10-K 1 scss_10kxfy12.htm 10-K SCSS_10K_FY12

 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
(Mark one)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 29, 2012
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________.
Commission File No. 0-25121
 

SELECT COMFORT CORPORATION
(Exact name of registrant as specified in its charter)
MINNESOTA
 
41-1597886
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
9800 59th Avenue North
 
 
Minneapolis, Minnesota
 
55442
(Address of principal executive offices)
 
(Zip Code)
Registrant's telephone number, including area code: (763) 551-7000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
 
Name of each exchange on which registered
Common Stock, par value $.01 per share
 
The NASDAQ Stock Market LLC
 
 
(NASDAQ Global Select Market)
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act. YES ý NO o
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o   NO ý
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 ý   NO o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ý NO o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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. ý
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
 
 
Accelerated filer o
Non-accelerated filer
o
(Do not check if a smaller reporting company)
 
Smaller reporting company o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO ý
The aggregate market value of the common equity held by non-affiliates of the Registrant as of June 30, 2012, was $741,776,000 (based on the last reported sale price of the Registrant’s common stock on that date as reported by NASDAQ).
As of January 26, 2013, there were 55,795,000 shares of the Registrant’s Common Stock outstanding.
 
 



DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement to be furnished to shareholders in connection with its 2013 Annual Meeting of Shareholders are incorporated by reference in Part III, Items 10-14 of this Annual Report on Form 10-K.

As used in this Form 10-K, the terms “we,” “us,” “our,” the “Company,” and “Select Comfort” mean Select Comfort Corporation and its subsidiaries and the term “common stock” means our common stock, par value $0.01 per share.

As used in this Form 10-K, the term “bedding” includes mattresses, box springs and foundations and does not include bedding accessories, such as sheets, pillows, headboards, frames, mattress pads and related products.

Select Comfort®, Sleep Number®, Comfort Club®, Sleep Better on Air®, Select Comfort (logo with double arrow design)®, Firmness Control System™, Precision Comfort®, Corner Lock™, Intralux®, You can only find your Sleep Number® setting on a Sleep Number Bed by Select Comfort™, Select Comfort Creator of the Sleep Number Bed®, What’s Your Sleep Number®?, Grand King®, Personalized Warmth Collection, GridZone®, It’s the Bed that Counts®, Luxlayer®, Pillow[ology]®, Take Control of Your Sleep®, Changing the way you sleep could change your life®, ComfortFit®, IndividualFit®, PillowFit®, Sleep Number® Inner Circle™, AirFit™, DualAir Technology Inside™ (logo with double arrow design), Dual Loft®, Personal Preference®, Personal Renewal® and our stylized logos are trademarks and/or service marks of Select Comfort. This Form 10-K may also contain trademarks, trade names and service marks that are owned by other persons or entities.

Our fiscal year ends on the Saturday closest to December 31, and, unless the context otherwise requires, all references to years in this Form 10-K refer to our fiscal years. Our fiscal year is based on a 52- or 53-week year. All years presented in this Form 10-K are 52 weeks, except for the 2008 fiscal year ended January 3, 2009, which is a 53-week year.
 
 











































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TABLE OF CONTENTS

PART I
 
 
 
 
 
Item 1.
 
 
 
 
 
Item 1A.
 
 
 
 
 
Item 1B.
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
PART II
 
 
 
 
 
Item 5.
 
 
 
 
 
Item 6.
 
 
 
 
 
Item 7.
 
 
 
 
 
Item 7A.
 
 
 
 
 
Item 8.
 
 
 
 
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
 
 
 
 
Item 9A.
 
 
 
 
 
Item 9B.
 
 
 
 
PART III
 
 
 
 
 
Item 10.
 
 
 
 
 
Item 11.
 
 
 
 
 
Item 12.
 
 
 
 
 
Item 13.
 
 
 
 
 
Item 14.
 
 
 
 
PART IV
 
 
 
 
 
Item 15.

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PART I

This Annual Report on Form 10-K contains or incorporates by reference certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. For this purpose, any statements contained in or incorporated by reference into this Annual Report on Form 10-K that are not statements of historical fact may be deemed to be forward-looking statements, including but not limited to projections of revenues, results of operations, financial condition or other financial items; any statements of plans, strategies and objectives of management for future operations; any statements regarding proposed new products, services or developments; any statements regarding future economic conditions, prospects or performance; statements of belief and any statement or assumptions underlying any of the foregoing. In addition, we or others on our behalf may make forward-looking statements from time to time in oral presentations, including telephone conferences and/or Web casts open to the public, in press releases or reports, on our Internet Web site or otherwise. We try to identify forward-looking statements in this report and elsewhere by using words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms.

Our forward-looking statements speak only as of the date made and by their nature involve substantial risks and uncertainties. Our actual results may differ materially depending on a variety of factors, including the items discussed in greater detail below under the caption “Risk Factors.” These risks and uncertainties are not exclusive and further information concerning the Company and our business, including factors that potentially could materially affect our financial results or condition, may emerge from time to time, including factors that we may consider immaterial or do not anticipate at this time.

We wish to caution readers not to place undue reliance on any forward-looking statement and to recognize that forward-looking statements are predictions of future results, which may not occur as anticipated. We assume no obligation to update forward-looking statements to reflect actual results or changes in factors or assumptions affecting such forward-looking statements. We advise you, however, to review and consider any further disclosures we make on related subjects in our quarterly reports on Form 10-Q and current reports on Form 8-K that we file with or furnish to the Securities and Exchange Commission.

ITEM 1. BUSINESS

Our Business

Overview

Select Comfort Corporation, based in Minneapolis, Minnesota, was founded in 1987. We believe that we are leading the industry in delivering an unparalleled sleep experience. We offer consumers high-quality, innovative and individualized sleep solutions and services, which include a complete line of SLEEP NUMBER® beds and bedding.

The Company is the exclusive manufacturer, marketer, retailer and servicer of the revolutionary Sleep Number bed, which allows individuals to adjust the firmness and support on each side at the touch of a button. We offer further individualization through a solutions-focused line of Sleep Number pillows, sheets and other bedding products.

Select Comfort has evolved from a specialty, niche direct marketer, to a nationwide vertically integrated business model that includes manufacturing, retail and service with fiscal 2012 net sales of $935 million. As the only national specialty-mattress retailer, consumers can take advantage of an enhanced mattress-buying experience at one of more than 400 SLEEP NUMBER® retail stores across the country, online at www.SleepNumber.com, or via phone through our direct sales number at 1-888-411-2188.

In 1998, Select Comfort became a publicly traded company and is listed on The NASDAQ Stock Market LLC (NASDAQ Global Select Market) under the symbol “SCSS.” When used herein, the terms “Select Comfort,” “Company,” “we,” “us” and “our” refer to Select Comfort Corporation, including consolidated subsidiaries.

Management Transition
 
On February 27, 2012, we announced that William R. McLaughlin, then President and Chief Executive Officer and a member of the Board of Directors of Select Comfort, would retire from Select Comfort effective June 1, 2012. We also announced that Shelly R. Ibach would succeed Mr. McLaughlin as President and Chief Executive Officer, effective June 1, 2012. The Board also elected Ms. Ibach as a Director, effective immediately, for an initial term expiring at our 2013 annual meeting of shareholders.



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Mission, Vision and Goals

Our mission is to improve lives by Individualizing Sleep Experiences.

Our vision is to become the world's most beloved brand by delivering an Unparalleled Sleep Experience. We plan to achieve this by executing our integrated growth formula, advancing our long-term goals and building on our competitive advantages.

We are executing against a defined set of goals:
Everyone will know Sleep Number and how it will improve their life;
Innovative Sleep Number products will move society forward with meaningful consumer benefits;
Sleep Number will be easy to find and customers will interact with us when and how they want;
Customers will love their Sleep Number experience and enthusiastically recommend Sleep Number to their family and friends; and
Leveraging our unique business model to fund innovation and growth will benefit our customers, employees and shareholders.

Customer-Focused Strategy

Our overall customer-focused strategy is to create a differentiated, proprietary, end-to-end Sleep Number experience that meaningfully improves our customers' lives. As the only major mattress brand that is both a manufacturer and a multi-channel retailer, we have the opportunity to know our customers and the capability to innovate across all touch points for their benefit. Between our consumer-insight research, the thousands of direct conversations we have with customers, and our real-time voice-of-the-customer tools, we are able to anticipate the needs of our customers, exceed their expectations and improve their lives with an individualized sleep experience.

Competitive Advantages

Differentiated, Proprietary Products

Sleep Number Bed

Unlike the “one-size-fits-all” solution offered by other mattress brands, the Sleep Number bed offers individualized comfort that is adjustable on each side. Our proprietary DualAir technology, which features two independent air chambers, allows couples to adjust firmness to their own individual preference at the touch of a button.

The unique benefits of our proprietary Sleep Number bed have been validated through clinical sleep research which has shown that people who sleep on a Sleep Number bed generally fall asleep faster, experience deeper sleep with fewer disturbances and experience greater relief from back pain than those sleeping on a traditional innerspring mattress.

We offer Sleep Number beds in good, better and best series to fit all budgets, with queen size mattresses starting at $699. 
The Classic Series launched a sleep revolution with personal adjustability at an affordable price. The series includes the Sleep Number c2, c3 and c4 beds.
The Performance Series includes our most popular beds, featuring enhanced performance, comfort and a great value. The series includes the Sleep Number p5 and p6 beds.
The Innovation Series is the premier experience in personalized comfort combined with leading-edge innovations in sleep technology. The series includes the Sleep Number i8 and i10 beds.
In 2012, memory foam found its better half with the introduction of the Sleep Number Memory Foam Series. Combining cradling memory foam with exclusive DualAir technology, the series includes the Sleep Number m7 bed that cools, contours and adjusts on each side, and the supremely soft and breathable Sleep Number m9 bed.

The Sleep Number bed series are available through our U.S. Company-Controlled and Wholesale distribution channels. Each bed series comes in standard mattress sizes, ranging from twin to king, as well as some specialty mattress sizes. Our bed series vary in features, functionality and price. As you move up the line, the Sleep Number bed series offer enhanced features and benefits, including higher quality fabrics, additional cushion and padding, higher overall mattress profiles, Firmness Control Systems™ with additional functions, and temperature balancing fabrics.


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The contouring support of our Sleep Number beds is optimized when used with our specially designed, proprietary modular base. This durable base, used in place of a box spring, is a modular design that can be disassembled and easily moved through staircases, hallways and other tight spaces.

Our U.S. mattress price points range from approximately $699 for the entry-level c2 queen-size mattress to $4,399 for the luxurious Sleep Number i10 queen-size mattress. Our most popular model is the p5 queen-size mattress, which sells for approximately $1,799. Actual prices are at times lower than those quoted due to promotional offerings.

Our unique product design allows us to ship our beds in a modular format to customers throughout the U.S. by United Parcel Service (“UPS”). For an additional fee, customers can take advantage of our Sleep Number® Comfort ServiceSM Home Delivery & Setup, which includes bed assembly and optional mattress removal services.

Each of our Sleep Number beds (not including our FlexFit Adjustable Bases) comes with a 30 night in-home trial and better night's sleep guarantee, which allows customers 30 nights at home to make sure they are completely satisfied with the bed. The customer is responsible for the return shipping costs. Independent durability testing has shown our Sleep Number beds can withstand more than 20 years of simulated use, and each of our Sleep Number beds is backed by our 20-year limited warranty.

Sleep Number Bedding Collection

Like our Sleep Number beds, our exclusive Sleep Number® Bedding Collection offers a proprietary line of products to meet each individual's needs. Our sales professionals have the expertise to guide our customers to sleep solutions that are just right for them. From the way their pillow fits, to the weight of their comforter, we offer the latest innovations. We also offer a number of products that allow for unique individualization, including Create your Perfect PillowSM and Create your Perfect ComforterSM.

In 2011, we introduced a pillow that's distinctively Sleep Number. Our exclusive AirFit Pillow adjusts to an individual's size, shape and sleeping position for more comfortable sleep. The pillow is available in our exclusive CoolFit Foam, memory fiber or white goose down.

Adjustable Bases/FlexFit

In 2003, we completed the roll-out of our Precision Comfort® adjustable base to all of our retail stores. The adjustable base enables customers to raise the head or foot of the bed, and to experience the comfort of massage, using a handheld remote control. In 2010, we updated the Precision Comfort name to FlexFit Plus and introduced a value option – FlexFit. Our FlexFit adjustable bases provide customers with an ideal upgrade for their Sleep Number bed, offering them a fully adjustable sleep experience.

Vertical Integration

Our vertically integrated business model allows us to control all expressions of the brand, including pricing, and execute innovations on behalf of our customers for product and service, as well as the unique opportunity to establish lifelong relationships with our customers through engagement.

As the manufacturer, retailer and servicer of the Sleep Number bed, we maintain exclusive national distribution of our products through our Company-Controlled distribution channel (Retail, Direct Marketing and E-Commerce). Our exclusive distribution channel ensures our customers fully experience our unique brand and receive extraordinary end-to-end customer service, while enabling us to control price points.

The modular design of our Sleep Number bed allows a just-in-time, build-to-order production process which requires minimal inventory in our manufacturing plants and retail stores, resulting in reduced working capital requirements. Our build-to-order production process also enables our retail stores to serve primarily as showrooms, without requiring significant product storage capacity, and provides us significant flexibility in changing our product models.

Extraordinary Retail Experience

As the only national specialty mattress retailer, Sleep Number stores provide a unique, elevated, relationship-based selling experience to deliver products that best fit customers' needs.


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The Sleep Number store is the sixth most productive retailer (based on sales per square foot) behind Apple Stores, Tiffany & Co., lululemon athletica, Coach and Michael Kors (source "retailsails.com"). We've created a consumer-centric, interactive shopping environment. A visually appealing storefront, a floor plan with a comfortable, residential feel, and the opportunity to find your Sleep Number setting with the help of a Sleep Professional establishes an emotional connection and sets the foundation for a lifelong relationship.

Controlling the selling process enables us to ensure that the unique benefits of our products are effectively communicated to customers. Our direct-to-consumer business model enables us to understand and respond quickly to consumer trends and preferences. Our multiple touch points of service include sales, delivery and post-sales service, which provide several opportunities to communicate with our customers, reinforcing the sale.

Growth Formula

Our integrated growth formula focuses on the following:
Increase awareness for both brand and stores
Develop local markets
Robust product and service innovation

We generated positive net income for six consecutive years from 2002 through 2007. In 2008 our operating results were significantly affected by a decrease in consumer spending, and we generated a net loss. In 2009, 2010, 2011 and 2012, we generated operating income of $20.7 million, $52.4 million, $90.5 million and $119.8 million, respectively. As of December 29, 2012, cash, cash equivalents and marketable debt securities totaled $178 million, compared with $146 million at December 31, 2011, and we had no borrowings under our revolving credit facility.

The expansion of profitability over the last four years has been driven by the combination of executing our integrated growth formula and employing continued operational efficiency. As we enter 2013, we plan to build on the learnings of recent years, targeting efficient sales gains and reinvesting in the business to drive sales and profit growth, while maintaining expense controls to expand operating margins.

Increase Awareness

Our most significant opportunity continues to be building brand awareness. We utilize a media mix that includes television, radio, print and digital advertising in support of our Sleep Number marketing campaign. During 2012, our national unaided brand awareness increased from 15% to 21%. While 21% is a historical high for us, we remain well below key competitors and will continue to focus on building brand awareness in 2013.

Historically, we've focused on a narrow consumer segment; in 2011, we redefined our target consumer, quadrupling our addressable market; our redefined target is more affluent, younger and health-focused and includes consumers during their prime mattress-buying years. We are focused on deeply knowing our new target customer and what she values, and how to better reach her so she understands how Sleep Number can uniquely improve her life.

Develop Local Markets

As of December 29, 2012, we had 410 retail stores in the U.S., and expect to end 2013 with between 435 and 445 retail stores. We are taking both a national and local market-based approach to our growth – increasing our national advertising and focusing on local marketing, real estate optimization and sales execution. We believe that through marketing and sales execution, we can continue to increase average sales per store to further leverage the profitability of our fixed cost store base. Beyond 2013, we plan to continue expanding our retail store base by 5-8% per year through 2015 to drive sales and profit growth.

Historically, our retail stores have been located in shopping malls. In 2010, we began operating in non-mall locations to help build store and brand awareness. As of December 29, 2012, 19% of our stores were in non-mall locations. The non-mall store format is typically located in highly visible, well-traveled locations and is intended to complement our existing mall-based stores. The non-mall design allows us to increase store square footage and provides a more differentiated, interactive customer experience.


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Robust Product and Service Innovation

In 2001, we created the Sleep Number brand and developed a branding strategy that allows our marketing communications to focus on the bed's distinguishing and proprietary features – adjustable firmness and support for individualized comfort. Since then, the brand has evolved to include a collection of innovations that make up the complete Sleep Number experience:
The Sleep Number bed with DualAir technology allows customers to adjust to the support their bodies need on each side of the bed.
The IndividualFit® 3-D imaging process lets customers see and feel how the bed adjusts to the exact comfort their bodies need.
The exclusive Sleep Number bedding collection's innovative solutions are dedicated to individualizing each sleep experience. In 2011, we introduced our exclusive AirFit Pillow that adjusts to an individual's size, shape and sleeping position for more comfortable sleep.
In 2012, memory foam found its better half with the introduction of the Sleep Number Memory Foam Series. Combining cradling memory foam with exclusive DualAir technology, the series includes the Sleep Number m7 bed that cools, contours and adjusts on each side, and the supremely soft and breathable Sleep Number m9 bed.

Exclusive Sales Distribution

Unlike traditional mattress manufacturers, which primarily sell through third-party retailers, over 96% of our net sales are through our Company-Controlled distribution channel (Retail, Direct Marketing and E-Commerce).

Our retail stores accounted for 89% of our net sales in 2012. Average annual net sales per store were $2,164,000 in 2012 versus $1,721,000 in 2011, $1,295,000 in 2010, $1,046,000 in 2009 and $984,000 in 2008, with average annual sales per square foot of $1,324 in 2012 versus $1,135 in 2011, $873 in 2010, $710 in 2009 and $703 in 2008. In 2012, 98% of our stores open for a full year generated net sales of over $1,000,000 and 49% of our stores open for a full year generated net sales over $2,000,000.

Our direct marketing call center and E-Commerce website provide national sales coverage, including markets not yet served by one of our retail stores, and accounted for 8% of our net sales in 2012. In addition, they provide a cost-effective way to market our products, are a source of information on our products and refer customers to our stores if there is one near the customer.

Beginning in 2002, we supplemented our sales through semi-exclusive relationships with selected home furnishing retailers and specialty bedding retailers. In August 2009, we discontinued distribution through non-company-controlled mattress retailers in the contiguous United States. This change was part of our efforts to deliver an unparalleled sleep experience by controlling all brand touch points. This action did not have a significant impact on sales or profit in 2010, 2011 or 2012. At the end of 2012, our retail partner program included retail partners in Hawaii, Alaska and Australia.

Marketing and Advertising

In 2012, our goal was to drive awareness and consideration for Sleep Number as well as our retail stores. With this strategy in mind, we launched a national Sleep Number store experience television campaign. We leveraged local advertising and introduced an accelerated growth strategy to build consumer awareness in major markets. This multi-media campaign also included national radio, drive-time radio, newspaper ads, inserts and billboards.

Since the campaign was launched, consumers' unaided store awareness has increased by approximately 40%. The 2011 redesign of the Sleep Number website and an enhanced digital and social media strategy have also increased awareness and consideration of the Sleep Number brand and products. Our total media spending was approximately $127 million in 2012, $92 million in 2011 and $70 million in 2010.

Owners of Sleep Number beds purchased through our Company-Controlled channel are considered Insiders in our InnerCircleSM rewards program. The program is designed primarily to increase referrals and repeat purchases by strengthening our ongoing relationship with our Insiders. Each time a referred customer purchases a Sleep Number bed, the referring Insider receives a $100 coupon for purchase of our products, with increasing benefits for multiple referrals.
 
Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Money Bank. Approximately 38% of our net sales in 2012 were financed by GE Money Bank. Our current agreement with GE Money Bank expires February 15, 2016, subject to earlier termination upon certain events and subject to automatic extensions. We pay GE Money Bank a fee for extended credit promotional financing offers. Under the terms of our agreement, GE Money Bank sets the

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minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures. As the receivables are owned by GE Money Bank, at no time are the receivables purchased or acquired from us. We are not liable to GE Money Bank for our customers' credit defaults. In connection with all purchases financed under these arrangements, GE Money Bank pays us an amount equal to the total amount of such purchases, net of promotional related discounts, upon delivery to the customer. Customers that do not qualify for credit under our agreement with GE Money Bank may apply for credit under a secondary program that we offer through another provider.

Operations

Manufacturing and Distribution

We have two manufacturing plants (one in Irmo, South Carolina and the other in Salt Lake City, Utah) which distribute products in the U.S. and Canada. The manufacturing operations in South Carolina and Utah consist of quilting and sewing of the fabric covers for our beds, and final assembly and packaging of mattresses and bases. In addition, our electrical Firmness Control Systems are assembled in our Utah plant.

We manufacture beds primarily on a just-in-time basis to fulfill orders rather than stocking inventory, which enables us to maintain lower levels of finished goods inventory and operate with limited regional warehousing. Orders are shipped, typically within 48 hours following order receipt, from our manufacturing facilities via UPS or through our home delivery service. Products are usually received by the customer within five to 14 days from the date of order.

We obtain all of the raw materials and components used to produce our beds from outside sources. A number of components, including our proprietary air chambers, our proprietary blow-molded bases, and various components for our Firmness Control Systems, as well as fabrics and zippers, are sourced from suppliers who currently serve as our sole or primary source of supply for these components. We believe we can obtain these raw materials and components from other sources of supply, although we could experience some short-term disruption in our ability to fulfill orders in the event of an unexpected loss of supply from one of the primary suppliers. In 2005, we began identifying secondary sources in order to provide continuity of supply for various components. We will continue to utilize dual sourcing on targeted components when effective.

Our proprietary air chambers are produced to our specifications by an Eastern European supplier, which has been our primary source of supply of air chambers since 1994. Our agreement with this supplier runs through December 2013 and is thereafter subject to automatic annual renewal unless either party gives 365 days' notice of its intention not to renew the agreement. We expect to continue this supplier relationship for the foreseeable future.

Our proprietary blow-molded bases are produced to our specifications by a single domestic supplier under an agreement that expires in December 2015. We expect to continue this supplier relationship for the foreseeable future.

We have taken, and continue to take, various measures to mitigate the potential impact of an unexpected disruption in supply from any sole-source suppliers, including increasing safety stocks and identifying potential secondary sources of supply. All of the suppliers that produce unique or proprietary products for us have in place either contingency or disaster recovery plans or redundant production capabilities in other locations in order to safeguard against any unforeseen disasters. We review these plans and sites on a regular basis to ensure the supplier's ability to maintain an uninterrupted supply of materials and components.

Home Delivery Service

Sleep Number Comfort Service Home Delivery & Setup, which includes assembly and mattress removal, has contributed to improving the overall customer experience. Our home delivery technicians can effectively communicate the benefits of the bed, reinforcing the sales process and helping to ensure satisfied customers. In some markets on the East Coast, we provide home delivery, assembly and mattress removal services through a third-party provider. Approximately 72% of beds sold through our Company-Controlled channel in 2012 were delivered by our full-service home delivery team or by our third-party provider.

In 2003, we expanded the availability of our delivery, assembly and removal services to all of our retail markets. In 2007, we continued improving our home delivery efficiency and service by consolidating over 100 individually managed cross-dock distribution locations into a Hub and Spoke network organized around regional hubs. At the end of 2012, we operated 14 regional hubs.


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Customer Service

We maintain an in-house customer service department staffed by customer service specialists who receive training in sleep technology and all aspects of our products and operations. Our customer service specialists field customer calls and emails, “live chat,” and monitor social media. They also interact with each of our retail stores to address customer questions and concerns. Our customer service team is part of our total quality process, facilitating early identification of emerging trends or issues. They coordinate with engineering, sourcing, manufacturing, and our Six Sigma team to segment these issues, implement immediate solutions and provide inputs for long-term improvements to product and service design.

Research and Development

Our research and development team defines and develops long-term product technology platforms to support regular and meaningful new product introductions. They continuously seek to improve product performance and benefits based on sleep science. Through research, customer surveys and consumer focus groups, we seek feedback on a regular basis to enhance our products. Since the introduction of our first bed, we have continued to improve and expand our product line, including new bed models, quieter and higher quality Firmness Control Systems, wireless remote controls, more luxurious fabrics and covers, and new generations of foams and base systems. Our research and development expenses were $6.2 million in 2012, $4.2 million in 2011 and $2.1 million in 2010.

Information Systems

We use information technology systems to operate, analyze and manage our business, to reduce operating costs and to enhance our customers' experience. Our major systems include an in-store point of sale system, a retail portal system, in-bound and out-bound telecommunications systems for direct marketing, delivery scheduling, and customer service, E-Commerce systems, a data warehouse system and an enterprise resource planning system. These systems are comprised of both packaged applications licensed from various software vendors and internally developed programs. Our production data center is located in our corporate headquarters with redundant capabilities located off site.

Intellectual Property

We hold various U.S. and foreign patents and patent applications regarding certain elements of the design and function of our products, including air control systems, remote control systems, air chamber features, border wall and corner piece systems, foundation systems, as well as other technology. We have 23 issued U.S. patents, expiring at various dates between July 2014 and September 2028, and six U.S. patent applications pending. We also hold 33 foreign patents and have six foreign patent applications pending. Notwithstanding these patents and patent applications, we cannot ensure that these patent rights will provide substantial protection or that others will not be able to develop products that are similar to or competitive with our products. To our knowledge, no third party has asserted a claim against us alleging that any element of our product infringes or otherwise violates any intellectual property rights of any third party.

Select Comfort” and “Sleep Number” are trademarks registered with the U.S. Patent and Trademark Office. We have a number of other registered trademarks including the double arrow logo, “Select Comfort” with the double arrow logo, “Select Comfort Creator of the Sleep Number Bed” with the double arrow logo, “The Sleep Number Bed by Select Comfort” with the double arrow logo and “What's Your Sleep Number?” Several of these trademarks have been registered, or are the subject of pending applications, in various foreign countries. Each registered mark is renewable indefinitely as long as the mark remains in use. We are not aware of any material claims of infringement or other challenges asserted against us or our right to use these marks.

Industry and Competition

The U.S. bedding manufacturing industry is a mature and generally stable industry. According to the International Sleep Products Association (“ISPA”), since 1984 the industry has consistently demonstrated growth on a dollar basis, with a 0.3% decline in 2001, 9.1% decline in 2008 and 9.0% decline in 2009 being the only exceptions. According to ISPA, industry wholesale shipments of mattresses and foundations were estimated to be $7.1 billion in 2012 compared to $6.3 billion in 2011. We estimate that traditional innerspring mattresses represent approximately 70% of total U.S. bedding sales (based on 2011 sales). Furniture/Today, a furniture industry trade publication, has ranked Select Comfort as the fifth largest mattress manufacturer and third largest U.S. bedding retailer for 2011, with a 4.7% market share of industry revenue and 1.5% market share of industry units.


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Over the 5-year, 10-year and 20-year periods ended 2012, the value of U.S. wholesale bedding shipments increased at compound annual growth rates of 2.6%, 3.2% and 5.2%, respectively. We believe that industry unit growth has been primarily driven by population growth, an increase in the number of homes (including secondary residences) and the increased size of homes. We believe growth in average wholesale prices resulted from a shift to both larger and higher quality beds, which are typically more expensive.

The bedding industry is very competitive. Participants in the bedding industry compete primarily on price, quality, brand name recognition, product availability and product performance, including the perceived levels of comfort and support provided by a mattress. There is a high degree of concentration among the largest manufacturers of innerspring bedding with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand name, Serta and Simmons. Numerous other manufacturers, primarily operating on a regional or niche basis, serve the balance of the innerspring bedding market. Tempur-Pedic International, Inc., the fourth largest bedding manufacturer (based on 2011 sales), and a number of other mattress manufacturers, offer foam mattress products. Tempur-Pedic has announced its intentions in 2013 to acquire Sealy and to offer an air-supported mattress. Simmons and Sealy, as well as a number of smaller manufacturers, have offered air-bed products in the past. The bedding retailer business is also highly competitive. Our Company-Controlled distribution channel, which includes our retail stores, competes against regional and local specialty bedding retailers, home furnishing stores, mass merchants and national discount stores. We compete principally on the differentiation and quality of our products, customer service and value pricing.

Governmental Regulation and Environmental Matters

Our operations are subject to federal and state consumer protection and other regulations relating to the bedding industry. These regulations vary among the jurisdictions in which we do business, but generally impose requirements as to the proper labeling of bedding merchandise.
 
The bedding industry is subject to federal fire retardancy standards developed by the U.S. Consumer Product Safety Commission, which became effective nationwide in July 2007. Compliance with these requirements has increased the cost and complexity of manufacturing our products. These regulations also result in higher product development costs as new products must undergo rigorous flammability testing.
 
Federal regulations adopted in 2010 restrict the types of credit-based promotional offerings that retailers are allowed to make available to consumers.

Our direct marketing and internet-based marketing operations are or may become subject to various adopted or proposed federal and state “do not call” and “do not mail” list requirements, limiting our ability to market our products directly to consumers over the telephone, by e-mail or by regular mail.  Additionally, existing federal laws governing telephone and mail order sales may be extended to encompass all internet sales, imposing compliance obligations on the timing of shipments as well as provisions of refunds to consumers.

We are subject to emerging federal, state and foreign data privacy regulations related to the safeguarding of sensitive customer and employee data, which may drive increased costs in our information systems infrastructure.

We are subject to federal and state labor laws, including but not limited to laws relating to occupational health and safety, employee privacy, wages and hours, overtime pay, harassment and discrimination, equal opportunity, and employee leaves and benefits.

We are subject to federal and state laws and regulations relating to pollution and environmental protection. We may also be subject to similar laws in foreign jurisdictions if we expand our operations internationally.

Our retail pricing policies and practices are subject to antitrust regulations in the U.S., and we may become subject to similar laws in other jurisdictions where we may sell our products in the future.

We are or may become subject to various adopted or proposed federal and state laws and regulations relating to supply chain transparency with respect to the sourcing of conflict minerals and labor conditions maintained by suppliers, which may result in increased compliance costs and increased component costs.

Proposed legislation in various states would impose responsibilities with respect to end-of-life disposal of various consumer or durable goods on the manufacturers and/or retailers of such goods, including mattresses. To the extent that any such legislation becomes effective in the states in which we sell or have sold mattresses and related products, we may be required to incur significant costs and operational changes in order to comply with these requirements, which may adversely impact our profitability, cash flows and financial condition.

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Although we believe that we are in compliance in all material respects with these regulations and have implemented a variety of measures to promote continuing compliance, regulations may change over time, and we may be required to incur expenses and/or to modify our operations in order to ensure compliance with these regulations, which could harm our profitability and financial condition. If we are found to be in violation of any of the foregoing laws or regulations, we could become subject to fines, penalties, damages or other sanctions, as well as potential adverse public relations, which could adversely impact our business, reputation, sales, profitability and financial condition.

We are not aware of any national or local provisions which have been enacted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, that have materially affected, or will materially affect, our net income or competitive position, or will result in material capital expenditures. During fiscal 2012, there were no material capital expenditures for environmental control facilities, and no such material expenditures are anticipated.

Customers

No single customer accounts for 10% or more of our net sales.

Seasonality

Our business is modestly impacted by seasonal influences inherent in the U.S. bedding industry and general retail shopping patterns. The U.S. bedding industry generally experiences lower sales in the second quarter and increased sales during selected holiday or promotional periods.

Working Capital

Selling directly to our customers, with a primarily just-in-time, build-to-order production process in our plants, and with retail stores that serve mainly as showrooms, allows us to maintain low inventory levels and operate with minimal working capital requirements. We have historically generated sufficient cash flows to self-fund operations through an accelerated cash-conversion cycle. As of December 29, 2012, we had $20.0 million available under our $20.0 million credit facility which contains an accordion feature that allows us to increase the amount of the line up to $50.0 million in total availability, subject to lender approval.

Employees

At December 29, 2012, we employed 2,791 persons, including 1,519 retail sales and support employees, 171 direct marketing and customer service employees, 793 manufacturing and logistics employees, and 308 management and administrative employees. Approximately 90 of our employees were employed on a part-time basis at December 29, 2012. Except for managerial employees and professional support staff, all of our employees are paid on an hourly basis (plus commissions for sales professionals). None of our employees is represented by a labor union or covered by a collective bargaining agreement. In recent periods we have focused on and improved our employee engagement levels, which we believe is important to driving both organizational productivity and customer satisfaction.


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Executive Officers of the Registrant

Shelly R. Ibach, 53, has served as President and Chief Executive Officer since June 2012 having previously served as Executive Vice President, Chief Operating Officer since June 2011 and as Executive Vice President, Sales & Merchandising since October 2008. Ms. Ibach joined Select Comfort as Senior Vice President, U.S. Sales - Company Owned Channels in April 2007. From 2004 to 2007, Ms. Ibach served as Senior Vice President and General Merchandise Manager for the Home division, within Macy’s North, formally Marshall Field’s. From 1982 to 2007, she held various leadership positions within Marshall Field’s Department Stores - Target Corporation. Other key positions included Vice President - Divisional Merchandise Manager, Director of Planning and Regional Director of Stores.

Michael A. Bills, 48, has served as Senior Vice President and Chief Marketing Officer at Select Comfort since June 2012. Prior to joining Select Comfort, he was the Executive Director of the Innovation Initiative at the Fisher College of Business at The Ohio State University in Columbus, Ohio from October 2008 to June 2012. From April 2004 to September 2008, Mr. Bills was President of Retail Planning Associates and Managing Partner, the Americas, for Fitch - a WPP agency. He also served as President of Retail Planning Associates from June 2001 to April 2004, the Chief Development Officer for Resource Interactive from 1999 to 2001 and Senior Vice President of Retail Planning Associates from 1993 to1999.

Andrea L. Bloomquist, 43, has served as the Senior Vice President and Chief Product Officer for Select Comfort since June 2012 and leads product innovation including product management, development, merchandise buying and R&D for all Sleep Number products. Ms. Bloomquist was the Chief Product and Merchandising Officer from June 2011 to June 2012. Ms. Bloomquist joined Select Comfort in May 2008 as Vice President and General Merchandise Manager. Prior to joining Select Comfort, Ms. Bloomquist held leadership positions in product and merchandising at Macy's and Marshall Field's Department Stores for Target Corporation from 1996 to 2008.

Andrew P. Carlin, 49, has served as the Senior Vice President and Chief Sales Officer for Select Comfort since June 2012 and leads all sales channels and real estate. From May 2011 to June 2012 Mr. Carlin was the Vice President and Chief Sales Officer, and from January 2009 to May 2011 he was the Vice President of U.S. Retail Sales. Mr. Carlin joined Select Comfort in January 2008 as Regional Vice President, East Region. Prior to joining Select Comfort, Mr. Carlin spent more than 20 years in a variety of sales leadership roles, including Senior Vice President of Store Operations at Gander Mountain from 2003 to 2008, Kohl's Department Stores from 1995 to 2003 and Target Corporation from 1986 to 1995.

Mark A. Kimball, 54, has served as Senior Vice President, General Counsel, Chief Administrative Officer and Secretary since May 1999. From July 2000 to August 2003, Mr. Kimball also assumed responsibility for the Company’s human resources function. For more than five years prior to joining us, Mr. Kimball was a partner in the law firm of Oppenheimer Wolff & Donnelly LLP practicing in the area of corporate finance.

Karen R. Richard, 42, has served as Senior Vice President, Chief Human Capital Officer for Select Comfort Corporation since March 2009. From January 2006 through February 2009, Ms. Richard served as Vice President, Human Resources and prior to that she served as Vice President, Finance supporting Select Comfort’s Consumer Channels and Marketing. Ms. Richard also held a variety of positions in the Company’s finance department after joining Select Comfort in May 1996. From 1993 to 1996, Ms. Richard held various accounting positions with TCF Mortgage Corporation, an affiliate of TCF Financial Corporation.

Kathryn V. Roedel, 52, has served as Executive Vice President and Chief Services and Fulfillment Officer since June 2011 having previously served as Executive Vice President, Product and Service since October 2008. Ms. Roedel joined Select Comfort as Senior Vice President, Global Supply Chain in April 2005. From 1983 to 2005, she held leadership positions within two divisions of General Electric Company, in Sourcing, Manufacturing, Quality and Service. From 2003 to March 2005, Ms. Roedel served as the General Manager, Global Supply Chain Strategy for GE Medical Systems. Other key positions included General Manager, Global Quality and Six Sigma; Vice President – Technical Operations and Director/Vice President – Quality Programs for GE Clinical Services, a division of GE Medical Systems.

Wendy L. Schoppert, 46, has served as Executive Vice President and Chief Financial Officer since May 2011 having previously served as Senior Vice President and Chief Information Officer since March 2008. Ms. Schoppert joined Select Comfort in April 2005 and previously served as Senior Vice President – New Channel Development and International. From 2002 to March 2005, Ms. Schoppert led various departments within U.S. Bancorp Asset Management, most recently serving as Head of Private Asset Management and Marketing. From 1996 to 2000, she held several positions with America West Holdings Corporation, including Vice President of America West Vacations and head of the airline’s Reservations division. Prior to 1996, Ms. Schoppert held various finance-related positions at both Northwest Airlines and American Airlines.

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Available Information

We are subject to the reporting requirements of the Exchange Act and its rules and regulations. The Exchange Act requires us to file reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Copies of our reports, proxy statements and other information can be read and copied at:

SEC Public Reference Room
100 F Street NE
Washington, D.C. 20549

Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy statements and other information regarding issuers that file electronically with the SEC. These materials may be obtained electronically by accessing the SEC’s home page at http://www.sec.gov.

Our corporate Internet website is www.SleepNumber.com. Through a link to a third-party content provider, our corporate website provides free access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after electronic filing with the SEC. These documents are posted on our website at www.SleepNumber.com — select the “About Us” link and then the “Investor Relations” link. The information contained on our website or connected to our website is not incorporated by reference into this Form 10-K and should not be considered part of this report.

We also make available, free of charge on our website, the charters of the Audit Committee, Management Development and Compensation Committee, and Corporate Governance and Nominating Committee as well as our Code of Business Conduct (including any amendment to, or waiver from, a provision of our Code of Business Conduct) adopted by our Board. These documents are posted on our website — select the “Investor Relations” link and then the “Corporate Governance” link.

Copies of any of the above referenced information will also be made available, free of charge, upon written request to:

Select Comfort Corporation
Investor Relations Department
9800 59th Avenue North
Minneapolis, MN 55442



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ITEM 1A. RISK FACTORS

An investment in our common stock involves a high degree of risk. You should carefully consider the specific risks set forth below and other matters described in this Annual Report on Form 10-K before making an investment decision. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties, including risks and uncertainties not presently known to us or that we currently see as immaterial, may also harm our business. If any of these risks occur, our business, results of operations, cash flows and financial condition could be materially and adversely affected.

Current and future economic conditions could materially adversely affect our sales, profitability, cash flows and financial condition.

Our success depends significantly upon discretionary consumer spending, which is influenced by a number of general economic factors, including without limitation consumer confidence, the housing market, employment levels, interest rates, inflation, taxation and the level of customer traffic in malls and shopping centers. Adverse trends in any of these economic factors may adversely affect our sales, profitability, cash flows and financial condition.

Our future growth and profitability depends upon the effectiveness and efficiency of our marketing programs.

We are highly dependent on the effectiveness of our marketing messages and the efficiency of our advertising expenditures in generating consumer awareness and sales of our products. We have experienced a significant degree of variability in the effectiveness and efficiency of our marketing messages and advertising expenditures in recent years and may continue to experience such variability in the future. We continue to evolve our marketing strategies, adjusting our messages, the amount we spend on advertising and where we spend it, and no assurance can be given that we will be successful in developing effective messages and in achieving efficiency in our advertising expenditures.

We also believe that consumers are increasingly using the Internet as a part of their shopping experience. As a result, our future growth and profitability will depend in part on (i) the effectiveness and efficiency of our on-line advertising and search optimization programs in generating consumer awareness and sales of our products, (ii) our ability to prevent confusion among consumers that can result from search engines that allow competitors to use or bid on our trademarks to direct consumers to competitors’ websites, and (iii) our ability to prevent Internet publication of false or misleading information regarding our products or our competitors’ products.

If our marketing messages are ineffective or our advertising expenditures and other marketing programs, including Internet-based programs, are inefficient in creating awareness of our products and brand name, in driving consumer traffic to our points of distribution and in motivating consumers to purchase our products, our sales, profitability, cash flows and financial condition may be adversely impacted.

Our future growth and profitability depends on our ability to execute our Company-Controlled distribution strategy.

The vast majority of our sales occur through our Company-Controlled distribution channel, including our retail stores, and this Company-Controlled distribution channel represents our largest opportunity for growth in sales and improvement in profitability. Our retail stores carry significant fixed costs. We are highly dependent on our ability to maintain and increase sales per store to improve our operating margins.

Our stores are largely mall-based. We depend on the continued popularity of malls as shopping destinations and the ability of mall anchor tenants and other attractions to generate customer traffic for our retail stores. Any decrease in mall traffic could adversely affect our sales, profitability, cash flows and financial condition.

In 2009 we evolved our retail strategy, closing 72 stores to increase trade area per store and discontinued selling through traditional mattress retailers to drive more customers to our Company-Controlled distribution channel. This strategy is designed to improve the customer experience by utilizing our sales process and to improve our profitability by driving a greater number of sales through a smaller base of stores. If we are unable to capture sales from these larger trade areas or to improve the overall customer experience, our sales and profitability may be negatively impacted.

Our Company-Controlled distribution strategy results in relatively few points of distribution, including 410 retail stores across the continental United States as of the end of 2012. Several of the mattress manufacturers and retailers with which we compete have significantly more points of distribution than we do, which makes us highly dependent on our ability to drive consumers to our points of distribution in order to gain market share.


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Our longer term Company-Controlled distribution strategy is also dependent on our ability to renew existing store leases and to secure suitable locations for new store openings, in each case on a cost-effective basis. We may encounter higher than anticipated rents and other costs in connection with managing our retail store base, or may be unable to find or obtain suitable new locations.

Failure to achieve and maintain a high level of product quality could negatively impact our sales, profitability, cash flows and financial condition.

Our products represent a significant departure from traditional innerspring mattresses and from viscoelastic foam mattresses, which have no moving parts and do not rely on electronics and air control systems. As a result, our beds may be susceptible to failures that do not exist with traditional or viscoelastic foam mattresses. Failure to achieve and maintain acceptable quality standards could impact consumer acceptance of our products or could result in negative media and Internet reports or owner dissatisfaction that could negatively impact our brand image and sales levels.

In addition, a decline in product quality could result in an increase in return rates and a corresponding decrease in sales, or an increase in product warranty claims in excess of our warranty reserves. An unexpected increase in return rates or warranty claims could harm our sales, profitability, cash flows and financial condition.

As a consumer products company, we face an inherent risk of exposure to product liability claims in the event that the use of our products is alleged to have resulted in personal injury or property damage. In the event that any of our products proves to be defective, we may be required to recall or redesign such products. We have at times experienced increased returns and adverse impacts on sales, as well as product liability litigation, as a result of media reports related to the alleged propensity of our products to develop mold. We may experience additional adverse impacts on sales and additional litigation in the event any similar media reports were to occur in the future. We maintain insurance against some forms of product liability claims, but such coverage may not be adequate for liabilities actually incurred. A successful claim brought against us in excess of available insurance coverage, or any claim or product recall that results in significant adverse publicity against us, may have a material adverse effect on our sales, profitability, cash flows and financial condition.

Our future growth and profitability depends in part on our ability to continue to improve and expand our product line.

As described in greater detail below, the mattress industry is highly competitive, and our ability to compete effectively and to profitably grow our market share depends in part on our ability to continue to improve and expand our product line of adjustable firmness air beds and related accessory products. We incur significant research and development and other expenditures in the pursuit of improvements and additions to our product line. If these efforts do not result in meaningful product improvements or new product introductions, or if we are not able to gain widespread consumer acceptance of product improvements or new product introductions, our sales, profitability, cash flows and financial condition may be adversely affected. In addition, if any significant product improvements or new product introductions are not successful, our reputation and brand image may be adversely affected.

Significant competition in our industry could adversely affect our business.

Because of the vertical integration of our business model, we face significant competition with both a number of different types of mattress alternatives and a variety of retailers.

The mattress industry is characterized by a high degree of concentration among the two largest manufacturers of innerspring mattresses and the largest manufacturer of viscoelastic foam mattresses. We believe that several of our competitors have greater financial, marketing and manufacturing resources and better brand name recognition than we do and sell products through broader and more established distribution channels. A number of mattress manufacturers, including several of these larger competitors, have offered adjustable firmness air beds in the past, and the largest manufacturer of viscoelastic foam mattresses recently announced plans to offer adjustable firmness air beds that will compete directly with our products. We believe several of the larger mattress manufacturers may also be pursuing plans to open their own retail stores to compete directly with our retail stores.

Our Company-Controlled distribution channel competes with other retailers who generally provide a wider selection of mattress alternatives than we offer. A number of these retailers also have more points of distribution and greater brand name recognition than we do.

These manufacturing and retailing competitors, or new entrants into the market, may compete aggressively and gain market share with existing or new mattress products, and may pursue or expand their presence in the adjustable firmness air bed segment of the market. We have limited ability to anticipate the timing and scale of new product introductions, advertising campaigns or new pricing strategies by our competitors, which could inhibit our ability to retain or increase market share, or to maintain our product margins.


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If we are unable to effectively compete with other bedding manufacturers and other retailers, our sales, profitability, cash flows and financial condition may be adversely impacted.

We may be unable to prevent other companies from using our technology or intellectual property in connection with the sale of competitive products.

We own various U.S. and foreign patents and patent applications related to certain elements of the design and function of our beds and related products. We also own several registered and unregistered trademarks and trademark applications, including in particular our Select Comfort and Sleep Number trademarks, which we believe have significant value and are important to the marketing of our products. Our intellectual property rights may not provide substantial protection against infringement or piracy and may not prevent our competitors from developing and marketing products that are similar to or competitive with our beds or other products. In addition, the laws of some foreign countries may not protect our intellectual property rights and confidential information to the same extent as the laws of the United States. If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology or trademarks in connection with competitive products, which could adversely affect our sales, profitability, cash flows and financial condition.

We are not aware of any intellectual property infringement claims that may be asserted against us, however, it is possible that third parties, including competitors, may successfully assert such claims. The cost of defending such claims, or any resulting liability, or any failure to obtain necessary licenses on reasonable terms, may adversely impact our sales, profitability, cash flows and financial condition.

A reduction in the availability of credit to consumers generally or under our existing consumer credit programs could harm our sales, profitability, cash flows and financial condition.

A significant percentage of our sales are made under consumer credit programs through third parties. The recent economic downturn resulted in a reduction of credit available to consumers as macroeconomic factors impacted the financial position of consumers and as suppliers of credit adjusted their lending criteria. In addition, changes in federal regulations effective in 2010 placed additional restrictions on all consumer credit programs, including limiting the types of promotional credit offerings that may be offered to consumers.

GE Money Bank provides credit to our customers through a private label credit card program that expires on February 15, 2016, subject to earlier termination upon certain events. GE Money Bank has discretion to set minimum credit standards under which credit is extended to customers.

Reduction of credit availability due to changing economic conditions, changes in credit standards under our private label credit card program or changes in regulatory requirements, or the termination of our agreement with GE Money Bank, could harm our sales, profitability, cash flows and financial condition.

We utilize “just-in-time” manufacturing processes with minimal levels of inventory, which could leave us vulnerable to shortages in supply that may harm our ability to satisfy consumer demand and may adversely impact our sales and profitability.

We generally assemble our products after we receive orders from customers utilizing “just-in-time” manufacturing processes with minimal levels of raw materials, work in process and finished goods inventories. Lead times for ordered components may vary significantly. In addition, some components used to manufacture our products are provided on a sole source basis. Any unexpected shortage of materials caused by any disruption of supply or an unexpected increase in the demand for our products, could lead to delays in shipping our beds to customers. Any such delays could adversely affect our sales, customer satisfaction, profitability, cash flows and financial condition.

We rely upon several key suppliers that are, in some instances, the only source of supply currently used by us for particular materials, components or services. A disruption in the supply or substantial increase in cost of any of these products or services could harm our sales, profitability, cash flows and financial condition.

We currently obtain all of the materials and components used to produce our beds from outside sources. In several cases, including our proprietary air chambers, our proprietary blow-molded foundations, our adjustable foundations, various components for our Firmness Control Systems, as well as fabrics and zippers, we have chosen to obtain these materials and components from suppliers who serve as the only source of supply used by us at this time. While we believe that these materials and components, or suitable replacements, could be obtained from other sources, in the event of a disruption or loss of supply of relevant materials or components for any reason, we may not be able to find alternative sources of supply, or if found, may not be found on comparable terms. If our relationship with either the supplier of our air chambers or the supplier of our blow-molded foundations is terminated, we could have difficulty in replacing these sources since there are relatively few other suppliers presently capable of manufacturing these components.

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Similarly, we rely on UPS and other carriers to deliver some of our products to customers on a timely and cost-effective basis. Any significant delay in deliveries to our customers could lead to increased returns and cause us to lose sales. Any increase in freight charges could increase our costs of doing business and harm our sales, profitability, cash flows and financial condition.

Fluctuations in commodity prices could result in an increase in component costs and/or delivery costs.

Our business is subject to significant increases or volatility in the prices of certain commodities, including but not limited to fuel, oil, natural gas, rubber, cotton, plastic resin, steel and chemical ingredients used to produce foam. Increases in prices of these commodities or other inflationary pressures may result in significant cost increases for our raw materials and product components, as well as increases in the cost of delivering our products to our customers. To the extent we are unable to offset any such increased costs through value engineering and similar initiatives, or through price increases, our profitability, cash flows and financial condition may be adversely impacted. If we choose to increase prices to offset the increased costs, our unit sales volumes could be adversely impacted.

Our business is subject to risks inherent in global sourcing activities.

Our air chambers and some of our other components are manufactured outside the United States, and therefore are subject to risks associated with foreign sourcing of materials, including but not limited to: 
Political instability resulting in disruption of trade;
Existing or potential duties, tariffs or quotas on certain types of goods that may be imported into the United States;
Disruptions in transportation due to acts of terrorism, shipping delays, foreign or domestic dock strikes, customs inspections or other factors;
Foreign currency fluctuations; and
Economic uncertainties, including inflation.

These factors could increase our costs of doing business with foreign suppliers, lead to inadequate inventory levels or delays in shipping beds to our customers, which could harm our sales, customer satisfaction, profitability, cash flows and financial condition.

Disruption of operations in either of our two manufacturing facilities could increase our costs of doing business or lead to delays in shipping our beds.

We have two manufacturing plants, which are located in Irmo, South Carolina and in Salt Lake City, Utah. We generally manufacture beds to fulfill orders rather than stocking finished goods inventory in our plants or stores. Therefore, the disruption of operations of either of our manufacturing facilities for a significant period of time may increase our costs of doing business and lead to delays in shipping our beds to customers. Such delays could adversely affect our sales, customer satisfaction, profitability, cash flows and financial condition.

Our manufacturing and retail operations are subject to a wide variety of government regulations which could increase costs or cause disruptions to our operations.

We are subject to a wide variety of government regulations relating to the bedding industry or to various aspects of our business and operations, including without limitation; regulations relating to the proper labeling of bedding merchandise; flammability standards applicable to mattresses; environmental and product safety regulations; consumer protection and data privacy regulations; various “do not call” or “do not mail” list requirements; labor laws, including but not limited to laws relating to occupational health and safety, employee privacy, wages and hours, overtime pay, harassment and discrimination, equal opportunity, and employee leaves and benefits; and import and export regulations.

Although we believe that we are in compliance in all material respects with these regulations and have implemented a variety of measures to promote continuing compliance, regulations may change over time, and we may be required to incur expenses and/or to modify our operations in order to ensure compliance with these regulations or we may be found to be in violation of the foregoing laws or regulations, which could harm our sales, profitability, cash flows and financial condition.

Proposed legislation in various states would impose responsibilities with respect to end-of-life disposal of various consumer or durable goods on the manufacturers and/or retailers of such goods, including mattresses. To the extent that any such legislation becomes effective in the states in which we sell or have sold mattresses and related products, we may be required to incur significant costs and operational changes in order to comply with these requirements, which may adversely impact our profitability, cash flows and financial condition.


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Regulatory requirements related to flammability standards for mattresses may increase our product costs and increase the risk of disruption to our business.

The federal Consumer Product Safety Commission adopted new flammability standards and related regulations which became effective nationwide in July 2007 for mattresses and mattress and foundation sets. Compliance with these requirements has resulted in higher materials and manufacturing costs for our products, and has required modifications to our information systems and business operations, further increasing our costs and negatively impacting our capacity.

These regulations require manufacturers to implement quality assurance programs and encourage manufacturers to conduct random testing of products. These regulations also require maintenance and retention of compliance documentation. These quality assurance and documentation requirements are costly to implement and maintain. If any product testing, other evidence, or regulatory inspections yield results indicating that any of our products may not meet the flammability standard, we may be required to temporarily cease production and distribution and/or to recall products from the field, and we may be subject to fines or penalties, any of which outcomes could harm our business, reputation, sales, profitability, cash flows and financial condition.

Our management information systems may not be adequate to meet the evolving needs of our business as well as existing and emerging regulatory requirements.

We depend on our management information systems for many aspects of our business. Our current information systems architecture includes some off-the-shelf programs as well as some key software that has been developed by our own programmers, using legacy programming languages that are no longer vendor-supported. Our business may be adversely affected if our management information systems are disrupted or if we are unable to improve, upgrade, integrate or expand our systems to meet the evolving needs of our business and existing and emerging regulatory requirements.

We are incurring significant capital expenditures in the pursuit of improvements and upgrades to our management information systems. These efforts may take longer and may require greater financial and other resources than anticipated, may cause distraction of key personnel, and may cause disruptions to our existing systems and our business. Any of these outcomes could impair our ability to achieve critical strategic initiatives and could adversely impact our sales, profitability, cash flows and financial condition

Our information systems contain personal information related to our customers and employees in the ordinary course of our business, such as credit card and demographic information of our customers and social security numbers of our employees. While we maintain security measures to protect this information, a breach of these security measures, such as through third-party action, employee error, malfeasance or otherwise, could compromise the security of our customers’ and employees’ personal information. As the techniques used to breach such security measures change frequently and may not be recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any failure of our systems and processes to adequately protect customer or employee personal information from theft or loss could adversely impact our business, reputation, sales, profitability, cash flows and financial condition.

Our future growth and profitability depends in part upon our ability to attract, retain and motivate qualified personnel.

As a vertically integrated manufacturer and retailer, our future growth and profitability will depend in part upon our ability to attract, retain and motivate qualified personnel in a wide variety of areas to execute our growth strategy, including qualified management and executive personnel and qualified retail sales professionals and managers. The failure to attract, retain and motivate qualified personnel may hinder our ability to execute our business strategy and growth initiatives and may adversely impact our sales, profitability, cash flows and financial condition.

Our charter and corporate documents and Minnesota law make a takeover of our company more difficult and expensive, which may prevent certain changes in control and limit the market price of our common stock.
 
Our charter, bylaws, certain corporate documents and sections 671 and 673 of the Minnesota Business Corporation Act contain provisions that might enable our management to resist a takeover of our company or which may increase the cost of an acquisition of our company. Provisions in our amended and restated articles of incorporation and amended and restated bylaws may discourage, delay or prevent a merger or acquisition involving us that our shareholders may consider favorable. For example, our amended and restated articles of incorporation authorize five million undesignated shares. Without shareholder approval, our board of directors has the authority to create a class or series of shares from the undesignated shares and to set the terms of the class or series, including voting and dividend rights. With these rights, it could be more difficult for a third party to acquire us. In addition, our amended and restated articles of incorporation provide for a staggered board of directors, with directors serving for three-year terms and approximately one-third of the directors coming up for re-election each year. Having a staggered board will make it more difficult for a third party to obtain control of our board of directors through a proxy contest, which may be a necessary step in any acquisition of us that is not favored by our board of directors. In addition, we have a severance plan that may provide certain employees and executive

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officers with severance compensation if they are terminated in connection with a change in control of our company and stock award plans that may provide for the acceleration of vesting of incentive stock awards in the event of termination of employment or other adverse effects upon the employment terms of employees and executive officers following a change in control of our company. The existence of these provisions could discourage or prevent a change in control of our company, could make a change in control of our company more difficult and expensive and could limit the price that investors might be willing to pay in the future for shares of our common stock.
 
Risks of certain global events, such as terrorist attacks or a pandemic outbreak, could adversely impact our sales, profitability, financial condition or stock price.

Additional terrorist attacks in the United States or against U.S. targets, or acts of war or threats of war or the escalation of current hostilities involving the United States or its allies, or military or trade disruptions impacting our domestic or foreign suppliers of components of our products, may adversely impact our operations, causing delays or losses in the delivery of merchandise to us and decreased sales. These events could also cause an increase in oil or other commodity prices, which could adversely affect our materials or transportation costs, including the costs of delivery of our products to customers.

A significant pandemic outbreak, or a perceived threat of such an outbreak, could cause significant disruptions to our supply chain, manufacturing capability and distribution system that could adversely impact our ability to produce and deliver products, which could result in a loss of sales and adversely impact our profitability, cash flows and financial condition.

Any of these events could adversely impact consumer confidence and spending or result in increased volatility in the U.S. and worldwide financial markets. These events also could cause, or deepen and prolong, an economic recession in the United States or abroad. Any of these occurrences could have an adverse impact on our sales, profitability, financial condition or stock price.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.


18


ITEM 2. PROPERTIES

Distribution Locations

We currently lease all of our existing retail store locations and expect that our policy of leasing stores, rather than owning stores, will continue. Our store leases generally provide for an initial lease term of five to ten years with a termination option if we do not achieve certain minimum annual sales thresholds. Generally, mall store leases require us to pay minimum rent plus percentage rent based on net sales in excess of certain thresholds, as well as certain operating expenses.

The following table summarizes the geographic location of our 410 retail stores as of December 29, 2012:

 
 
Retail
Stores

 
 
 
Retail
Stores

 
 
 
Retail
Stores

Alabama
 
4

 
Louisiana
 
6

 
North Carolina
 
13

Arizona
 
8

 
Maine
 
2

 
North Dakota
 
2

Arkansas
 
3

 
Maryland
 
11

 
Ohio
 
17

California
 
50

 
Massachusetts
 
4

 
Oklahoma
 
4

Colorado
 
11

 
Michigan
 
12

 
Oregon
 
4

Connecticut
 
6

 
Minnesota
 
13

 
Pennsylvania
 
17

Delaware
 
2

 
Mississippi
 
3

 
South Carolina
 
4

Florida
 
25

 
Missouri
 
12

 
South Dakota
 
1

Georgia
 
13

 
Montana
 
2

 
Tennessee
 
8

Idaho
 
2

 
Nebraska
 
4

 
Texas
 
33

Illinois
 
19

 
Nevada
 
4

 
Utah
 
3

Indiana
 
12

 
New Hampshire
 
5

 
Vermont
 
1

Iowa
 
6

 
New Jersey
 
12

 
Virginia
 
11

Kansas
 
3

 
New Mexico
 
3

 
Washington
 
10

Kentucky
 
5

 
New York
 
9

 
Wisconsin
 
11

 
 
 
 
 
 
 
 
Total
 
410


Manufacturing and Headquarters

We lease our 159,000-square-foot corporate headquarters in the Minneapolis, Minnesota area. The lease commenced in November 2007 and runs through 2017 with two five-year renewal options.

We also lease approximately 122,000 square feet in the Minneapolis, Minnesota area that includes our research and development department, and a distribution center that accepts returns, fulfills accessory orders and processes warranty claims. This lease expires in 2017 and contains one five-year renewal option.

We lease two manufacturing and distribution centers in Irmo, South Carolina and Salt Lake City, Utah of approximately 105,000 square feet and approximately 101,000 square feet, respectively. We lease the Irmo facility through February 2016, and the Salt Lake City facility through July 2015, with a five-year renewal option thereafter.



19


ITEM 3. LEGAL PROCEEDINGS

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, product liability, employment and intellectual property claims. In accordance with generally accepted accounting principles in the United States, we record a liability in our consolidated financial statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. With respect to currently pending legal proceedings, we have not established an estimated range of reasonably possible additional losses either because we believe that we have valid defenses to claims asserted against us or the proceeding has not advanced to a stage of discovery that would enable us to establish an estimate. We currently do not expect the outcome of these matters to have a material effect on our consolidated results of operations, financial position or cash flows. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our results of operations, financial position or cash flows. We expense legal costs as incurred.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.


20


PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock trades on The NASDAQ Stock Market LLC (NASDAQ Global Select Market) under the symbol “SCSS.” As of January 26, 2013, there were approximately 311 holders of record of our common stock. The following table sets forth the quarterly high and low sales prices per share of our common stock as reported by NASDAQ for the two most recent fiscal years. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.
 
 
Fourth
Quarter
 
Third
Quarter
 
Second
Quarter
 
First
Quarter
Fiscal 2012
 
 
 
 
 
 
 
 
High
 
$
33.16

 
$
33.58

 
$
35.24

 
$
33.20

Low
 
24.48

 
21.10

 
19.33

 
22.15

 
 
 
 
 
 
 
 
 
Fiscal 2011
 
 

 
 

 
 

 
 

High
 
$
22.04

 
$
18.86

 
$
18.41

 
$
12.44

Low
 
12.41

 
12.20

 
12.09

 
9.64


We are not restricted from paying cash dividends under our credit agreement other than customary legal and contractual restrictions. However, we have not historically paid, and have no current plans to pay, cash dividends on our common stock.

Information concerning share repurchases completed during the fourth quarter of fiscal 2012 is set forth below:
Fiscal Period
 
Total Number of Shares
Purchased(1)(2)
 
Average Price Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)
 
Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
September 30, 2012 through October 27, 2012
 
101,460

 
$
30.98

 
101,460

 
$
183,603,000

October 28, 2012 through November 24, 2012
 
106,900

 
26.62

 
106,900

 
180,757,000

November 25, 2012 through December 29, 2012
 
189,952

 
25.44

 
156,933

 
176,739,000

Total
 
398,312

 
$
27.17

 
365,293

 
$
176,739,000

        
(1) 
Under the current Board approved $290.0 million share repurchase program, we repurchased 365,293 shares of our common stock at a cost of $10.0 million (based on trade dates) during the three months ended December 29, 2012. As of December 29, 2012, the remaining authorization under our Board approved share repurchase program was $176.7 million. There is no expiration date governing the period over which we can repurchase shares. Any repurchased shares are constructively retired and returned to an unissued status.
(2) In connection with the vesting of employee restricted stock grants, we also repurchased 33,019 shares of our common stock at a cost of $0.8 million, during the three months ended December 29, 2012.





21


Comparative Stock Performance

The graph below compares the total cumulative shareholder return on our common stock over the last five years to the total cumulative return on the Standard and Poor’s (“S&P”) 400 Specialty Stores Index and The NASDAQ Stock Market (U.S.) Index assuming a $100 investment made on December 29, 2007. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance. The information contained in this “Comparative Stock Performance” section shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that we specifically request that it be treated as soliciting material or incorporate it by reference into a document filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN
AMONG SELECT COMFORT CORPORATION, S&P 400 SPECIALTY STORES INDEX,
AND THE NASDAQ STOCK MARKET (U.S.) INDEX
 
 
12/29/2007
 
1/3/2009
 
1/2/2010
 
1/1/2011
 
12/31/2011
 
12/29/2012
Select Comfort Corporation
 
$
100

 
$
4

 
$
91

 
$
128

 
$
303

 
$
343

S&P 400 Specialty Stores Index
 
100

 
60

 
88

 
132

 
151

 
184

The NASDAQ Stock Market (U.S.) Index
 
100

 
59

 
82

 
97

 
99

 
111





22


ITEM 6. SELECTED FINANCIAL DATA
(in thousands, except per share and selected operating data, unless otherwise indicated)
The Consolidated Statements of Operations Data and Consolidated Balance Sheet Data presented below have been derived from our Consolidated Financial Statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and Notes thereto included in this Annual Report on Form 10-K.
 
Year
 
2012
 
2011
 
2010
 
2009
 
2008(1)
 
2007
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
 
 
Net sales
$
934,978

 
$
743,203

 
$
605,676

 
$
544,202

 
$
608,524

 
$
799,242

Gross profit
596,546

 
470,345

 
378,263

 
335,460

 
358,572

 
486,415

Operating expenses:
 
 
 

 
 

 
 

 
 

 
 

Sales and marketing
398,205

 
317,502

 
269,901

 
259,244

 
332,068

 
372,467

General and administrative
66,617

 
58,106

 
53,572

 
49,560

 
57,994

 
64,351

Research and development
6,194

 
4,175

 
2,147

 
1,973

 
3,374

 
5,682

Asset impairment charges
148

 
109

 
260

 
686

 
34,594

 
409

Other(2)(3)
5,595

 

 

 
3,324

 

 

Operating income (loss)
119,787

 
90,453

 
52,383

 
20,673

 
(69,458
)
 
43,506

Net income (loss)
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
 
$
27,620

Net income (loss) as adjusted(8)
$
81,748

 
$
60,478

 
$
31,568

 
$
11,169

 
$
(23,174
)
 
$
27,620

Net income (loss) per share:
 
 
 

 
 

 
 

 
 

 
 

Basic
$
1.41

 
$
1.10

 
$
0.58

 
$
0.78

 
$
(1.59
)
 
$
0.59

Diluted
$
1.37

 
$
1.07

 
$
0.57

 
$
0.77

 
$
(1.59
)
 
$
0.57

Diluted - as adjusted(8)
$
1.43

 
$
1.07

 
$
0.57

 
$
0.24

 
$
(0.52
)
 
$
0.57

Shares used in calculation of net income (loss) per share:
 
 
 

 
 

 
 

 
 

 
 

Basic
55,516

 
55,081

 
54,005

 
45,682

 
44,186

 
46,536

Diluted
57,076

 
56,432

 
55,264

 
46,198

 
44,186

 
48,292

 
 
 
 
 
 
 
 
 
 
 
 
Consolidated Balance Sheet Data:
 
 
 

 
 

 
 

 
 

 
 

Cash, cash equivalents and marketable debt securities(4)
$
177,821

 
$
146,317

 
$
76,016

 
$
12,184

 
$
10,987

 
$
2,361

Working capital
77,517

 
72,145

 
20,053

 
(25,435
)
 
(90,534
)
 
(70,000
)
Total assets
342,021

 
262,657

 
169,957

 
118,240

 
135,413

 
190,489

Borrowings under revolving credit facility

 

 

 

 
79,150

 
37,890

Total shareholders’ equity (deficit)
193,697

 
129,391

 
57,977

 
22,458

 
(41,630
)
 
24,126

 
 
 
 
 
 
 
 
 
 
 
 
Selected Operating Data:
 
 
 

 
 

 
 

 
 

 
 

Stores open at period-end
410

 
381

 
386

 
403

 
471

 
478

Stores opened during period
57

 
19

 
7

 
4

 
19

 
45

Stores closed during period
28

 
24

 
24

 
72

 
26

 
9

Average net sales per store (000’s)(5)
$
2,164

 
$
1,721

 
$
1,295

 
$
1,046

 
$
984

 
$
1,318

Percentage of stores with more than $1.0 million in net sales(5)
98
%
 
93
%
 
70
%
 
48
 %
 
45
 %
 
73
 %
Percentage of stores with more than $2.0 million in net sales(5)
49
%
 
24
%
 
7
%
 
2
 %
 
2
 %
 
8
 %
Average net sales per mattress unit - Company-Controlled channel(6)
$
3,050

 
$
2,694

 
$
2,424

 
$
2,369

 
$
2,370

 
$
2,223

Company-Controlled comparable-sales increase (decrease)(7)
23
%
 
26
%
 
19
%
 
(4
)%
 
(26
)%
 
(11
)%
Average square footage per store open during period(5)
1,670

 
1,526

 
1,484

 
1,474

 
1,410

 
1,315

Net sales per square foot(5)
$
1,324

 
$
1,135

 
$
873

 
$
710

 
$
703

 
$
1,024

Average store age (in months at period end)
113

 
113

 
113

 
102

 
91

 
84

Earnings before interest, depreciation and amortization (“Adjusted EBITDA”)(8)
$
150,285

 
$
109,180

 
$
69,675

 
$
42,289

 
$
(9,437
)
 
$
75,768

Free cash flows(4)(8)
$
49,033

 
$
67,519

 
$
64,058

 
$
60,717

 
$
(26,381
)
 
$
2,139

        
(1) 
Fiscal year 2008 had 53 weeks. All other fiscal years presented had 52 weeks.
(2) 
In February 2012, we announced that William R. McLaughlin, then President and Chief Executive Officer, would retire from the Company effective June 1, 2012. In recognition of Mr. McLaughlin's contributions, the Company's Compensation Committee approved the modification of Mr. McLaughlin's unvested stock awards, including performance stock awards. The performance stock awards are subject to applicable performance adjustments (through 2014) based on free cash flows and actual market share growth versus performance targets. During 2012, we incurred $5.6 million ($3.7 million, net of income tax) of non-recurring, non-cash expenses associated with these stock award modifications.
(3) 
In 2009, we expensed $3.3 million ($2.1 million, net of income tax) of direct, incremental costs incurred in connection with a terminated equity financing transaction.
(4) 
At the beginning of 2011, we changed our accounting policy for payments due from financial services companies for credit card and debit card transactions. Historically, at each reporting period, we classified all credit card and debit card transactions that processed in less than seven days as cash and cash equivalents on our consolidated balance sheets. We now classify these credit card and debit card transactions as accounts receivable until the cash is received. All previous periods have been restated to conform to the current year presentation.
(5) 
For stores open during the entire period indicated.
(6) 
Represents Company-Controlled channel total net sales divided by Company-Controlled channel mattress units.
(7) 
Stores are included in the comparable sales calculation in the 13th full month of operation. Stores that have been remodeled or repositioned within the same shopping center remain in the comparable-store base. The number of comparable-stores used to calculate such data was 348, 359, 379, 399, 452 and 432 for 2012, 2011, 2010, 2009, 2008 and 2007, respectively. Fiscal 2008 included 53 weeks, as compared to 52 weeks for the other periods presented. Comparable sales have been adjusted and reported as if all years had the same number of weeks.
(8) 
These non-GAAP measures are not in accordance with, or preferable to, GAAP financial data. However, we are providing this information as we believe it facilitates annual and year-over-year comparisons for investors and financial analysts. See pages 24 and 25 for the reconciliation of these non-GAAP measures to the appropriate GAAP measure.

23


Non-GAAP Data Reconciliations

Reported to Adjusted Statements of Operations Data
(in thousands, except per share amounts)

In addition to disclosing results that are determined in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), we also disclose non-GAAP results that exclude certain significant charges or credits. Our "as adjusted" data is considered a non-GAAP financial measure and is not in accordance with, or preferable to, "as reported," or GAAP financial data. However, we believe that the disclosure of results excluding certain significant charges or credits provides additional insights into underlying business performance and facilitates year-over-year comparisons. Below are our reconciliations of our non-GAAP financial measures to the most comparable GAAP financial measures.
 
 
Year
 
 
2012
 
2011
 
2010
 
2009
 
2008
 
2007
Net income (loss) – as reported
 
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
 
$
27,620

Adjustments – net of income tax (1):
 
 
 
 

 
 

 
 

 
 

 
 

CEO transition costs(2)
 
3,654

 

 

 

 

 

Terminated equity financing costs (3)
 

 

 

 
2,061

 

 

Impairments (4)
 

 

 

 

 
20,163

 

Income tax valuation (5)
 

 

 

 
(26,444
)
 
26,840

 

Net income (loss) – as adjusted
 
$
81,748

 
$
60,478

 
$
31,568

 
$
11,169

 
$
(23,174
)
 
$
27,620

 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss) per share – as adjusted:
 
 
 
 

 
 

 
 

 
 

 
 

Basic
 
$
1.47

 
$
1.10

 
$
0.58

 
$
0.24

 
$
(0.52
)
 
$
0.59

Diluted
 
$
1.43

 
$
1.07

 
$
0.57

 
$
0.24

 
$
(0.52
)
 
$
0.57

 
 
 
 
 
 
 
 
 
 
 
 
 
Basic shares
 
55,516

 
55,081

 
54,005

 
45,682

 
44,186

 
46,536

Diluted shares
 
57,076

 
56,432

 
55,264

 
46,198

 
44,186

 
48,292

        
(1) 
Reflects annual effective income tax rates, before discrete adjustments, of 34.7%, 38.0% and 40.0% for 2012, 2009 and 2008, respectively.
(2) 
In February 2012, we announced that William R. McLaughlin, then President and Chief Executive Officer, would retire from the Company effective June 1, 2012. In recognition of Mr. McLaughlin's contributions, the Company's Compensation Committee approved the modification of Mr. McLaughlin's unvested stock awards, including performance stock awards. The performance stock awards are subject to applicable performance adjustments (through 2014) based on free cash flows and actual market share growth versus performance targets. During 2012, we incurred $5.6 million ($3.7 million, net of income tax) of non-recurring, non-cash expenses associated with these stock award modifications.
(3) 
In 2009, we expensed $3.3 million ($2.1 million, net of income tax) of direct, incremental costs incurred in connection with a terminated equity financing transaction.
(4) 
Fiscal 2008 includes impairment charges for the abandonment of our plan to implement SAP®-based applications and impairment charges in excess of $1.0 million for underperforming stores.
(5) 
In 2008, we established a $26.8 million valuation allowance against deferred taxes based on uncertainty regarding future taxable income. In 2009, we reversed the valuation allowance against deferred taxes based on all available positive and negative evidence.



24


Non-GAAP Data Reconciliations (continued)

Earnings before Interest, Taxes, Depreciation and Amortization (Adjusted EBITDA)
(in thousands)

We define earnings before interest, taxes, depreciation and amortization (“Adjusted EBITDA”) as net income plus: income tax expense, interest expense, depreciation and amortization, stock-based compensation and asset impairments. Management believes Adjusted EBITDA is a useful indicator of our financial performance and our ability to generate cash from operating activities. Our definition of Adjusted EBITDA may not be comparable to similarly titled definitions used by other companies. The table below reconciles Adjusted EBITDA, which is a non-GAAP financial measure, to the comparable GAAP financial measure.
 
 
Year
 
 
2012
 
2011
 
2010
 
2009
 
2008
 
2007
Net income (loss)
 
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
 
$
27,620

Income tax expense (benefit)
 
41,911

 
29,942

 
18,922

 
(20,862
)
 
(2,566
)
 
15,846

Interest expense
 
91

 
187

 
1,951

 
5,996

 
3,375

 
849

Depreciation and amortization
 
19,735

 
13,493

 
13,012

 
17,681

 
21,635

 
24,792

Stock-based compensation
 
10,306

 
4,971

 
3,962

 
3,236

 
3,702

 
6,252

Asset impairments
 
148

 
109

 
260

 
686

 
34,594

 
409

Adjusted EBITDA
 
$
150,285

 
$
109,180

 
$
69,675

 
$
42,289

 
$
(9,437
)
 
$
75,768


Free Cash Flows
(in thousands)

Our “free cash flow” data is considered a non-GAAP financial measure and is not in accordance with, or preferable to, “net cash provided by operations,” or GAAP financial data. However, we are providing this information as we believe it facilitates analysis for investors and financial analysts.
 
 
Year
 
 
2012
 
2011
 
2010
 
2009
 
2008
 
2007
Net cash provided by operating activities
 
$
100,626

 
$
91,046

 
$
71,407

 
$
63,176

 
$
5,821

 
$
45,653

Subtract: Purchases of property and equipment
 
51,593

 
23,527

 
7,349

 
2,459

 
32,202

 
43,514

Free cash flow
 
$
49,033

 
$
67,519

 
$
64,058

 
$
60,717

 
$
(26,381
)
 
$
2,139




25


ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

The discussion in this Annual Report contains certain forward-looking statements that relate to future plans, events, financial results or performance. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. These risks and uncertainties include, among others:

Current and future general and industry economic trends and consumer confidence;
The effectiveness of our marketing messages;
The efficiency of our advertising and promotional efforts;
Our ability to execute our Company-Controlled distribution strategy;
Our ability to achieve and maintain acceptable levels of product and service quality, and acceptable product return and warranty claims rates;
Our ability to continue to improve and expand our product line, and consumer acceptance of our products, product quality, innovation and brand image;
Industry competition, the emergence of additional competitive products, and the adequacy of our intellectual property rights to protect our products and brand from competitive or infringing activities;
Availability of attractive and cost-effective consumer credit options, including the impact of recent changes in federal law that restricts various forms of consumer credit promotional offerings;
Pending and unforeseen litigation and the potential for adverse publicity associated with litigation;
Our “just-in-time” manufacturing processes with minimal levels of inventory, which may leave us vulnerable to shortages in supply;
Our dependence on significant suppliers and our ability to maintain relationships with key suppliers, including several sole-source suppliers;
Rising commodity costs and other inflationary pressures;
Risks inherent in global sourcing activities;
Risks of disruption in the operation of either of our two manufacturing facilities;
Increasing government regulation;
The adequacy of our management information systems to meet the evolving needs of our business and existing and evolving regulatory standards applicable to data privacy and security;
The costs and potential disruptions to our business related to upgrading our management information systems;
Our ability to attract, retain and motivate qualified management, executive and other key employees, including qualified retail sales professionals and managers; and
Uncertainties arising from global events, such as terrorist attacks or a pandemic outbreak, or the threat of such events.

Additional information concerning these and other risks and uncertainties is contained under the caption "Risk Factors" in the Annual Report on Form 10-K.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in six sections:

Overview
Results of Operations
Liquidity and Capital Resources
Off-Balance-Sheet Arrangements and Contractual Obligations
Critical Accounting Policies and Estimates
Recent Accounting Pronouncements



26


Overview

Business Overview

We believe that we are leading the industry in delivering an unparalleled sleep experience by offering consumers high-quality, innovative and individualized sleep solutions and services, which include a complete line of Sleep Number® beds and bedding. We are the exclusive manufacturer, marketer, retailer and servicer of the revolutionary Sleep Number bed, which allows individuals to adjust the firmness and support of each side at the touch of a button. We offer further individualization through our solutions-focused line of Sleep Number pillows, sheets and other bedding products.
 
As the only national specialty-mattress retailer, we generate revenue by selling products through two distribution channels. Our Company-Controlled channel, which includes Retail, Direct Marketing and E-Commerce, sells directly to consumers. Our Wholesale channel sells to and through the QVC shopping channel and wholesale customers in Alaska, Hawaii and Australia.

Mission, Vision and Strategy

Our mission is to improve lives by individualizing sleep experiences. Our vision is to become the world's most beloved brand by delivering an Unparalleled Sleep Experience.

We are executing against a defined strategy which focuses on the following key components:
Everyone will know Sleep Number and how it will improve their life;
Innovative Sleep Number products will move society forward with meaningful consumer benefits;
Sleep Number will be easy to find and customers will interact with us when and how they want;
Customers will love their Sleep Number experience and enthusiastically recommend Sleep Number to their family and friends; and
Leveraging our unique business model to fund innovation and growth will benefit our customers, employees and shareholders.

Results of Operations

Fiscal 2012 Summary

Financial highlights for fiscal 2012 were as follows:

Net income increased 29% to $78.1 million, or $1.37 per diluted share, compared with net income of $60.5 million, or $1.07 per diluted share in 2011.

Financial results for 2012 included a $5.6 million ($3.7 million, net of income tax), or $0.06 per diluted share, non-recurring, non-cash charge associated with the June 1, 2012 chief executive officer transition.

Net sales increased 26% to $935.0 million, compared with $743.2 million in 2011, primarily due to a 23% comparable sales increase in our Company-Controlled channel.

Operating income for 2012 improved to $119.8 million, or 12.8% of net sales, compared with $90.5 million, or 12.2% of net sales, for the same period one year ago. Excluding the $5.6 million CEO transition charge, 2012 operating income was $125.4 million, or 13.4% of net sales. The operating income improvement was driven by strong comparable sales growth and a 0.5 percentage points increase in our gross profit rate. Annual retail sales-per-store for 2012 increased by 26% from one year ago to $2.2 million (for stores open at least one year).

Cash provided by operating activities in 2012 totaled $100.6 million, compared with $91.0 million for the prior year.

At December 29, 2012, cash, cash equivalents and marketable debt securities totaled $177.8 million compared with $146.3 million at December 31, 2011, and we had no borrowings under our revolving credit facility. In 2012, we repurchased 1,140,861 shares of our common stock under our Board approved share repurchase program at a cost of $30.0 million ($26.32 per share).




27


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

 
 
2012
 
2011
 
2010
 
 
$
 
% of
Net Sales
 
$
 
% of
Net Sales
 
$
 
% of
Net Sales
Net sales
 
$
935.0

 
100.0
%
 
$
743.2

 
100.0
 %
 
$
605.7

 
100.0
 %
Cost of sales
 
338.4

 
36.2

 
272.9

 
36.7

 
227.4

 
37.5

Gross profit
 
596.5

 
63.8

 
470.3

 
63.3

 
378.3

 
62.5

 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 

 
 
 
 
 
 
Sales and marketing
 
398.2

 
42.6

 
317.5

 
42.7

 
269.9

 
44.6

General and administrative
 
66.6

 
7.1

 
58.1

 
7.8

 
53.6

 
8.8

Research and development
 
6.2

 
0.7

 
4.2

 
0.6

 
2.1

 
0.4

CEO transition costs
 
5.6

 
0.6

 

 
0.0

 

 
0.0

Asset impairment charges
 
0.1

 
0.0

 
0.1

 
0.0

 
0.3

 
0.0

Total operating expenses
 
476.8

 
51.0

 
379.9

 
51.1

 
325.9

 
53.8

Operating income
 
119.8

 
12.8

 
90.5

 
12.2

 
52.4

 
8.6

Operating income – as adjusted (1)
 
125.4

 
13.4

 
90.5

 
12.2

 
52.4

 
8.6

Other income (expense), net
 
0.2

 
0.0

 

 
0.0

 
(1.9
)
 
(0.3
)
Income before income taxes
 
120.0

 
12.8

 
90.4

 
12.2

 
50.5

 
8.3

Income tax expense
 
41.9

 
4.5

 
29.9

 
4.0

 
18.9

 
3.1

Net income
 
$
78.1

 
8.4
%
 
$
60.5

 
8.1
 %
 
$
31.6

 
5.2
 %
Net income – as adjusted (1)
 
$
81.7

 
8.7
%
 
$
60.5

 
8.1
 %
 
$
31.6

 
5.2
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income per share:
 
 

 
 

 
 

 
 
 
 
 
 
Basic
 
$
1.41

 
 

 
$
1.10

 
 
 
$
0.58

 
 
Diluted
 
$
1.37

 
 

 
$
1.07

 
 
 
$
0.57

 
 
Diluted – as adjusted (1)
 
$
1.43

 
 
 
$
1.07

 
 
 
$
0.57

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average number of common shares:
 
 

 
 

 
 
 
 
 
 
Basic
 
55.5

 
 

 
55.1

 
 
 
54.0

 
 
Diluted
 
57.1

 
 

 
56.4

 
 
 
55.3

 
 
        
(1) 
This non-GAAP measure is not in accordance with, or preferable to, GAAP financial data. However, we are providing this information as we believe it facilitates annual and year-over-year comparisons for investors and financial analysts. See page 24 for a reconciliation of this non-GAAP measure to the appropriate GAAP measure.
GAAP – generally accepted accounting principles

The percentage of our total net sales, by dollar volume, from each of our channels was as follows:
 
 
2012
 
2011
 
2010
Company-Controlled channel
 
96.7
%
 
96.2
%
 
94.8
%
Wholesale channel
 
3.3
%
 
3.8
%
 
5.2
%
Total
 
100.0
%
 
100.0
%
 
100.0
%









28


The components of total net sales growth, including comparable net sales changes, were as follows: 
 
 
Net Sales Increase/(Decrease)
 
 
2012
 
2011
 
2010
 
 
 
 
 
 
 
Retail comparable-store sales(1)
 
24
%
 
29
%
 
21
%
Direct and E-Commerce
 
9
%
 
(1
%)
 
5
%
Company-Controlled comparable sales change
 
23
%
 
26
%
 
19
%
Net store openings/closings
 
3
%
 
(1
%)
 
(5
%)
Total Company-Controlled channel
 
26
%
 
25
%
 
14
%
Wholesale channel
 
10
%
 
(11
%)
 
(21
%)
Total net sales change
 
26
%
 
23
%
 
11
%
        
(1) Stores are included in the comparable-store calculation in the 13th full month of operations. Stores that have been remodeled or repositioned within the same shopping center remain in the comparable-store base.

Other sales metrics were as follows: 
 
 
2012
 
2011
 
2010
 
 
 
 
 
 
 
Average sales per store(1) ($ in thousands)
 
$
2,164

 
$
1,721

 
$
1,295

Average sales per square foot(1)
 
$
1,324

 
$
1,135

 
$
873

Stores > $1 million in net sales(1)
 
98
%
 
93
%
 
70
%
Stores > $2 million in net sales(1)
 
49
%
 
24
%
 
7
%
Average net sales per mattress unit – Company-Controlled channel(2)
 
$
3,050

 
$
2,694

 
$
2,424

        
(1) Trailing twelve months for stores open at least one year.
(2) Represents Company-Controlled channel total net sales divided by Company-Controlled channel mattress units.

The number of retail stores operating during the last three years was as follows:
 
 
2012
 
2011
 
2010
 
 
 
 
 
 
 
Beginning of period
 
381

 
386

 
403

Opened
 
57

 
19

 
7

Closed
 
(28
)
 
(24
)
 
(24
)
End of period
 
410

 
381

 
386


Comparison of 2012 and 2011

Net sales

Net sales in 2012 increased 26% to $935.0 million, compared with $743.2 million for the same period one year ago. The sales increase was primarily driven by a 23% comparable sales increase in our Company-Controlled channel and the sales from 29 net new retail stores opened in the past 12 months. Company-Controlled mattress units increased 12% compared to the prior-year period. Average net sales per mattress unit in our Company-Controlled channel increased by 13%.
 
The $191.8 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $147.5 million increase in sales from our Company-Controlled comparable retail stores and a $35.7 million sales increase resulting from net new retail store openings; (ii) a $5.8 million increase in Direct and E-Commerce sales; and (iii) a $2.8 million increase in Wholesale channel sales.


29


Gross profit

The gross profit rate increased to 63.8% of net sales in 2012, compared with 63.3% for the prior-year period. Approximately 0.9 percentage points (“ppt.”) of the gross profit rate increase was due to price increases and product mix changes resulting from product innovations over the last 12 months. In addition, the prior-year period included a $1.6 million (0.2 ppt.) warranty charge related to customer-service reserves. These gross profit rate increases in 2012 were partially offset by a variety of factors that can fluctuate from year-to-year, including sales return and exchange costs and logistics expenses.

Sales and marketing expenses

Sales and marketing expenses in 2012 increased 25% to $398.2 million, or 42.6% of net sales, compared with $317.5 million, or 42.7% of net sales, for the same period one year ago. The $80.7 million increase was primarily due to a $35.3 million, or 39%, increase in media spending, an increase in variable selling expenses due to the higher sales volume and the additional costs associated with operating 29 net new retail stores. The sales and marketing expense rate declined 0.1 ppt. compared with the same period one year ago due to the leveraging impact of the 26% net sales increase.
 
General and administrative expenses

General and administrative (“G&A”) expenses increased $8.5 million to $66.6 million in 2012, compared with $58.1 million in the prior year, but decreased to 7.1% of net sales, compared with 7.8% of net sales one year ago. The $8.5 million increase in G&A expenses was primarily due to (i) a $4.2 million increase in outside consulting and legal expenses; (ii) $2.1 million of additional depreciation expense resulting from the increase in capital expenditures to support the growth of the business; (iii) a $0.6 million increase in employee compensation expenses resulting from an increase in employee headcount to support the growth of the business, and salary and wage rate increases that were in line with inflation, partially offset by lower performance-based incentive compensation and stock-based compensation; and (iv) a $1.6 million net increase in miscellaneous other expenses. The G&A expense rate decreased by 0.7 ppt. in the current period compared with the same period one year ago due to the leveraging impact of the 26% net sales increase.

Research and development expenses

Research and development expenses increased to $6.2 million, or 0.7% of net sales in 2012, compared with $4.2 million, or 0.6% of net sales, for the same period one year ago. The $2.0 million increase in R&D expenses was due to increased investments in product innovation during 2012.

CEO transition costs

In February 2012, we announced that William R. McLaughlin, then President and Chief Executive Officer would retire from the Company effective June 1, 2012. In recognition of Mr. McLaughlin’s contributions to the Company, the Company’s Compensation Committee approved the modification of Mr. McLaughlin’s unvested stock awards, including performance stock awards. The performance stock awards are subject to applicable performance adjustments (through 2014) based on free cash flow and actual market share growth versus performance targets. During 2012, we incurred $5.6 million ($3.7 million, net of income tax) of non-recurring, non-cash expenses associated with these stock award modifications.

Asset impairment charges

During 2012, we recognized asset impairment charges of $0.1 million related to computer software and certain retail store assets. During 2011, we recognized asset impairment charges of $0.1 million related to production machinery, computer equipment and certain retail store assets.

Other income (expense), net

Other income, net was $0.2 million for 2012, compared with other expense, net of $33 thousand for the comparable period one year ago. The current-year improvement in other income (expense), net was primarily due to a reduction in fees associated with our line of credit, a higher average yield on our investment portfolio in the current-year period, and an increase in our average cash, cash equivalents and marketable debt securities balance in 2012 compared with the prior year.


30


Income tax expense

Income tax expense was $41.9 million in 2012 compared with $29.9 million for the same period one year ago. The effective tax rate for 2012 increased to 34.9% compared with the prior-year period rate of 33.1%. The 2011 effective tax rate benefited from the favorable resolution of certain prior years' income tax matters.

Comparison of 2011 and 2010

Net Sales

Net sales in 2011 increased 23% to $743.2 million, compared with $605.7 million for the same period one year ago. The sales increase was driven by a 26% comparable sales increase in our Company-Controlled channel. This increase was partially offset by the decrease in sales resulting from the year-over-year decline in the number of retail stores we operated and a decrease in Wholesale channel sales. Company-Controlled sales of mattress units increased 12% compared to the same period one year ago. Average net sales per mattress unit in our Company-Controlled channel increased by 11%.

The $137.5 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $141.9 million increase in sales from our retail comparable stores, partially offset by a $0.1 million sales decrease resulting from the net decline in the number of retail stores we operated, (ii) a $3.6 million decrease in the Wholesale channel sales, and (iii) a $0.7 million decrease in Direct and E-Commerce sales.

Gross Profit

The gross profit rate increased to 63.3% in 2011 compared with 62.5% in 2010. Approximately 1.5 percentage points (ppt.) of the gross profit rate improvement was due to a reduction in promotional costs incurred to generate customer traffic, selected product price increases, leverage from the higher sales volume and manufacturing efficiencies. These improvements were partially offset by an increase in warranty costs, including additional customer-service reserves established in the third quarter of 2011, and higher performance-based incentive compensation.

Sales and Marketing Expenses

Sales and marketing expenses in 2011 increased to $317.5 million, or 42.7% of net sales, compared with $269.9 million, or 44.6% of net sales, in 2010. The $47.6 million increase was primarily due to a $21.4 million, or 30%, increase in media spending, an increase in variable selling expenses due to the higher sales volume, and an increase in customer financing expenses as a larger percentage of our customers took advantage of promotional financing offers. The sales and marketing expense rate declined 1.9 ppt. compared with the same period one year ago due to the leveraging impact of the 23% net sales increase.

General and Administrative Expenses

General and administrative (“G&A”) expenses increased $4.5 million to $58.1 million in 2011, compared with $53.6 million in 2010, but decreased to 7.8% of net sales, compared with 8.8% of net sales in the prior year. The $4.5 million increase in G&A expenses was primarily due to (i) a $4.8 million increase in employee compensation expenses including higher performance-based incentive compensation resulting from our strong 2011 financial performance, salaries and wages increases which were in-line with inflation, and increased stock-based compensation expense; and (ii) $0.6 million of additional depreciation expenses resulting from the current-year increase in capital expenditures to support the growth of the business. These increases were partially offset by the benefit from a $1.1 million reduction to previously recorded contingent liabilities in the second quarter of 2011. The G&A expense rate decreased by 1.0 ppt. in the current period compared with the same period one year ago, primarily due to the leveraging impact of the 23% net sales increase and the reduction in contingent liabilities.

Research and Development

Research and development (“R&D”) expenses increased to $4.2 million in 2011 compared with $2.1 million in 2010. R&D expenses for 2011 were 0.6% of net sales compared with 0.4% of net sales in 2010. The $2.0 million change in R&D expenses was due to increased investments in product innovation during 2011.


31


Asset Impairment Charges

During 2011, we recognized impairment charges of $0.1 million related to production machinery, computer equipment and certain retail store assets. During 2010, we recognized impairment charges of $0.3 million primarily related to assets at underperforming retail stores.

Other Expense, Net

Other expense, net was $33 thousand for 2011, compared with $1.9 million for the same period one year ago. Other expense, net for 2010 included a $1.1 million write-off of unamortized debt costs as we entered into a new credit agreement on March 26, 2010 and terminated our prior credit agreement. The remaining reduction is primarily due to lower debt amortization costs associated with our current credit agreement as compared with our prior credit agreement.

Income Tax Expense

Income tax expense was $29.9 million for 2011, compared with $18.9 million for the same period one year ago. The effective tax rate for 2011 was 33.1% compared with 37.5% for the same period one year ago. The 2011 effective tax rate benefited from the favorable resolution of certain prior years’ income tax matters and an increase in the tax deduction related to manufacturing activities.

Liquidity and Capital Resources

As of December 29, 2012, cash, cash equivalents and marketable debt securities totaled $177.8 million compared with $146.3 million as of December 31, 2011. The $31.5 million increase was primarily due to $100.6 million of cash provided by operating activities offset by $51.6 million of cash used to purchase property and equipment, and $34.9 million of cash used to repurchase our common stock ($30.0 million under our Board approved share repurchase program and $4.9 million in connection with the vesting of employee restricted stock grants). Our $89.9 million of marketable debt securities held as of December 29, 2012 are all highly liquid and include U.S. government and agency securities, corporate debt securities and municipal bonds.

The following table summarizes our cash flows for the fiscal years ended December 29, 2012, and December 31, 2011 (dollars in millions). Amounts may not add due to rounding differences:
 
 
Fiscal Year Ended
 
 
December 29,
2012
 
December 31,
2011
Total cash provided by (used in):
 
 
 
 
Operating activities
 
$
100.6

 
$
91.0

Investing activities
 
(112.1
)
 
(56.2
)
Financing activities
 
(16.9
)
 
5.4

Net (decrease) increase in cash and cash equivalents
 
$
(28.3
)
 
$
40.2

 
Cash provided by operating activities for the fiscal year ended December 29, 2012 was $100.6 million compared with $91.0 million for the fiscal year ended December 31, 2011. The $9.6 million year-over-year increase in cash from operating activities was comprised of a $17.6 million increase in our 2012 net income compared with the same period one year ago, and an $8.6 million increase in adjustments to reconcile net income to net cash provided by operating activities, partially offset by a $16.7 million decrease in cash from changes in operating assets and liabilities.
 
Investing activities for the fiscal year ended December 29, 2012 consisted of $51.6 million of property and equipment purchases, compared with $23.5 million for the same period one year ago. During 2012, we opened 57 retail stores and repositioned or remodeled 38 retail stores, while in 2011 we opened 19 retail stores and repositioned or remodeled 16 retail stores. Capital expenditures for 2013 are projected to be $70 - $80 million compared with $51.6 million in 2012. The capital expenditures for 2013 are primarily for new retail stores, repositioned and remodeled retail stores, continued investment in customer-management systems and other information technology that supports the growth of the business, and investments to support product innovation initiatives. On a net basis, we invested $60.6 million in marketable debt securities during the fiscal year ended December 29, 2012 compared with $30.0 million during the comparable period one year ago. Investing activities for the fiscal year ended December 31, 2011 also included the replacement of an outstanding letter of credit held by our workers’ compensation insurance carrier with a $2.7 million restricted cash deposit.


32


Net cash used in financing activities was $16.9 million for the fiscal year ended December 29, 2012, compared with net cash provided by financing activities of $5.4 million for the same period one year ago. During the fiscal year ended December 29, 2012, we repurchased $34.9 million of our stock ($30.0 million under our Board approved share repurchase program and $4.9 million in connection with the vesting of employee restricted stock grants) compared with $0.4 million during the same period one year ago. Changes in book overdrafts and payments on capital lease obligations are included in the net change in short-term borrowings. Financing activities for both periods reflect the cash proceeds from the exercise of employee stock options along with the excess tax benefits related to stock-based compensation.

During the second quarter of 2012, we reinitiated repurchasing our common stock with the objective to maintain common shares outstanding at current levels. Under the Board approved $290 million share repurchase program, we repurchased 1,140,861 shares at a cost of $30.0 million ($26.32 per share) during the fiscal year ended December 29, 2012. We did not repurchase any shares under our Board approved share repurchase program during the fiscal year ended December 31, 2011. As of December 29, 2012, the remaining authorization under our Board approved share repurchase program was $176.7 million. There is no expiration date governing the period over which we can repurchase shares.

On April 23, 2012, we entered into an Amendment to our $20.0 million Credit Agreement (the “Amendment”) with Wells Fargo Bank, National Association. The Amendment changes the Credit Agreement from a secured revolving credit facility to an unsecured revolving credit facility and extends the maturity date of the credit facility from July 1, 2012 to April 23, 2015. The amended credit facility contains an accordion feature that allows us to increase the amount of the line from $20.0 million to up to $50.0 million in total availability, subject to lender approval. The Amendment also decreases the amount of commitment fees, lowers the rate at which interest accrues and increases the financial flexibility with regard to our financial covenants. As of December 29, 2012 we were in compliance with all financial covenants.

Any borrowings under the Amendment will, at our request, be classified as either LIBOR Loans or Adjusted Base Rate (“ABR”) Loans (both as defined in the Credit Agreement). The rate of interest payable by us in respect of loans outstanding under the revolving credit facility is (i) with respect to LIBOR Loans, the Adjusted LIBO Rate (as defined in the Credit Agreement) for the interest period then in effect, plus 1.25%; or (ii) with respect to ABR Loans, the ABR (as defined in the Credit Agreement) then in effect for the Daily One-Month LIBO Rate (as defined in the Credit Agreement), plus 1.50% or the prime rate. We are subject to certain financial covenants under the Amendment, including minimum tangible net worth, a requirement to maintain a minimum amount of cash, cash equivalents and marketable debt securities, and to maintain at the administrative agent cash, cash equivalents and marketable debt securities equal to the amount the lenders are committed to lend under the Amendment.
 
Our business model, which can operate with minimal working capital, does not require significant additional capital to fund operations or organic growth. The $177.8 million of cash, cash equivalents and marketable debt securities, cash generated from ongoing operations, and cash available under our revolving credit facility are expected to be adequate to maintain operations, and fund anticipated expansion and strategic initiatives for the foreseeable future.

We have an agreement with GE Capital Retail Bank to offer qualified customers revolving credit arrangements to finance purchases from us (“GE Agreement”). The GE Agreement contains certain financial covenants, including a minimum tangible net worth requirement and a minimum cash requirement. As of December 29, 2012 we were in compliance with all financial covenants.

Under the terms of the GE Agreement, GE Capital Retail Bank sets the minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures, and is the owner of the accounts.

Off-Balance-Sheet Arrangements and Contractual Obligations

As of December 29, 2012, we were not involved in any unconsolidated special purpose entity transactions. Other than our operating leases, we do not have any off-balance-sheet financing. There were no outstanding letters of credit at December 29, 2012. A summary of our operating lease obligations by fiscal year is included in the “Contractual Obligations” section below. Additional information regarding our operating leases is available in Item 2, Properties, and Note 6, Leases, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.



33


Contractual Obligations

The following table presents information regarding our contractual obligations by fiscal year (in thousands):
 
 
Payments Due by Period(1)
 
 
Total
 
< 1 Year
 
1 - 3 Years
 
3 - 5 Years
 
> 5 Years
Operating leases(2)
 
$
161,190

 
$
37,322

 
$
56,950

 
$
37,782

 
$
29,136

Capital leases
 
115

 
112

 
3

 

 

Purchase commitments
 
4,023

 
4,023

 

 

 

    Total
 
$
165,328

 
$
41,457

 
$
56,953

 
$
37,782

 
$
29,136

        
(1) Our unrecognized tax benefits, including interest and penalties, of $0.2 million have not been included in the Contractual Obligations table as we are not able to determine a reasonable estimate of timing of the cash settlement with the respective taxing authorities.
(2) At December 29, 2012, we had entered into 26 lease commitments for future retail store locations. These lease commitments provide for minimum rentals over the next five to ten years, which if consummated based on current cost estimates, would approximate $17.2 million over the initial lease term.

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). In connection with the preparation of our financial statements, we are required to make estimates and assumptions about future events, and apply judgments that affect the reported amounts of assets, liabilities, sales, expenses and the related disclosure. Predicting future events is inherently an imprecise activity and as such requires the use of judgment. We base our assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time our consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.

Our significant accounting policies are discussed in Note 1, Business and Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K. Management believes the accounting policies discussed below are the most critical because they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting policies and estimates, and related disclosures with the Audit Committee of our Board.

Our critical accounting policies and estimates relate to asset impairment charges, stock-based compensation, warranty liabilities and revenue recognition.

34


Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Asset Impairment Charges
 
 
 
 
Long-lived assets other than goodwill and other intangible assets, which are separately tested for impairment, are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. When evaluating long-lived assets for potential impairment, we first compare the carrying value of the asset to the asset’s estimated future cash flows (undiscounted and without interest charges). If the estimated undiscounted cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value. We generally estimate fair value of long-lived assets, including our retail stores, using the income approach, which we base on estimated future cash flows (discounted and with interest charges). The inputs used to determine fair value relate primarily to future assumptions regarding sales volumes, gross profit rates, retail store operating expenses and applicable probability weightings regarding future alternative uses. These inputs are categorized as Level 3 inputs under the fair value measurements guidance. The inputs used represent management’s assumptions about what information market participants would use in pricing the assets and are based upon the best information available at the balance sheet date.

Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated fair value plus net proceeds expected from disposition of the asset (if any). When we recognize an impairment loss, the carrying amount of the asset is permanently reduced to estimated fair value based on discounted cash flows, quoted market prices or other valuation techniques.

Assets to be disposed of are reported at the lower of the carrying amount of the asset or fair value less costs to sell. We review retail store assets for potential impairment based on historical cash flows, lease termination provisions and expected future retail store operating results.

If we recognize an impairment loss, the adjusted carrying amount of the asset becomes its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset.
 
Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to identify events or changes in circumstances indicating the carrying value of assets may not be recoverable, estimate future cash flows, estimate asset fair values, and select a discount rate that reflects the risk inherent in future cash flows.

Expected cash flows may not be realized, which could cause long-lived assets to become impaired in future periods and could have a material adverse effect on future results of operations.

 
We have not made any material changes in our impairment loss assessment methodology during the past three fiscal years.

As of December 29, 2012, all retail stores had sufficient projected future cash flows to support the carrying value of their long-lived assets.

We believe that our estimates and assumptions used to determine long-lived asset impairment charges were reasonable and reflect the current economic environment. Our fair value calculations reflect current consumer spending trends. Our fair value calculations assume the ongoing availability of consumer credit and our ability to provide cost-effective consumer credit options. However, it is reasonably possible that an unexpected decline in consumer spending may expose us to future impairment charges that could be material.

Asset impairment charges totaled $0.1 million, $0.1 million and $0.3 million for 2012, 2011 and 2010, respectively.


35


Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Stock-Based Compensation
 
 
 
 
We have a stock-based compensation plan, which includes non-qualified stock options and stock awards. See Note 1, Business and Summary of Significant Accounting Policies, and Note 8, Shareholders’ Equity, to the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K, for a complete discussion of our stock-based compensation programs.

We determine the fair value of our nonqualified stock option awards and the resulting compensation expense at the date of grant using the Black-Scholes-Merton option-pricing model. The most significant inputs into the Black-Scholes-Merton model are exercise price, our estimate of expected stock price volatility and the expected term of the options.

We determine the fair value of our performance-based stock awards at the date of grant based on the closing market price of our stock. However, the final number of shares earned and the related compensation expense is adjusted up or down to the extent the performance target is met as of the last day of the performance period. The actual number of shares that will ultimately vest ranges from 0% to 150% of the targeted amount. We evaluate the likelihood of meeting the performance targets at each reporting period and adjust compensation expense, on a cumulative basis, based on the expected achievement of each of the performance targets. For performance stock awards granted in 2012, the performance target is actual market share growth and the performance period is from January 2012 through December 2014. For performance stock awards granted in 2011, the performance targets are actual market share growth and free cash flow and the performance period is from January 2011 through December 2013. For performance stock awards granted in 2010, the performance targets were net sales and net operating profit and the performance period was from January 2010 through December 2010. The actual number of shares that ultimately vested for the 2010 performance stock awards was 150% of the targeted amount.

 
Option-pricing models and generally accepted valuation techniques require management to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the volatility of our stock price, future employee forfeiture rates and future employee stock option exercise behaviors. Changes in these assumptions can materially affect the fair value estimate or future earnings adjustments.

Performance-based stock awards require management to make assumptions regarding the likelihood of achieving performance targets.

 
We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to determine stock-based compensation expense. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to changes in stock-based compensation expense that could be material.

In addition, if actual results are not consistent with the assumptions used, the stock-based compensation expense reported in our financial statements may not be representative of the actual economic cost of the stock-based compensation. Finally, if the actual forfeiture rates, or the actual achievement of performance targets, are not consistent with the assumptions used, we could experience future earnings adjustments.

A 10% change in our stock-based compensation expense for the year ended December 29, 2012, would have affected net income by approximately $673,000 in 2012.
Warranty Liabilities
 
 
 
 
The estimated cost to service warranty and customer service claims is included in cost of sales. This estimate is based on historical trends and warranty claim rates.

We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.

 
The majority of our warranty claims are incurred within the first year. However, our warranty liability contains uncertainties because our warranty obligations cover an extended period of time. A revision of estimated claim rates or the projected cost of materials and freight associated with sending replacement parts to customers could have a material adverse effect on future results of operations.

 
We have not made any material changes in our warranty liability assessment methodology during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our warranty liability. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.

 A10% change in our warranty liability at December 29, 2012, would have affected net income by approximately $317,000 in 2012.

 
 
 
 
 
 
 
 
 
 

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Revenue Recognition
 
 
 
 
Revenue is recognized when the sales price is fixed or determinable, collectability is reasonably assured and title passes. Amounts billed to customers for delivery and set up are included in net sales. Revenue is reported net of estimated sales returns and excludes sales taxes.

We accrue for sales returns at the time revenue is recognized and charge actual returns against the liability when they are received. Our general return policy is to accept returns after a 30-night trial period. We estimate future projected returns based on historical return rates.

 
Our estimates of sales returns contain uncertainties as actual returns may vary from expected rates, resulting in adjustments to net sales in future periods. These adjustments could have an adverse effect on future results of operations.

 
We have not made any material changes in the accounting methodology used to establish our sales returns allowance during the past three fiscal years. We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our sales returns allowance. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to additional losses or gains in future periods. A 10% change in our sales returns allowance at December 29, 2012 would have affected net income by approximately $348,000 in 2012.

Recent Accounting Pronouncements

None currently applicable.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Changes in the overall level of interest rates affect interest income generated from our short-term and long-term investments in marketable debt securities. If overall interest rates were one percentage point lower than current rates, our annual interest income would not change by a significant amount based on our investments in marketable debt securities as of December 29, 2012 and the current low interest-rate environment. We do not manage our investment interest-rate volatility risk through the use of derivative instruments.

As of December 29, 2012, we had no borrowings under our revolving credit facility.
 

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders of
Select Comfort Corporation
Minneapolis, MN

We have audited the internal control over financial reporting of Select Comfort Corporation and subsidiaries (the "Company") as of December 29, 2012 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonabl