Exhibit
General Electric Capital Corporation.......................... 4.8 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.1 Net Lease Agreement dated December 3, 1993 between the Company Incorporated by reference to Exhibit
and Opus Corporation.......................................... 10.1 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.2 Amendment of Lease dated August 10, 1994 between the Company Incorporated by reference to Exhibit
and Opus Corporation.......................................... 10.2 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.3 Second Amendment to Lease dated May 10, 1995 between the Incorporated by reference to Exhibit
Company and Rushmore Plaza Partners Limited Partnership 10.3 contained in the Company's
(successor to Opus Corporation)................................ Registration Statement on Form S-1, as
amended (File 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 Limited Partnership... 10.4 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.5 Third Amendment of Lease, Assignment and Assumption of Lease Incorporated by reference to Exhibit
and Consent dated as of January 1, 1996 among the Company, 10.5 contained in the Company's
Rushmore Plaza Partners Limited Partnership and Select Registration Statement on Form S-1, as
Comfort Direct Corporation.................................... amended (File No. 333-62793)
10.6 Sublease dated as of March 27, 1997 between Select Comfort SC Incorporated by reference to Exhibit
Corporation and Bellsouth Telecommunications, Inc. ........... 10.6 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.7 Master Lease Agreement dated August 27, 1996 between Incorporated by reference to Exhibit
Comdisco, Inc. and the Company and Equipment 10.7 contained in the Company's
Schedules VL-1 dated August 27, 1996 and VL-2 and VL-3 dated Registration Statement on Form S-1, as
November 11, 1996............................................. amended (File No. 333-62793)
10.8 Supply Agreement dated August 23, 1994 between the Company Incorporated by reference to Exhibit
and Supplier (1).............................................. 10.8 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
27
<PAGE>
10.9 Equipment Purchase and Software License Agreement dated Incorporated by reference to Exhibit
February 6, 1996 between the Company and Supplier (1)......... 10.9 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.10 Consumer Credit Card Program Agreement dated as of May 22,
1997 among the Company, Select Comfort Retail Corporation,
Select Comfort Direct Corporation, Select Comfort SC Incorporated by reference to Exhibit
Corporation and Monogram Credit Card Bank of Georgia; 10.12 contained in the Company's
amended in First Amendment to Consumer Credit Card Registration Statement on Form S-1, as
Program Agreement dated November 18, 1987 (1) ................ as amended (File No. 333-62793)
10.11 Major Merchant Agreement dated December 19, 1997 Incorporated by reference to Exhibit
among First National Bank of Omaha and the Company, Select 10.13 contained in the Company's
Comfort SC Corporation, Select Comfort Retail Corporation Registration Statement on Form S-1, as
and Select Comfort Direct Corporation......................... amended (File No. 333-62793)
10.12 1990 Omnibus Stock Option Plan, as amended.................... Incorporated by reference to Exhibit
10.14 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.13 1997 Stock Incentive Plan..................................... Incorporated by reference to Exhibit
10.15 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.14 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 (File No. 333-62793)
10.15 Form of Performance Based Stock Option Agreement under the Incorporated by reference to Exhibit
1997 Stock Incentive Plan..................................... 10.17 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.16 Employment Letter Agreement dated April 3, 1997 between the Incorporated by reference to Exhibit
Company and H. Robert Hawthorne............................... 10.18 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.17 Employment Letter Agreement dated October 20, 1995 between the Incorporated by reference to Exhibit
Company and Daniel J. McAthie................................. 10.19 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
28
<PAGE>
10.18 Employment Letter Agreement dated July 11, 1995 between the Incorporated by reference to Exhibit
Company and Gregory T. Kliner................................. 10.20 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.19 Consulting Agreement and Stock Option Agreement dated Incorporated by reference to Exhibit
April 1, 1996 between the Company and Ervin R. Shames......... 10.21 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
10.20 Employment Letter Agreement dated November 12, 1997
between the Company and Ronald E. Mayle........................ Filed herewith electronically
10.21 Lease Agreement dated September 30, 1998 between the Company Incorporated by reference to Exhibit
and ProLogis Development Services Incorporated................. 10.28 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
13.1 Excerpts from the 1998 Annual Report to Shareholders........... Filed herewith electronically
21.1 Subsidiaries of the Company.................................... Incorporated by reference to Exhibit
21.1 contained in the Company's
Registration Statement on Form S-1, as
amended (File No. 333-62793)
23.1 Independent Auditors' Consent ................................. Filed herewith electronically
27.1 Financial Data Schedule........................................ Filed herewith electronically
</TABLE>
- ----------------------
(1) 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.
29
<PAGE>
[Select Comfort Letterhead]
November 12, 1997
Mr. Ron Mayle
4565 Landover Way
Suwanee, GA 30024
Dear Ron:
As a follow up to our conversation, following is a revised summary of our offer
to you:
- - The starting salary will be $160,000 annually with a start date of
December 1, 1997.
- - You will participate in the Management Incentive Plan, which in 1997
provides a payout target of up to 50%, with a maximum of up to 80% of base
salary on a prorated basis if certain performance criteria are met.
- - As an employee of Select Comfort, you will be eligible for our company
benefits beginning December 1, 1997. Our benefits include: medical, dental,
flex account, life insurance, supplemental life insurance, short-term
disability, long-term disability, travel accident insurance, Paid Time Off
(PTO) and 401(k). The details of your benefits package will be reviewed in
a new hire orientation.
- - We will provide an annual payment of $3,600 to cover your portable
disability plan which you will, in turn, pay for yourself.
- - You will also be eligible for stock options of 135,000 shares at $10.00
per share vested monthly over 24 months of employment
- - You will spend approximately two to three days per week at Home Office in
Minneapolis and the balance of the week working from your home in Atlanta.
Select Comfort will pay for all of your travel to and from Atlanta, plus
lodging during time spent in Minneapolis. Also, Select Comfort will pay for
any modifications to your home office computer in Atlanta and overall
communications set-up that will enable you to work with our data bases. If
you decide
<PAGE>
Mr. Ron Mayle
November 12, 1997
Page 2
to move to Minneapolis during your first twelve months of employment,
Select Comfort will pay for your household moving expenses as outlined in
our corporate relocation policy.
I am extremely enthusiastic about your joining Select Comfort to help lead us
into the next century, when we will be recognized as the most successful
mattress company ever. Additionally, I stand ready to help you in any way as you
work to take our retail company to a "world class" level.
Any questions you have, please feel free to contact me directly. I look forward
to a successful and rewarding working relationship.
Sincerely,
/s/ Rob Hawthorne
Rob Hawthorne
President & CEO
kkj
Accepted by: /s/ Ronald E. Mayle Date: 11/13/97
------------------------ --------------------
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The data presented below has been derived from the Company's consolidated
financial statements and should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Company's consolidated financial statements and notes thereto:
<TABLE>
<CAPTION>
JAN. 2, 1999 JAN. 3, 1998 DEC. 28, 1996 DEC. 30, 1995 DEC. 31, 1994
YEAR ENDED(1)
(IN THOUSANDS, EXCEPT PER SHARE AND SELECTED OPERATING DATA)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net sales $246,269 $184,430 $102,028 $68,629 $30,472
Gross margin 161,082 117,801 63,507 39,796 19,420
Operating income (loss) 11,465 2,078 (3,764) (4,589) (3,297)
Net income (loss) before extraordinary item 6,636 (2,846) (3,685) (4,560) (3,371)
Net income (loss) 5,195 (2,846) (3,685) (4,560) (3,371)
Net income (loss) per share - diluted (2):
Net income (loss) per share before
extraordinary item 0.28 (1.59) (2.61) (3.16) (2.65)
Net income (loss) per share 0.19 (1.59) (2.61) (3.16) (2.65)
Weighted average common shares - diluted 15,928 2,353 1,753 1,444 1,274
Dividends paid per share - - - - -
SELECTED OPERATING DATA:
Stores open at period-end (3) 264 200 143 68 35
Average square footage of stores open during
period (4) 895 866 768 703 642
Sales per square foot (4) 742 666 622 611 442
Average store age (in months at period end) 27 22 15 15 12
Comparable store sales increase (5) 23.5% 27.3% 26.1% 59.8% 57.6%
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents $45,561 $12,670 $2,422 $6,862 $3,770
Working capital 42,249 757 (7,809) 2,734 2,614
Total assets 106,234 57,241 29,794 23,838 14,243
Long-term debt, less current maturities 29 19,511 1,162 40 77
Mandatorily redeemable preferred stock - 27,612 27,612 27,625 18,669
Total common shareholders' equity (deficit) 70,691 (21,038) (18,216) (14,779) (10,592)
</TABLE>
(1) Except for the year ended January 3, 1998, which included 53 weeks, all
years presented included 52 weeks.
(2) See Note 11 of Notes to Consolidated Financial Statements.
(3) Includes Select Comfort stores operated in leased departments within
larger retail stores (14 at January 2, 1999 and one at January 3, 1998).
(4) For stores open during the entire period indicated.
(5) Stores enter the comparable store calculation in their 13th full month
of operation. The number of comparable stores used to calculate such
data were 199, 138, 65, 32 and 13 for 1998, 1997, 1996, 1995 and 1994,
respectively. Reflects adjustment for an additional week of sales in
1997. Without adjusting for the additional week, comparable store sales
would have been 17.9% in 1998 and 34.6% in 1997.
16
<PAGE>
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. THE
DISCUSSION IN THIS ANNUAL REPORT CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS
THAT INVOLVE RISKS AND UNCERTAINTIES, SUCH AS STATEMENTS OF THE COMPANY'S PLANS,
OBJECTIVES, EXPECTATIONS AND INTENTIONS. THE CAUTIONARY STATEMENTS MADE IN THIS
ANNUAL REPORT SHOULD BE READ AS BEING APPLICABLE TO ALL RELATED FORWARD-LOOKING
STATEMENTS WHEREVER THEY APPEAR IN THIS ANNUAL REPORT. ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM THOSE DISCUSSED HERE.
OVERVIEW
Select Comfort was founded in 1987 and has become the leading vertically
integrated manufacturer, specialty retailer and direct marketer of innovative
air beds and sleep-related products. Management's initial focus was on its
direct marketing operations, which have grown in depth and sophistication and
now provide critical support for retail and road show distribution channels.
Since the first retail stores were opened in 1992, an increasing percentage of
net sales has occurred at the retail stores, which now account for a majority of
net sales. In 1994, the road show distribution channel was established and
focuses primarily on markets where retail stores have not been established.
Vertically integrated operations and control over three separate but
complementary distribution channels enable us to develop and maintain direct
customer relationships as well as leverage advertising dollars. Sales generation
is driven by targeted print, radio and television media which generate customer
inquiries that historically were pursued primarily through direct marketing
operations. As the retail store base has expanded, we believe the direct
marketing infrastructure has been leveraged and the process of converting
inquiries into sales has been improved. Marketing programs at retail stores have
been enhanced to focus more on increasing customer traffic, including a number
of in-store activities and promotions. We believe that direct marketing
operations will also continue to play a significant role in building consumer
awareness and product sales. We believe that sales will continue to grow for the
foreseeable future as advertising expenditures are increased and as additional
retail stores are opened, and as consumer awareness of our products and brand
name increases. The magnitude of future sales growth will depend on our ability
to create product and brand name awareness, the level of consumer acceptance of
the Company's products, the effectiveness and efficiency of the Company's
advertising, the ability of the Company 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.
Retail operations included 264 stores at January 2, 1999 including 14 leased
departments within larger retail stores (13 in Bed Bath & Beyond stores), 200
stores at January 3, 1998 and 143 stores at December 28, 1996. We plan to
open approximately 75 additional retail stores in 1999 including the
expansion of the leased department concept. Approximately 46% of the 1998
retail store openings, including leased departments, were in new markets. As
of January 2, 1999, we had closed five stores.
Historically, we have experienced strong comparable store sales growth,
reporting increases of 23.5%, 27.3% and 26.1% in 1998, 1997 and 1996,
respectively (comparable store sales amounts have been adjusted to reflect 52
weeks in fiscal 1997 consistent with all other periods). We believe this
performance is due to increased awareness of our brand and product benefits, the
relatively young age of the store base and various initiatives implemented in
recent periods related to increased emphasis on the retail distribution channel.
These initiatives include (i) a change in focus of advertising toward brand
awareness, (ii) the evolution of retail store operations, including improvements
in store design, and (iii) the closer integration of direct marketing and retail
distribution channels. Comparable store sales results in the future will be
influenced by factors similar to those which will impact overall sales growth.
Advertising expenditures increased from $5.5 million in 1994 to $31.6 million in
1998. Advertising costs are expensed as incurred as a component of sales and
marketing expenses, although we believe that advertising expenditures provide
significant benefits beyond the period in which they are expensed. 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 retail stores.
Advertising expenditures are expected to continue to increase in the foreseeable
future.
17
<PAGE>
We believe historical operating losses have been primarily the result of an
aggressive retail store opening strategy, a relatively immature store base,
significant marketing, advertising and research and development expenditures,
and the development of a substantial corporate infrastructure to support future
growth. Future increases in net sales and the achievement of long-term
profitability will depend upon greater consumer awareness and acceptance of air
bed products, the opening and successful performance of new retail stores, and
continued improvement in the performance of current stores as they mature.
Furthermore, a substantial portion of operating expenses is related to sales and
marketing expenses, including costs associated with opening new 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. If we 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.
In addition, 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, competitive factors, net sales contributed by new stores, any
disruptions in third-party delivery services 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. There can be no assurance that we will be able to
achieve or sustain our historical sales growth or profitability in the future,
on a quarterly or annual basis.
In connection with our March 1997 $15.0 million debt financing, a warrant with a
put feature was issued. This put feature required that the warrant be recorded
at fair value as long-term debt. Furthermore, any change in the fair value of
this warrant has been reflected as interest expense, resulting in non-cash
interest expense of $5.6 million and $3.3 million during 1998 and 1997,
respectively. The put feature of this warrant was eliminated upon the closing of
our initial public offering in December 1998, resulting in the reclassification
of the warrant liability from long-term debt to common shareholders' equity.
There will be no further interest expense associated with the warrant.
In November 1998, we agreed to reduce the conversion price of the Series E
Preferred Stock from $8.82 to $8.20 per share. This reduction of the conversion
price had no impact on net income (loss). However, for purposes of calculating
net income (loss) per share, net income available to common shareholders was
reduced by $1.3 million, an amount equal to the 77,155 incremental shares
issuable as a result of this change multiplied by $17.00, the Companies
IPO price.
Net income (loss) as reported was $5.2 million and ($2.8) million for 1998 and
1997, respectively resulting in net income (loss) per share of $0.19 and
($1.59), respectively. Pro forma net income, was $7.6 million and $0.4 million
in 1998 and 1997, respectively. Pro forma net income reflects adjustments for
non-recurring, non-cash items associated with put warrant interest expense
referred to above, a $1.4 million extraordinary charge associated with early
repayment of $15.0 million debt, as well as an income tax benefit of $4.7
million associated with the elimination of the Company's deferred tax valuation
allowance. Pro forma net income per share, which reflects these non-recurring
non-cash adjustments as well as adjustments related to undeclared and unpaid
dividends, was $0.45 and $0.03 in 1998 and 1997, respectively. In addition, as a
result of the repayment of the $15.0 million debt financing in December 1998, we
anticipate a reduction of interest expense in future periods. Interest expense
associated with this debt totaled $1.6 million in 1998.
At January 2, 1999, the Company had net operating loss carryforwards for federal
income tax purposes of approximately $1.6 million, of which it expects to be
able to use approximately $200,000. The Company's effective tax rate will
increase from that experienced in prior years as a result of the elimination of
substantially all of its net operating loss carry forwards.
18
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the Company's results
of operations expressed as percentages of net sales. Percentage amounts may not
total due to rounding.
<TABLE>
<CAPTION>
JAN. 2, 1999 JAN. 3, 1998 DEC. 28, 1996
YEAR ENDED
PERCENTAGE OF NET SALES
<S> <C> <C> <C>
Net sales 100.0% 100.0% 100.0%
Cost of sales 34.6 36.1 37.8
................................................................................................
Gross margin 65.4 63.9 62.2
................................................................................................
Operating expenses:
Sales and marketing 52.7 53.8 53.7
General and administrative 8.0 8.9 12.2
................................................................................................
Total operating expenses 60.8 62.7 65.9
................................................................................................
Operating income (loss) 4.7 1.1 (3.7)
Other income (expense), net (2.9) (2.6) 0.1
................................................................................................
Income (loss) before income taxes 1.8 (1.5) (3.6)
Income tax expense (benefit) (0.9) 0.1 0.0
................................................................................................
Net income (loss) before extraordinary item, net 2.7 (1.5) (3.6)
Extraordinary item (0.6) 0.0 0.0
................................................................................................
Net income (loss) 2.1% (1.5)% (3.6)%
- ------------------------------------------------------------------------------------------------
</TABLE>
COMPARISON OF YEAR ENDED JANUARY 2, 1999 AND JANUARY 3, 1998
NET SALES
Net sales increased 33.5% to $246.3 million for 1998 from $184.4 million for
1997, primarily due to an increase in unit sales. The components of the increase
in net sales were (i) a $29.1 million increase associated with the opening of 64
new retail stores during 1998, (ii) a $22.0 million increase associated with an
increase of 23.5% in comparable store sales over the comparable period of the
prior year, resulting primarily from the continuing maturation of stores, offset
by an estimated $4.4 million in comparable store sales in the 53rd week in 1997
and (iii) a $14.6 million increase in direct marketing sales. For a significant
portion of the third quarter of 1997, due to a UPS work stoppage, UPS was unable
to deliver the Company's products within acceptable time periods, causing delays
in deliveries to customers and requiring the Company to use alternative
carriers. Also, during this period, the Company converted its manufacturing and
financial operations to a new integrated information system. These factors
resulted in higher than normal customer returns and canceled orders, lower order
volumes and substantially increased freight charges, which the Company estimates
negatively impacted its operating income by approximately $3.9 million in the
second half of 1997, principally incurred in the third quarter.
GROSS MARGIN
Gross margin increased to 65.4% in 1998 from 63.9% in 1997 primarily due to
improved purchasing through volume discounts and better relationships with key
suppliers and improved leverage of fixed manufacturing costs over higher unit
volumes as well as reduced costs in 1998 compared with 1997 when the UPS strike
occurred.
SALES AND MARKETING
Sales and marketing expenses increased 30.9% to $129.9 million in 1998 from
$99.2 million in 1997, and decreased slightly as a percentage of net sales to
52.7% in 1998 from 53.8% in 1997. The increase in the dollar amount of sales and
marketing expenses was primarily due to the opening of 64 new retail stores
during 1998, increased advertising expenditures to support the Company's growth,
and higher commissions, percentage rents and freight expense related to the
higher net sales. The decrease in sales and marketing expenses as a percentage
of net sales was primarily due to improved leverage on advertising expenditures.
19
<PAGE>
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 19.5% to $19.7 million in 1998
from $16.5 million in 1997, but decreased as a percentage of net sales to 8.0%
in 1998 from 8.9% in 1997. The increase in the dollar amount of general and
administrative expenses was primarily due to increased spending to provide
infrastructure to support overall net sales growth. The decrease in general and
administrative expenses as a percentage of net sales was primarily due to
improved leverage of fixed costs over the increase in net sales.
OTHER INCOME (EXPENSE), NET
Other expense increased $2.3 million to $7.1 million in 1998 from $4.8 million
in 1997 primarily due to the inclusion of $5.6 million of non-cash interest
expense in 1998 relating to the change in the fair value of an outstanding put
warrant compared with $3.3 million in 1997. The put provision associated with
the warrant was eliminated effective on completion of the IPO. Future periods
will not require the recording of non-cash interest expense associated with the
put warrant.
INCOME TAX EXPENSE (BENEFIT)
Income tax expense decreased to a $2.2 million benefit in 1998 from a $0.1
million expense in 1997 primarily due to a $4.7 million benefit in 1998
associated with the recognition of deferred tax assets. This benefit is a
non-recurring item that should not impact future year operating results. The
benefit was partially offset by income tax expense associated with taxable
income in 1998. Income tax expense in 1997 was limited due to the utilization of
net operating losses to offset taxable income in 1997.
EXTRAORDINARY ITEM
1998 net income includes an extraordinary charge, net of income tax benefits, of
$1.4 million. The charge relates to the write-off of certain deferred assets and
issuance costs associated with our $15.0 million debt financing, which was
repaid in December 1998.
COMPARISON OF YEARS ENDED JANUARY 3, 1998 AND DECEMBER 28, 1996
NET SALES
Net sales increased 80.8% to $184.4 million in 1997 from $102.0 million in 1996,
primarily due to an increase in unit sales. The components of the net sales
increase were (i) a $36.6 million increase associated with the opening of 58 new
retail stores in 1997, (ii) a $27.4 million increase in direct marketing sales,
and (iii) a $12.3 million increase associated with an increase of 27.3% in
comparable store sales over the comparable period of the prior year, resulting
primarily from the continuing maturation of stores and an estimated $3.3 million
in comparable store sales in the 53rd week of 1997. For a significant portion
of the third quarter of 1997, due to a UPS work stoppage, UPS was unable to
deliver the Company's products within acceptable time periods, causing delays
in deliveries to customers and requiring the Company to use alternative
carriers. Also, during this period, the Company converted its manufacturing and
financial operations to a new integrated information system. These factors
resulted in higher than normal customer returns and canceled orders, lower order
volumes and substantially increased freight charges, which the Company estimates
negatively impacted its operating income by approximately $3.9 million in the
second half of 1997.
GROSS MARGIN
Gross margin increased to 63.9% in 1997 from 62.2% in 1996, primarily due to
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 81.0% to $99.2 million in 1997 from $54.8
million in 1996, and increased slightly as a percentage of net sales to 53.8% in
1997 from 53.7% in 1996. The increase in the dollar amount of sales and
marketing expenses was primarily due to the opening of 58 new retail stores in
1997, higher commissions, percentage rents and freight expenses related to the
higher level of net sales, increased advertising expenditures to support the
Company's growth, and an increase in freight charges due to the UPS strike.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased 32.5% to $16.5 million in 1997
from $12.5 million in 1996, but decreased as a percentage of net sales to 8.9%
in 1997 from 12.2% in 1996. The increase in the dollar amount of general and
administrative expenses was primarily due to increased infrastructure to support
overall net sales growth. The decrease in general and administrative expenses as
a percentage of net sales was primarily due to improved leverage of fixed costs
over the increase in net sales.
20
<PAGE>
OTHER INCOME (EXPENSE), NET
Other income (expense) decreased to $4.8 million of other expense in 1997 from
$0.1 million of other income in 1996 primarily due to (i) the inclusion of $3.3
million of non-cash interest expense relating to the change in the fair value of
an outstanding put warrant and (ii) interest expense associated with the
Company's March 1997 $15.0 million debt issuance, offset in part by the interest
income associated with the proceeds thereof.
LIQUIDITY AND CAPITAL RESOURCES
Our primary source of liquidity has been the sale of equity securities,
including the completion of our initial public offering in December 1998, a
$15.0 million senior subordinated debt financing transaction completed in March
1997, and cash generated from operations. The initial public offering resulted
in net proceeds of $44.6 million, which were partially used for the December
1998 repayment of the $15.0 million debt. Primary uses of cash have been for
the development and manufacturing of the Company's air bed product line,
sales and marketing expenses, costs associated with the opening of new retail
stores and manufacturing facilities and other required infrastructure and
general corporate purposes, including working capital. The Company had
working capital of approximately $42.2 million at January 2, 1999.
Net cash provided by operating activities in 1998 was approximately $11.0
million and consisted primarily of net income adjusted for non-cash expenses and
increases in accruals, partially offset by increases in accounts receivables and
inventories. Net cash provided by operating activities in 1997 was approximately
$7.3 million and consisted primarily of increases in accounts payable, accruals
and net loss adjusted for non-cash expenses, partially offset by increases in
accounts receivable, inventories and prepaid expenses. Net cash provided by
operating activities in 1996 was approximately $3.1 million and consisted
primarily of increases in accounts payable and accruals, partially offset by a
net loss adjusted for non-cash expenses and increases in inventories, accounts
receivable and prepaid expenses.
Beginning in May 1997, we began offering an unsecured revolving credit
arrangement to finance purchases through a third-party bank. Amounts owed to the
bank by the Company's customers aggregated $73.8 million at January 2, 1999. The
bank's current commitment extends to a maximum of $85.0 million of receivables
outstanding. In connection with all purchases financed under these arrangements,
the bank pays an amount equal to the total amount of purchases net of
promotional related discounts and less amounts retained for limited recourse on
bad debts. The bank had retained $11.3 million and $3.9 million as of January 2,
1999 and January 3, 1998, respectively. In March 1999, we notified the bank of
our intent to terminate this consumer credit arrangement. In addition, we have
signed a letter of intent with a third-party provider to replace the existing
arrangement. We anticipate that the new arrangement will be under terms that are
no less favorable than under the existing arrangement and that the transition to
the new provider will occur near the beginning of the third quarter of 1999. In
addition, amounts retained under the existing agreement will likely be returned
to the Company shortly following termination and are not anticipated to be
replaced by similar retainage amounts under the new agreement.
Net cash used in investing activities was approximately $8.8 million, $10.7
million, and $10.1 million in the years 1998, 1997 and 1996, respectively.
Investing activities consisted of purchases of property and equipment for new
retail stores in all periods as well as for a new manufacturing and distribution
facility and the conversion to a new information system in 1997.
Net cash provided by financing activities for 1998, 1997 and 1996 was
approximately $30.7 million, $13.6 million and $2.6 million, respectively. Net
cash provided by financing activities for 1998 consisted primarily of proceeds
from completion of our IPO, partially offset by debt repayments. Net cash
provided by financing activities for 1997 and 1996 consisted primarily of
proceeds from debt issuances, partially offset by debt repayments.
At January 2, 1999, we had 264 retail stores, including 13 leased departments
in Bed Bath & Beyond stores. We plan to open approximately 75 retail stores
in 1999 including expansion of the leased department concept. Management
expects that new stores will be leased on terms generally comparable to those
of existing store leases. In addition, we plan to open a third manufacturing
and distribution facility in Salt Lake City during the first half of 1999.
Capital expenditures in 1999 will be approximately $15.0 million based on
currently planned store openings, the planned new manufacturing and
distribution facility and the central office facilities and systems necessary
to support such additional stores.
We believe cash generated from operations will be sufficient to satisfy
anticipated working capital needs and that capital expenditure requirements
through at least the end of 1999 will be funded primarily by January 2, 1999
cash balances. Cash generated from operations and cash remaining at the end
of 1999 will be used to meet long-term liquidity needs, although additional
financing may be required.
21
<PAGE>
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 an independent consultant was retained 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, to facilitate and manage our
growth, 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 system
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 customer
inquiries and for processing and tracking warranty claims and returns have been
purchased. We anticipate these upgrades will be completed in the third quarter
of 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 second 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. The Year 2000 Project Team is
currently in the process of inventorying all material Year 2000 issues in non-IT
systems. We expect that remedial action for all non-IT systems will be completed
by the end of the second quarter of 1999.
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, nine key
suppliers were certified and other authorized suppliers are in the process of
seeking certification. Our key suppliers, including the supplier of our 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
and operating results.
COSTS TO ADDRESS THE YEAR 2000 ISSUE
We estimate approximately $165,000 has been incurred, through January 2, 1999,
to address Year 2000 issues. We estimate that by mid-1999 an additional $100,000
will be incurred to complete our remediation plans required for IT systems,
including systems software costs and consulting fees. We do not have an estimate
on Year 2000 remediation costs that may be required for non-IT systems, but we
believe that such costs will not have a material adverse effect on our business,
financial condition and operating results.
RISKS PRESENTED BY THE YEAR 2000 ISSUE
As the process of inventorying non-IT systems proceeds, we may identify systems
that present a Year 2000 risk. In addition, if any third parties who provide
goods or services essential to our business activities fail to appropriately
address their Year 2000 issues, such failure could have a material adverse
effect on our business, financial condition and operating results. For example,
a Year 2000 related disruption on the part of the financial institutions which
process credit card sales would have a material adverse effect on our business,
financial condition and 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 parties who provide goods or
services essential to our business fail to appropriately address their Year 2000
issues. The Year 2000 Project Team expects to conclude the development of these
contingency plans by the end of the second quarter of 1999.
22
<PAGE>
INDEPENDENT AUDITORS' REPORT
We have audited the accompanying consolidated balance sheets of Select Comfort
Corporation and subsidiaries (the Company) as of January 2, 1999 and January 3,
1998 and the related consolidated statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended
January 2, 1999. 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 generally accepted auditing
standards. 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 January 2, 1999 and January 3, 1998, and the
results of their operations and their cash flows for each of the years in the
three-year period ended January 2, 1999 in conformity with generally accepted
accounting principles.
/s/ KPMG Peat Marwick LLP
Minneapolis, Minnesota
January 22, 1999
23
<PAGE>
CONSOLIDATED BALANCE SHEETS
JANUARY 2, 1999 AND JANUARY 3, 1998
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
ASSETS 1998 1997
<S> <C> <C>
Current assets:
Cash and cash equivalents $45,561 $12,670
Accounts receivable, net of allowance
for doubtful accounts of $2,750 and
$1,901, respectively (note 2) 10,624 5,961
Inventories (note 3) 10,136 7,749
Prepaid expenses 4,048 4,256
Deferred tax assets (note 10) 5,448 -
.............................................................................................
Total current assets 75,817 30,636
Property and equipment, net (note 4) 29,125 25,183
Deferred tax assets (note 10) 440 -
Other assets 852 1,382
.............................................................................................
Total assets $106,234 $57,201
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt (note 6) $930 $999
Accounts payable 12,079 12,199
Accruals:
Sales returns 6,021 5,324
Warranty costs 4,486 3,257
Compensation, taxes and benefit 4,843 3,149
Income taxes (note 10) 648 125
Other 4,561 4,826
.............................................................................................
Total current liabilities 33,568 29,879
Long-term debt, less current maturities (note 6) 29 13,841
Warrants subject to put provision (note 7) - 5,670
Other liabilities 1,946 1,237
.............................................................................................
Total liabilities 35,543 50,627
- ---------------------------------------------------------------------------------------------
Series A-E mandatorily redeemable preferred stock,
$1.00-$1.25 par value; none and 12,123,390 shares
authorized, none and 12,091,962 shares issued
and outstanding, respectively (note 8) - 12,692
Additional paid-in capital - 14,920
.............................................................................................
- 27,612
.............................................................................................
Common shareholders' equity (notes 7, 8 and 9):
Undesignated preferred stock; 5,000,000 shares
authorized, no shares issued and outstanding - -
Common stock, $.01 par value; 95,000,000 shares
authorized, 18,435,687 and 2,477,660 shares issued
and outstanding, respectively 184 25
Additional paid-in capital 87,619 1,662
Accumulated deficit (17,112) (22,307)
Notes receivable investors (note 14) - (418)
.............................................................................................
Total common shareholders' equity (deficit) 70,691 (21,038)
.............................................................................................
Commitments (notes 5 and 15)
Total liabilities and shareholders' equity $106,234 $57,201
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
24
<PAGE>
CONSOLIDATED STATEMENTS OF OPERATIONS
JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Net sales $246,269 $184,430 $102,028
Cost of sales 85,187 66,629 38,521
.............................................................................................
Gross margin 161,082 117,801 63,507
.............................................................................................
Operating expenses:
Sales and marketing 129,894 99,218 54,814
General and administrative 19,723 16,505 12,457
.............................................................................................
Total operating expenses 149,617 115,723 67,271
.............................................................................................
Operating income (loss) 11,465 2,078 (3,764)
.............................................................................................
Other income (expense):
Interest income 825 682 244
Interest expense (note 6 and 7) (7,834) (5,234) (88)
Other, net (52) (231) (77)
.............................................................................................
Other income (expense), net (7,061) (4,783) 79
.............................................................................................
Income (loss) before income taxes and
extraordinary item 4,404 (2,705) (3,685)
Income tax expense (benefit) (note 10) (2,232) 141 -
.............................................................................................
Net income (loss) before extraordinary item 6,636 (2,846) (3,685)
Extraordinary item, net of tax benefit (note 6) (1,441) - -
.............................................................................................
Net income (loss) $5,195 $(2,846) $(3,685)
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
Deemed dividend from revision of preferred
stock conversion rate (note 8) $(1,312) $ - $ -
Cumulative preferred dividends (821) (900) (900)
.............................................................................................
Net income (loss) available to common shareholders $3,062 $(3,746) $(4,585)
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
Net income (loss) per share - basic (note 11)
Net income (loss) before extraordinary item $1.09 (1.59) (2.61)
Net income (loss) 0.74 (1.59) (2.61)
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
Net income (loss) per share - diluted (note 11)
Net income (loss) before extraordinary item 0.28 (1.59) (2.61)
Net income (loss) 0.19 (1.59) (2.61)
- ---------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
25
<PAGE>
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONAL NOTES
PAID-IN ACCUMULATED RECEIVABLE-
SHARES AMOUNT CAPITAL DEFICIT INVESTORS TOTAL
<S> <C> <C> <C> <C> <C> <C>
Balance at December 30, 1995 1,586,808 $ 16 $ 981 $(15,776) $ - $(14,779)
Exercise of common
stock options 260,338 3 245 - - 248
Net loss - - - (3,685) - (3,685)
...................................................................................................................
Balance at December 28, 1996 1,847,146 19 1,226 (19,461) - (18,216)
Exercise of common
stock options 630,514 6 436 - - 442
Issuance of investor notes - - - - (418) (418)
Net loss - - - (2,846) - (2,846)
...................................................................................................................
Balance at January 3, 1998 2,477,660 25 1,662 (22,307) (418) (21,038)
Issuance of shares in initial
public offering (note 9) 2,922,350 29 44,614 - - 44,643
Conversion of manditorily
redeemable preferred stock
(note 8) 12,332,364 123 27,489 - - 27,612
Exercise of common stock
options and warrants 703,313 7 4,639 - - 4,646
Issuance of investor notes - - - - (487) (487)
Payment of investor notes - - - - 905 905
Elimination of put provision
on warrant (note 7) - - 9,215 - - 9,215
Net income - - - 5,195 - 5,195
...................................................................................................................
Balance at January 2, 1999 18,435,687 $184 $87,619 $(17,112) $ - $70,691
- -------------------------------------------------------------------------------------------------------------------
- -------------------------------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
26
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996
(IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $5,195 $(2,846) $(3,685)
Adjustments to reconcile net income (loss)
to net cash provided by operating activities:
Depreciation and amortization 5,351 4,030 2,094
Loss on disposal of property and equipment 50 264 66
Extraordinary item 1,441 - -
Deferred tax assets (5,888) - -
Interest expense from put warrant valuation 5,625 3,250 -
Change in operating assets and liabilities:
Accounts receivable, net (4,663) (4,799) (421)
Inventories (2,387) (2,167) (500)
Prepaid expenses 208 (2,567) (781)
Accounts payable (120) 3,026 4,039
Accrued sales returns 697 2,529 888
Accrued warranty costs 1,229 1,221 646
Accrued compensation, taxes and benefits 1,694 1,426 393
Accrued income taxes 1,856 125 -
Other accrued liabilities (265) 3,829 158
Other assets 252 (565) (91)
Other liabilities 709 705 270
..............................................................................................
Net cash provided by operating activities 10,984 7,336 3,076
..............................................................................................
Cash flows used in investing activities -
Purchases of property and equipment (8,812) (10,727) (10,122)
..............................................................................................
Cash flows from financing activities:
Proceeds from issuance of debt - 16,184 2,850
Principal payments on debt (15,999) (2,203) (523)
Debt issuance costs - (781) -
Proceeds from issuance of common stock 46,702 439 292
Proceeds from issuance of redeemable
preferred stock 16 - (13)
..............................................................................................
Net cash provided by financing activities 30,719 13,639 2,606
..............................................................................................
Increase (decrease) in cash and
cash equivalents 32,891 10,248 (4,440)
Cash and cash equivalents, at beginning of year 12,670 2,422 6,862
..............................................................................................
Cash and cash equivalents, at end of year $45,561 $12,670 $2,422
- ----------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------
</TABLE>
See accompanying notes to consolidated financial statements.
27
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
Select Comfort Corporation and its wholly owned subsidiaries (the Company)
develop, manufacture, and market air beds and sleep-related products. The
Company's fiscal year ends on the Saturday closest to December 31. Fiscal years
1998 and 1996 had 52 weeks. Fiscal year 1997 had 53 weeks. Certain prior-year
amounts have been reclassified to conform to the current-year presentation.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and
its subsidiaries. All significant inter-company balances and transactions have
been eliminated in consolidation.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include highly liquid investments with initial
maturities of three months or less.
INVENTORIES
Inventories includes material, labor, and overhead and is 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 or ten years.
OTHER ASSETS
Other assets include security deposits, patents, trademarks, and debt issuance
costs. Patents and trademarks are amortized using the straight-line method over
17-year and 15-year periods, respectively. Debt issuance costs are amortized
using the straight-line method over the term of the debt.
NEW ACCOUNTING PRONOUNCEMENTS
During 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No 133, "Accounting for Derivative Instruments
and Hedging Activities". This pronouncement is not expected to have a material
impact on the Company's consolidated financial statements.
ACCOUNTING ESTIMATES
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
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.
ACCRUED WARRANTY COSTS
The Company provides a 20-year warranty on air beds, the last 15 years of which
are on a prorated basis. Estimated warranty costs are provided at the time of
sale of the warranted products. Estimates are based upon historical warranty
claims incurred by the Company. Given the limited history available, actual
results could differ from these estimates.
28
<PAGE>
(1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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 90 nights following the
sale.
IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED
The Company reviews its long-lived assets and certain identifiable intangibles
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 are reported at the lower of the carrying
amount or fair value less costs to sell.
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.
REVENUE RECOGNITION
Revenue is recognized when products are shipped to customers net of estimated
returns.
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 net
income impact 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 9.
RESEARCH AND DEVELOPMENT COSTS
Costs incurred in connection with research and development are charged to
expense as incurred. Research and development expense was $1,638,000, $1,819,000
and $1,464,000 in 1998, 1997 and 1996, respectively.
PRE-OPENING COSTS
Costs associated with the opening of new stores are expensed as incurred.
DIRECT RESPONSE ADVERTISING COSTS
The Company incurs direct response advertising costs associated with print
and broadcast advertisements. Such costs are charged to expense as incurred.
Advertising expense was $31,648,000, $28,281,000 and $16,224,000 in 1998,
1997 and 1996, 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.
29
<PAGE>
EARNINGS PER SHARE
Basic earnings per share excludes dilution and is computed by dividing the
income available to common shareholders by the weighted average number of common
shares outstanding during the period. Diluted earnings per share includes common
stock equivalents consisting of stock options and warrants determined by the
treasury stock method and dilutive convertible securities.
(2) ACCOUNTS RECEIVABLE
In June 1997, the Company began utilizing a third-party bank to offer its
qualified customers an unsecured revolving credit arrangement to finance
purchases from the Company. The bank sets the 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, the bank pays the Company an amount equal to
the total amount of such purchases, net of promotional related discounts and
less amounts retained for recourse related to returned products and limited
recourse related to bad debts. The bank's recourse for bad debts is limited to a
specified percent of receivables generated. The bank had retained $11,350,000
and $3,882,000 as of January 2, 1999 and January 3, 1998, respectively, under
terms of the agreement. The Company has included such amounts in its accounts
receivable net of estimated allowance for doubtful accounts.
(3) INVENTORIES
Inventories consist of the following (in thousands):
<TABLE>
<CAPTION>
JANUARY 2, 1999 JANUARY 3, 1998
<S> <C> <C>
Raw materials $6,533 $5,891
Work in progress 67 39
Finished goods 3,536 1,819
.............................................................................
$10,136 $7,749
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
</TABLE>
(4) PROPERTY AND EQUIPMENT
Property and equipment are summarized as follows (in thousands):
<TABLE>
<CAPTION>
JANUARY 2, 1999 JANUARY 3, 1998
<S> <C> <C>
Leasehold improvements $24,865 $18,164
Office furniture and equipment 3,079 2,698
Production machinery and computer equipment 8,610 7,062
Property and equipment under capital lease 2,963 2.971
Other 1,446 1,256
Less accumulated depreciation and amortization (11,838) (6,968)
.............................................................................
$29,125 $25,183
-----------------------------------------------------------------------------
-----------------------------------------------------------------------------
</TABLE>
30
<PAGE>
(5) LEASES
The Company rents office and manufacturing space under three 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:
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Minimum rents $11,127 $8,465 $4,875
Percentage rents 1,522 892 237
..........................................................................
Total $12,649 $9,357 $5,112
--------------------------------------------------------------------------
Equipment rent $952 $683 $402
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</TABLE>
The aggregate minimum rental commitments under operating leases for
subsequent years are as follows (in thousands):
<TABLE>
<S> <C>
1999 $11,939
2000 11,696
2001 11,731
2002 11,490
2003 10,765
Thereafter 31,278
..........................................................................
$88,899
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</TABLE>
(6) NOTES PAYABLE AND CAPITAL LEASE OBLIGATIONS
In March 1997, the Company completed a financing under which it issued a senior
subordinated promissory note in the principal amount of $15,000,000, a warrant
to purchase 1,100,000 shares of the Company's common stock at $10.50 per share
and a warrant to purchase 1,000,000 shares of common stock at $0.01 per share.
These warrants were subsequently adjusted and combined with the issuance of
anti-dilution shares, resulting in a single warrant to purchase 1,315,096 shares
of common stock at $8.82 per share, exercisable at any time prior to March 31,
2005. (see Note 7).
In December 1998, the Company repaid the promissory note resulting in an
extraordinary loss of $1,441,000 from early repayment. The loss was comprised of
unamortized debt discount and issuance costs totaling $2,281,000, and net of
income tax benefits of $840,000.
31
<PAGE>
Long-term obligations under notes and capital leases are as follows (in
thousands):
<TABLE>
<CAPTION>
JANUARY 2, 1999 JANUARY 3, 1998
<S> <C> <C>
Senior subordinated note payable to
financing company due March 2003
with interest payable quarterly
at 11% per annum. Face amount of
$15,000,000 net of $1,815,000 debt
discount with an effective interest
rate of 13.7%, paid in full in 1998 $ - $12,882
Notes payable under capital lease
agreements, payable in monthly
installments through March 2000,
with interest at 9.75% - 12.5%
per annum. Financing available under
these agreements aggregates $3,000,000,
of which $2,963,000 had been utilized at
January 2, 1999. In connection with these
notes, the Company granted the vendor warrants
to acquire 31,428 shares of the Company's
Series E convertible preferred stock
(note 9) 959 1,958
..........................................................................
959 14,840
Less current maturities 930 999
..........................................................................
$29 $13,841
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</TABLE>
Aggregate maturities of long-term debt subsequent to January 2, 1999 are due in
2000.
(7) WARRANTS SUBJECT TO PUT PROVISION
In connection with the financing completed in March 1997 (see Note 6), the
Company issued a warrant to purchase 1,100,000 shares of Common Stock at $10.50
per share (Series A Warrant) and a warrant to purchase 1,000,000 shares of
Common Stock at $0.01 per share (Series B Warrant). The Series B Warrant
provided that the number of shares exercisable could be reduced based on future
earnings levels or in the event the Company completed an initial public
offering. Effective March 31, 1998, the warrants were adjusted and combined,
resulting in a single warrant to purchase 1,309,583 shares of Common Stock at
$8.82 per share, exercisable at any time prior to March 31, 2005. In addition,
in connection with antidilution provisions included in the warrant agreement,
the Company agreed to issue an additional warrant to purchase 5,513 shares of
common stock exercisable at $8.82 per share. Warrants for 1,076,098 shares
remained outstanding at January 2, 1999.
The original warrant agreement provided the holder could require repurchase of
the warrant if an IPO had not been completed prior to March 27, 2002. The
repurchase amount would have been equal to the excess of the estimated fair
market value of the Company's common stock, as determined by the warrant
agreement, over the exercise price of the warrant. The Company also has an
option to repurchase the warrant if the warrant has not been exercised prior to
March 27, 2004. As required by Emerging Issues Task Force Issue 96-13 (EITF
96-13), the warrant was recorded at fair value and recorded as long-term debt.
In addition, EITF 96-13 requires that any change in fair value of the warrant be
reflected as interest expense. Accordingly, the financial statements reflect
interest expense of $5,625,000 and $3,250,000 for 1998 and 1997, respectively.
Upon completion of the Company's initial public offering the put option on the
warrants expired and the warrants were reclassified into $9,215,000 of
additional paid-in-capital. In addition, effective upon completion of the
Company's initial public offering, warrant revaluation is no longer required and
accordingly interest expense will no longer be recorded.
32
<PAGE>
(8) MANDATORILY REDEEMABLE PREFERRED STOCK
Prior to completion of the Company's initial public offering in December 1998,
the Company had issued and outstanding 12,091,962 shares of mandatorily
redeemable preferred stock. The holders of the Series A, B, C, D, and E
mandatorily redeemable preferred stock had certain rights and preferences,
including those involving dividend participation, special voting, liquidation
preferences, antidilution rights, redemption rights and in certain cases, those
involving cumulative dividends.
In November 1998, the Company adjusted the conversion price of the Series E
Mandatorily Redeemable Preferred Stock from $8.82 per share to $8.20. The
adjustment was made in accordance with the Series E Stock Purchase Agreement and
was effective on the closing of the Company's initial public offering. The
adjustment resulted in the issuance of an additional 77,155 shares of common
stock upon conversion. For purposes of calculating net income (loss) per share
in the period in which the initial public offering is completed, net income
available to common shareholders has been reduced by $1,312,000 for the
estimated value of additional shares issued under these antidilution provisions
(note 11).
Upon completion of the Company's initial public offering in December 1998, the
Series A, B, C, D, and E mandatorily redeemable preferred stock converted into
an aggregate of 12,332,364 shares of common stock. In addition, all rights and
preferences, including those involving cumulative dividends expired. Cumulative
but undeclared and unpaid dividends have been deducted from net income available
to common shareholders in determining net income (loss) per share (note 11).
As of January 2, 1999, there were no remaining shares of mandatory redeemable
shares outstanding. The following summarizes mandatorily redeemable preferred
stock as of January 3, 1998 (in thousands):
<TABLE>
<CAPTION>
ADDITIONAL
PAR VALUE PAID-IN CAPITAL
<S> <C> <C>
Series A, $1.00 par value; 4,458,852
shares authorized, issued, and outstanding $4,459 $ -
Series B, $1.25 par value; 2,400,000
shares authorized, issued, and outstanding 3,000 -
Series C, $1.00 par value; 2,292,635
shares authorized, issued, and outstanding 2,293 2,972
Series D, $1.00 par value; 2,083,332
shares authorized, issued, and outstanding 2,083 3,862
Series E, $1.00 par value; 888,571
shares authorized and 857,143 shares
issued and outstanding 857 8,086
..........................................................................
Total mandatorily redeemable preferred stock $12,692 $14,920
--------------------------------------------------------------------------
</TABLE>
Changes in mandatorily redeemable preferred stock are as follows (dollars in
thousands):
<TABLE>
<CAPTION>
ADDITIONAL
PAID-IN
SHARES AMOUNT CAPITAL TOTAL
<S> <C> <C> <C> <C>
Balance at December 28,
1996 and January 3, 1998 12,091,962 $12,692 $14,920 $27,612
Conversion to common stock (12,091,962) (12,692) (14,920) (27,612)
..........................................................................
Balance at January 2, 1999 - $ - $ - $ -
--------------------------------------------------------------------------
</TABLE>
33
<PAGE>
(9) SHAREHOLDERS' EQUITY
Effective December 3, 1998, the Company issued 2,922,350 shares of common stock
in completion of its initial public offering resulting in net proceeds of
$46,702,000.
STOCK OPTIONS
The Board of Directors has reserved 5,300,000 shares of common stock for options
that may be granted to key employees, directors, or others under the Company's
stock option plans.
A summary of the changes in the Company's stock option plans for each of the
years in the three year-period ended January 2, 1999 is as follows:
<TABLE>
<CAPTION>
AVERAGE
EXERCISE
SHARES PRICE
<S> <C> <C>
Outstanding at December 30, 1995
(including 947,193 shares exercisable) 1,635,183 $1.59
Granted 443,850 5.25
Exercised (260,338) 1.09
Canceled (139,522) 2.29
..........................................................................
Outstanding at December 28, 1996
(including 1,105,468 shares exercisable) 1,679,173 2.58
Granted 1,073,750 6.20
Exercised (630,514) 0.70
Canceled (26,800) 4.29
..........................................................................
Outstanding at January 3, 1998
(including 931,319 shares exercisable) 2,095,609 4.98
Granted 443,075 14.70
Exercised (526,880) 3.18
Canceled (208,070) 5.82
..........................................................................
Outstanding at January 2, 1999
(including 884,807 shares exercisable) 1,803,734 $7.77
--------------------------------------------------------------------------
--------------------------------------------------------------------------
</TABLE>
The following table summarizes information about options outstanding at January
2, 1999:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------- -------------------
AVERAGE
RANGE OF REMAINING AVERAGE AVERAGE
EXERCISE CONTRACTUAL LIFE EXERCISE EXERCISE
PRICE SHARES (YEARS) PRICE SHARES PRICE
<S> <C> <C> <C> <C> <C>
$ 0.45 - 1.00 81,678 5.62 $0.90 81,678 $0.90
4.80 - 6.50 1,100,573 7.73 5.26 634,866 5.22
7.50 - 11.00 352,075 9.02 10.24 158,469 10.02
14.00 - 17.00 269,408 9.86 16.92 9,794 16.36
................................................................................................
$ 0.45 - 17.00 1,803,734 8.21 $7.77 884,807 $5.80
- ------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------
</TABLE>
34
<PAGE>
(9) SHAREHOLDERS' EQUITY (CONTINUED)
No compensation cost has been recognized in the consolidated financial
statements for employee stock option grants. Had the Company determined
compensation cost based on the fair value at the grant date for its stock
options under an alternative accounting method, the Company's net income
(loss) would have been adjusted as indicated below (in thousands):
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Net income (loss): As reported $5,195 $(2,846) $(3,685)
Pro forma $4,144 $(3,563) $(4,253)
</TABLE>
The fair value of each option grant is estimated on the date of grant using the
Black-Sholes option-pricing model with the following assumptions: expected
dividend yield-0%; expected stock price volatility-40%; risk-free interest
rate-4.6% for 1998, and 6.4% for 1997 and 1996; expected life of options-3.0
years, 4.2 years, 3.0 years for 1998, 1997, 1996, respectively. The per share
weighted-average fair value of stock options granted during 1998, 1997, 1996 was
$4.72, $1.92, $2.03, respectively.
WARRANTS
In April 1996, the Company issued warrants to the holders of Series E preferred
stock (note 8) to purchase an aggregate of 171,429 shares of common stock at an
exercise price of $5.25 per share. During 1998, warrants for 54,430 shares of
common stock were exercised. Warrants for 116,999 shares remained outstanding at
January 2, 1999.
In connection with a capital lease transaction with a vendor in 1997, the
Company granted the vendor warrants to acquire 31,428 shares of the Company's
Series E convertible preferred stock at a purchase price of $10.50 per share.
The warrants are exercisable for five years beginning December 3, 1998. In
December 1998, the Preferred Stock warrants were converted into warrants
exercisable into 40,243 shares of common stock at $8.20 per share.
In connection with short-term debt issued to related parties in 1996, the
Company granted warrants to purchase 71,525 shares of the Company's common stock
at a purchase price of $5.25 per share. The warrants are exercisable for ten
years from the grant date. During December 1998, warrants for 7,003 shares of
common stock were exercised. Warrants for 64,522 shares remained outstanding at
January 2, 1999.
35
<PAGE>
(10) INCOME TAXES
The provision (benefit) for income taxes consists of the following (in
thousands):
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Current:
Federal $2,969 $125 $ -
State 687 16 -
...............................................................................
3,656 141
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
Deferred:
Federal (5,803) - -
State (85) - -
...............................................................................
(5,888) - -
-------------------------------------------------------------------------------
Income tax expense (benefit) $(2,232) $141 $ -
-------------------------------------------------------------------------------
-------------------------------------------------------------------------------
</TABLE>
Effective tax rates differ from statutory federal income tax rates as follows:
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Statutory federal income tax rate 35.0% (34.0)% (34.0)%
Nondeductible interest expense, put warrants 44.7 40.8 0.0
Change in valuation allowance (147.0) (2.7) 33.0
Effect of change in tax rate on deferred tax asset 6.7 0.0 8.6
State income taxes, net of federal benefit 8.9 0.4 (4.0)
General business credits 0.0 0.0 (2.6)
Other 1.0 0.7 (1.0)
............................................................................................
(50.7) 5.2 % 0.0 %
- --------------------------------------------------------------------------------------------
</TABLE>
The tax effects of temporary differences that give rise to deferred tax assets
at January 2, 1999 and January 3, 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997
<S> <C> <C>
Deferred tax assets:
Current:
Inventory, warranty, and returns reserves $4,371 $3,361
Allowance for doubtful accounts 117 722
Other 960 214
Long term:
Net operating loss carryforwards 602 2,842
Other 361 344
.............................................................................
Total gross deferred tax assets 6,411 7,483
Valuation allowance (523) (7,483)
.............................................................................
Total net deferred tax assets $5,888 $ -
-----------------------------------------------------------------------------
</TABLE>
In 1998 the Company reduced the valuation allowance applied against the deferred
tax assets by $6.9 million based upon tax planning strategies and future income
projections.
At January 2, 1999, the Company had net operating loss carryforwards for federal
income tax purposes of approximately $1,600,000 expiring between the years 2003
and 2006. The Company expects that approximately $1,400,000 of these
carryforwards will expire unutilized due to an Internal Revenue Code (IRC)
Section 382 limitation resulting from a prior ownership change.
36
<PAGE>
(11) NET INCOME (LOSS) PER COMMON SHARE
The following computations reconcile net income (loss) with net income (loss)
per common share-basic and diluted (dollars in thousands, except per share
amounts).
<TABLE>
<CAPTION>
NET PER SHARE
1998 LOSS SHARES AMOUNT
<S> <C> <C> <C>
Net income before extraordinary item $ 6,636 -
Less: Deemed dividend from revision
of preferred stock (1,312) -
Cumulative preferred dividends (821) -
...............................................................................
BASIC EPS
Net income available to
common shareholders $4,503 4,114,219 $1.09
...............................................................................
EFFECT OF DILUTIVE SECURITIES
Options - 912,448
Warrants - 654,436
Convertible preferred stock - 10,247,143
...............................................................................
DILUTED EPS
Net income available to common
shareholders plus assumed conversion $4,503 15,928,246 $0.28
------------------------------------------------------------------------------
<CAPTION>
NET PER SHARE
1997 LOSS SHARES AMOUNT
<S> <C> <C> <C>
Net loss $(2,846)
Less cumulative preferred dividends (900) -
...............................................................................
BASIC AND DILUTED EPS
Net loss available to
common shareholders $(3,746) 2,352,947 $(1.59)
------------------------------------------------------------------------------
<CAPTION>
NET PER SHARE
1996 LOSS SHARES AMOUNT
<S> <C> <C> <C>
Net loss $(3,685)
Less cumulative preferred dividends (900) -
...............................................................................
BASIC AND DILUTED EPS
Net loss available to
common shareholders $(4,585) 1,753,484 $(2.61)
------------------------------------------------------------------------------
</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>
1998 1997 1996
<S> <C> <C> <C>
Options - 1,679,173 2,095,609
Common stock warrants - 154,023 2,342,954
Preferred stock warrants - 31,428 31,428
Convertible preferred stock - 12,091,962 12,091,962
</TABLE>
Convertible preferred stock and preferred stock warrants were convertible into
12,292,623 shares of common stock during 1997 and 1996.
37
<PAGE>
(12) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Total cash paid for interest during 1998, 1997, and 1996 was $1,719,000,
$1,598,000 and $44,000 respectively. Income tax payments during 1998 and 1997
totaled $1,800,000 and $16,000, respectively. There were no cash payments for
income taxes during 1996.
Exercises of common stock options and warrants in the Consolidated Statement of
Shareholders' Equity includes a cashless exercise of $2,035,000 and tax benefits
related to stock option exercises totaling $552,000 in 1998.
(13) EMPLOYEE BENEFIT PLANS
Effective January 1, 1994, the Company adopted a profit sharing and 401(k) plan
for eligible employees. The plan allows employees to defer up to 15% of their
compensation on a pretax basis. Each year, the Company may make a discretionary
contribution equal to a percentage of the employee's contribution. During 1998
and 1997, the Company expensed $375,000 and $78,000, respectively, relating to
its contribution to the 401(k) plan. The Company did not make a contribution for
1996.
(14) RELATED PARTY TRANSACTIONS
At December 28, 1996, the Company had a $50,000 note receivable due from a
former director and executive officer of the Company. The note plus interest at
6% per annum was due on August 31, 1997. On February 20, 1997, the former
director and executive officer signed a promissory note for $387,000, which
replaced the $50,000 note receivable. The note, with interest at 9.25% per
annum, is due and payable to the Company on the earlier of (1) six months
following the completion of an initial public offering of the Company's
securities, or (2) April 30, 1999. The full recourse note is secured by a pledge
of 150,000 shares of the Company's common stock. In April 1998, the former
director and executive officer borrowed an additional $425,000 from the Company
under the same terms as the February 1997 note. On December 10, 1998 the former
director and executive officer repaid the outstanding balance of the notes.
(15) COMMITMENTS AND CONTINGENCIES
The Company is a party to 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 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.
(16) SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a condensed summary of actual quarterly results for 1998 and
1997:
<TABLE>
<CAPTION>
1998 Fourth Third Second First
<S> <C> <C> <C> <C>
Net sales $67,434 $60,034 $60,129 $58,672
Gross margin 44,537 39,291 39,663 37,591
Operating income 4,083 2,679 3,666 1,037
Net income (loss) before
extraordinary item 7,047 (1,903) 1,910 (418)
Net income (loss) 5,606 (1,903) 1,910 (418)
Net income (loss) per share
before extraordinary
item - diluted 0.32 (0.72) 0.11 (0.26)
Net income (loss) per
share - diluted 0.24 (0.72) 0.11 (0.26)
<CAPTION>
1997 Fourth Third Second First
<S> <C> <C> <C> <C>
Net sales $57,961 $44,391 $46,074 $36,004
Gross margin 36,218 28,502 29,917 23,164
Operating income (loss) 1,563 (742) 3,081 (1,824)
Net income (loss) before
extraordinary item (319) (1,916) 1,295 (1,906)
Net income (loss) (319) (1,916) 1,295 (1,906)
Net income (loss) per share
before extraordinary
item - diluted (0.22) (0.88) 0.07 (1.02)
Net income (loss) per
share - diluted (0.22) (0.88) 0.07 (1.02)
</TABLE>
COMMON STOCK
Select Comfort's common stock trades on the Nasdaq Stock Market-Registered
Trademark- under the symbol AIRB, since the Company's initial public offering
on December 3, 1998. The high and low closing prices for the Company's common
stock, as reported by the Nasdaq Stock Market-Registered Trademark-, for the
period from December 3, 1998 to January 2, 1999 was $29.19 and $19.63
respectively. The foregoing prices reflect inter-dealer prices, without
retail mark-up, mark-down or commission, and may not necessarily represent
actual transactions. Select Comfort has never paid any cash dividends on its
common stock and does not anticipate paying any cash dividends on its common
stock in the foreseeable future.
38
<PAGE>
Exhibit 23.1
Independent Auditors' Consent
The Board of Directors
Select Comfort Corporation:
We consent to incorporation by reference in the registration statement on
Form S-8 (No. 333-70493) of Select Comfort Corporation, of our reports dated
January 22, 1999 relating to the consolidated balance sheets of Select
Comfort Corporation and subsidiaries, as of January 2, 1999 and January 3,
1998, and the related consolidated statements of operations, stockholders'
equity and cash flows and the related financial statement schedule for each
of the years in the three-year period ended January 2, 1999, which reports
appear in the January 2, 1999, Annual Report on Form 10-K of Select Comfort
Corporation, which is incorporated by reference in the registration statement.
/s/ KPMG Peat Marwick LLP
Minneapolis, Minnesota
March 31, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C> <C> <C>
<PERIOD-TYPE> 12-MOS 12-MOS 12-MOS
<FISCAL-YEAR-END> JAN-02-1999 JAN-03-1998 DEC-28-1996
<PERIOD-START> JAN-04-1998 DEC-29-1996 DEC-31-1995
<PERIOD-END> JAN-02-1999 JAN-03-1998 DEC-28-1996
<CASH> 45,561 12,670 0
<SECURITIES> 0 0 0
<RECEIVABLES> 13,374 7,862 0
<ALLOWANCES> 2,750 1,901 0
<INVENTORY> 10,136 7,749 0
<CURRENT-ASSETS> 75,817 30,636 0
<PP&E> 40,963 32,151 0
<DEPRECIATION> 11,838 6,968 0
<TOTAL-ASSETS> 106,234 57,201 0
<CURRENT-LIABILITIES> 33,568 29,879 0
<BONDS> 0 0 0
0 27,612 0
0 0 0
<COMMON> 184 25 0
<OTHER-SE> 70,507 21,063 0
<TOTAL-LIABILITY-AND-EQUITY> 106,234 57,201 0
<SALES> 246,269 184,430 102,028
<TOTAL-REVENUES> 246,269 184,430 102,028
<CGS> 85,187 66,629 38,521
<TOTAL-COSTS> 85,187 66,629 38,521
<OTHER-EXPENSES> 52 231 77
<LOSS-PROVISION> 2,794 2,101 63
<INTEREST-EXPENSE> 7,834 5,234 88
<INCOME-PRETAX> 4,404 (2,705) (3,685)
<INCOME-TAX> (2,232) 141 0
<INCOME-CONTINUING> 6,636 (2,846) (3,685)
<DISCONTINUED> 0 0 0
<EXTRAORDINARY> (1,441) 0 0
<CHANGES> 0 0 0
<NET-INCOME> 5,195 (2,846) (3,685)
<EPS-PRIMARY> .74 (1.59) (2.61)
<EPS-DILUTED> .19 (1.59) (2.61)
</TABLE>
