10-K 1 a2013form10-k.htm 10-K 2013 Form 10-K


 
 
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 28, 2013
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. o
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 29, 2013, was $1,204,735,000 (based on the last reported sale price of the Registrant’s common stock on that date as reported by NASDAQ).
As of January 25, 2014, there were 54,761,000 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 2014 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 the term "bedding accessories" includes sheets, pillows, headboards, frames, mattress pads and related products.

Sleep Number®, Select Comfort®, Double Arrow logo, Know Better SleepSM, Sleep IQ™, AirFit™, Comfort.Individualized. SM, ComfortFit®, CoolFit™, DualAir Technology Inside logo, DualAir™, DualTemp™, Comfortaire®, Dreamaire®, Firmness Control™ System, FlexFit™, Grand King®,  In Balance™, IndividualFit®, Individualized Sleep Experiences®, LuxFit™, Pillow[ology]®, PillowFit®, PlushFit™, Sleep Number Inner Circle®, Take Control of Your Sleep®, Tech-e™, The Only Bed That Knows YouSM, What’s Your Sleep Number?®, our bed model names, and our other marks and 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

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 our new sleep tracking technology, SleepIQTM, and a solutions-focused line of Sleep Number pillows, sheets, adjustable bases, and other bedding products, including the innovative DualTempTM temperature-balancing layer.

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 2013 net sales of $960 million. As the only national specialty-mattress retailer, consumers can take advantage of a value added mattress-buying experience at one of our 440 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.

In 2009, 2010, 2011, 2012 and 2013, we generated operating income of $20.7 million, $52.4 million, $90.5 million, $119.8 million and $90.7 million, respectively. As of December 28, 2013, cash, cash equivalents and marketable debt securities totaled $145.0 million and we had no borrowings under our revolving credit facility.

On January 17, 2013, we completed the purchase of the business and assets of Comfortaire Corporation, a manufacturer and marketer of adjustable air-supported sleep systems. We purchased Comfortaire to advance our innovation leadership in individualized comfort. The acquisition price was $15.5 million. Comfortaire Corporation was a privately held company with 2012 net sales of $10.5 million. The purchase of Comfortaire's business and assets did not have a significant impact on our consolidated results of operations, cash flows or financial position.


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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 participants who slept on a Sleep Number bed generally fell asleep faster, experienced more deep sleep with fewer disturbances and experienced 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.
The Memory Foam Series combines cradling memory foam with exclusive DualAir technology. The series includes the Sleep Number m7 bed.

In January 2014, we introduced our most advanced Sleep Number bed, the x12, at the International Consumer Electronics Show (CES). The Sleep Number x12 bed with SleepIQ™ technology is a breakthrough advancement in sleep technology, providing consumers with simple and intuitive knowledge of how they slept and what changes they can make to achieve their very best sleep. In addition to SleepIQ, the Sleep Number x12 bed combines three other new and proprietary technologies with the Company’s core DualAir™ technology to deliver the ultimate, comfortable sleep experience. These include the exclusive FlexFit™ adjustable base technology, FlexTop™ mattress design, and a communication platform that brings together all of these technologies and provides control through a single universal remote or with simple voice commands.

Sleep Number Bedding Collection

Like our Sleep Number beds, our exclusive Sleep Number® bedding collection is a proprietary line of products that are designed to meet each individual's needs. Create Your Perfect PillowSM and our AirFit pillow adjust to an individual's size, shape and sleeping position for more comfortable sleep. The pillows are available in our exclusive CoolFit foam, memory fiber or white goose down. We also offer Create Your Perfect ComforterSM.

In 2013, we introduced the breakthrough DualTemp™ layer, a new product that addresses one of the most significant sleep issues experienced by customers - sleeping too hot or sleeping too cold. DualTemp attracts new customers to our brand and stores while also engaging our current customers. The DualTemp layer can be used with any mattress brand.

FlexFit Adjustable Bases

We offer a full line of FlexFit™ adjustable bases which enable customers to raise the head or foot of the bed, and to experience the comfort of massage, using a handheld remote control.

Exclusive 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 2013. Average annual net sales per comparable store have doubled since 2009 and were $2,093,000 in 2013 versus $2,164,000 in 2012, $1,721,000 in 2011, $1,295,000 in 2010 and $1,046,000 in 2009. In 2013, 96% of our stores open for a full year generated net sales over $1,000,000 and 46% of our stores open for a full year generated net sales over $2,000,000.


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As of December 28, 2013, we had 440 retail stores in the U.S., and expect to end 2014 with between 460 and 470 retail stores. We are taking both a national and local market-based approach to our growth – national advertising combined with local marketing, real estate optimization and sales execution – to increase market share. 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.

Historically, our retail stores have been located in shopping malls. In 2010, we began operating in non-mall locations. As of December 28, 2013, 31% 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 format provides more flexibility to our real estate strategy.

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 7% of our net sales in 2013.

Operations

Manufacturing and Distribution

We have two manufacturing plants (one in Irmo, South Carolina and the other in Salt Lake City, Utah) which distribute Sleep Number products. 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 have one manufacturing plant in Greensboro, South Carolina which distributes Comfortaire products. The manufacturing operations consist of final assembly and packaging of mattresses and bases.

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 June 2016 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

We offer Sleep Number Comfort ServiceSM Home Delivery & Setup, which includes assembly and mattress removal. In some markets on the East Coast, we provide home delivery, assembly and mattress removal services through a third-party provider. Approximately 76% of beds sold through our Company-Controlled channel in 2013 were delivered by our full-service home delivery team or by our third-party service provider.

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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. 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

Sleep Number uses systematic approaches to understand consumer needs as well as customers' responses to key features and benefits. Extensive consumer research is conducted from the product concept through the customer product ownership experience. Since the introduction of our first bed, we have continued to improve and expand our product lines to offer new beds and adjustable models as well as complete bedding collection assortments. Our research and development expenses were $9.5 million in 2013, $6.2 million in 2012 and $4.2 million in 2011.

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, an order entry 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. We are currently engaged in a multi-year project to upgrade our core information technology systems.

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 24 issued U.S. patents, expiring at various dates between July 2014 and September 2028, and 23 U.S. patent applications pending. We also hold 36 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.

Select Comfort®, Sleep Number® and the double arrow logo are trademarks registered with the U.S. Patent and Trademark Office. We have a number of other registered trademarks including Comfortaire®, ComfortFit®, DualTemp™, Grand King®, IndividualFit®, Individualized Sleep Experiences®, Pillow[ology]®, PillowFit®, Sleep Number Inner Circle®, Take Control of Your Sleep® and What’s Your Sleep Number?®. Several trademarks are the subject of pending applications including Sleep IQ™, AirFit™, Comfort.Individualized. SM, DualAir Technology Inside logo, Know Better SleepSM, LuxFit™, PlushFit™, Tech-e™ and The Only Bed That Knows YouSM. Each registered mark is renewable indefinitely as long as the mark remains in use. We also have a number of common law trademarks including CoolFit™, DualAir™, Firmness Control™ System, FlexFit™, In Balance™ and our bed model names. We are not aware of any material claims of infringement or other credible challenges asserted against us or our right to use these marks.

Industry and Competition

The U.S. bedding industry is a mature and generally stable industry. According to the International Sleep Products Association (“ISPA”), since 1984 the bedding manufacturing 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 $7.0 billion in 2013 compared to $6.8 billion in 2012. We estimate that traditional innerspring mattresses represent approximately 68% of total U.S. bedding sales (based on 2012 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 2012, with a 5.2% market share of industry revenue and 1.6% market share of industry units.

Over the 5-year, 10-year and 20-year periods ended 2013, the value of U.S. wholesale bedding shipments increased at compound annual growth rates of 2.2%, 3.1% and 4.7%, respectively. We believe that industry unit growth has been primarily driven by

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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, Stearns & Foster, Serta and Simmons. Numerous other manufacturers, primarily operating on a regional or niche basis, serve the balance of the innerspring bedding market. During 2013, Tempur-Pedic completed the acquisition of Sealy and now offers an air-supported mattress. Tempur Sealy International, Inc., the fourth largest bedding manufacturer (based on 2012 sales, prior to the acquisition of Sealy), and a number of other mattress manufacturers, offer foam mattress products. Simmons and Sealy, as well as a number of smaller manufacturers, have offered air-bed products in the past. The retail bedding industry 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 retardant 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.

Adopted or 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 2013, 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 28, 2013, 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.

Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Capital Retail Bank. Approximately 40% of our net sales in 2013 were financed by GE Capital Retail Bank. Our current agreement with GE Capital Retail Bank expires February 15, 2016, subject to earlier termination upon certain events and subject to automatic extensions. We pay GE Capital Retail Bank a fee for extended credit promotional financing offers. Under the terms of our 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. As the receivables are owned by GE Capital Retail Bank, at no time are the receivables purchased or acquired from us. We are not liable to GE Capital Retail Bank for our customers' credit defaults. In connection with all purchases financed under these arrangements, GE Capital Retail 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 Capital Retail Bank may apply for credit under a secondary program that we offer through another provider.

Employees

At December 28, 2013, we employed 2,858 persons, including 1,544 retail sales and support employees, 213 direct marketing and customer service employees, 751 manufacturing and logistics employees, and 350 management and administrative employees. Approximately 88 of our employees were employed on a part-time basis at December 28, 2013. 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 improving 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, 54, 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. Prior to joining Select Comfort, Ms. Ibach was Senior Vice President and General Merchandise Manager for Macy’s home division. From 1982 to 2005, Ms. Ibach held various leadership positions within Target Corporation at Marshall Field’s Department Stores. Other key positions included Vice President - Divisional Merchandise Manager, Director of Planning and Regional Director of Stores.

Andrea L. Bloomquist, 44, 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 1996-2008.

Kevin K. Brown, 45, has served as the Senior Vice President and Chief Marketing Officer for Select Comfort since January 2014. Prior to joining Select Comfort in January 2014, Mr. Brown served as Group Vice President, Chief Marketing Officer for Meijer, Inc., a regional chain of retail supercenters, from 2011 to 2013. From 2007 to 2011, Mr. Brown held executive marketing leadership roles at Sears Holdings Corporation, including Vice President, Chief Marketing Officer for the home appliances business unit. From 2004 to 2006, Mr. Brown held the position of Senior Vice President, Marketing for Jo-Ann Stores, Inc. Prior to Jo-Ann Stores, he was an associate partner for Accenture.
Andrew P. Carlin, 50, 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 sales leadership roles for companies including Senior Vice President of Store Operations at Gander Mountain from 2003-2008, Kohl’s Department Stores from 1995-2003 and Target Corporation from 1986-1995.

Mark A. Kimball, 55, has served as Select Comfort’s Senior Vice President and Chief Legal and Risk Officer and Secretary since June 2011. From August 2003 to June 2011, Mr. Kimball held the position of Senior Vice President, General Counsel, Chief Administrative Officer and Secretary. From July 2000 to August 2003, Mr. Kimball served as Senior Vice President, Human Resources and Legal, General Counsel, Chief Administrative Officer and Secretary. From May 1999 to July 2000, Mr. Kimball served as the company’s Senior Vice President, Chief Administrative Officer, General Counsel and Secretary. For more than five years prior to joining Select Comfort, Mr. Kimball was a partner in the law firm of Oppenheimer Wolff & Donnelly LLP practicing in the area of corporate finance.

Kathryn V. Roedel, 53, has served as Select Comfort’s Executive Vice President and Chief Services and Fulfillment Officer since June 2011. From October 2008 to June 2011 Ms. Roedel served as Select Comfort’s Executive Vice President, Product and Service. Ms. Roedel joined Select Comfort as the company’s Senior Vice President, Global Supply Chain in April 2005. From 2003 to March 2005, Ms. Roedel served as the General Manager, Global Supply Chain Strategy for GE Medical Systems. From 1983 to 2003, she held leadership positions within two divisions of General Electric Company, in Sourcing, Manufacturing, Quality and Service. Other key positions included General Manager, Global Quality and Six Sigma; Vice President of Technical Operations and Director/Vice President of Quality Programs for GE Clinical Services, a division of GE Medical Systems.

Wendy L. Schoppert, 47, has served as Select Comfort’s Executive Vice President and Chief Financial Officer since May 2011. From March 2008 to June 2011, Ms. Schoppert served as the company’s Senior Vice President, Chief Information Officer. She served as the company’s Senior Vice President, International from January 2007 to March 2008. Ms. Schoppert joined Select Comfort as Senior Vice President and General Manager, New Channel Development & Strategy in April 2005. 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. On November 12, 2013, Ms. Schoppert announced her plans to resign from her position at Select Comfort in 2014.


8



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 “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


9



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, (iii) our ability to prevent Internet publication of false or misleading information regarding our products or our competitors’ products; and (iv) the stability of our website.

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 sale 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 also make significant capital expenditures as we open new stores and remodel or reposition existing stores. We are highly dependent on our ability to maintain and increase sales per store to cover these fixed expenses, provide a return on our capital investments and 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.

Our Company-Controlled distribution strategy results in relatively few points of distribution, including 440 retail stores across the continental United States as of the end of 2013. 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.

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.


10



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, our products and stores, as well as other points of sale, 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 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 introduced adjustable firmness air beds that 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.

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.


11



Our intellectual property rights may not prevent others from using our technology or trademarks in connection with the sale of competitive products. We may be subject to claims that our products, processes or trademarks infringe intellectual property rights of others.

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 Sleep Number trademarks, which we believe have significant value and are important to the marketing of our products. These intellectual property rights may not provide sufficient 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. Our patents are also subject to varying expiration dates. In particular, our patents related to wireless remote control systems with digital displays will expire in November of 2014 and other patents will expire on various dates through September 2028. 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 may be subject to claims that our products, processes or trademarks infringe the intellectual property rights of others. The defense of these claims, even if we are ultimately successful, may result in costly litigation, and if we are not successful in our defense, we could be subject to liability for damages or royalty obligations and our sales, profitability, cash flows and financial condition could be adversely affected.

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 Capital Retail Bank provides credit to our customers through a private label credit card agreement that is currently scheduled to expire on February 15, 2016, subject to earlier termination upon certain events. GE Capital Retail Bank has discretion to control the content of financing offers to our customers and 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 Capital Retail 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, or who supply the vast majority of our needs of the particular material or component. 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

12



not be found on comparable terms. If our relationship with either the primary 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.

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 three manufacturing plants, which are located in Irmo, South Carolina, Salt Lake City, Utah and Greensboro, SC. 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.


13



Adopted or 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.

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. Improvements and upgrades to our systems will be costly to implement and may take longer or require greater resources than anticipated, and may result in disruptions to our systems or business.

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 may be subject to attacks by hackers or other cyber threats that could compromise the security of our systems, which could substantially disrupt our business and could result in the breach of consumers' or employees' private data.

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 and demographic information 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.


14



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 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.


15



ITEM 2. PROPERTIES

Retail 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 440 retail stores as of December 28, 2013:

 
 
Retail
Stores

 
 
 
Retail
Stores

 
 
 
Retail
Stores

Alabama
 
4

 
Louisiana
 
7

 
North Carolina
 
12

Arizona
 
8

 
Maine
 
2

 
North Dakota
 
2

Arkansas
 
3

 
Maryland
 
11

 
Ohio
 
18

California
 
58

 
Massachusetts
 
5

 
Oklahoma
 
4

Colorado
 
11

 
Michigan
 
13

 
Oregon
 
6

Connecticut
 
7

 
Minnesota
 
13

 
Pennsylvania
 
18

Delaware
 
2

 
Mississippi
 
4

 
Rhode Island
 
1

Florida
 
27

 
Missouri
 
13

 
South Carolina
 
4

Georgia
 
14

 
Montana
 
2

 
South Dakota
 
1

Idaho
 
2

 
Nebraska
 
3

 
Tennessee
 
9

Illinois
 
19

 
Nevada
 
4

 
Texas
 
37

Indiana
 
11

 
New Hampshire
 
4

 
Utah
 
3

Iowa
 
7

 
New Jersey
 
14

 
Vermont
 
1

Kansas
 
4

 
New Mexico
 
3

 
Virginia
 
11

Kentucky
 
6

 
New York
 
12

 
Washington
 
10

 
 
 
 
 
 
 
 
Wisconsin
 
10

 
 
 
 
 
 
 
 
Total
 
440


Manufacturing, Distribution 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.

We also lease three buildings used for manufacturing purposes for our Comfortaire business in Greenville, South Carolina of approximately 65,000 total square feet. The current lease term for these three buildings runs through February 28, 2015, with a one-year renewal option thereafter.


16



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.

On August 23, 2013, we filed a complaint in U.S. District Court in the District of Minnesota against Gentherm, Inc. seeking a declaratory judgment that Select Comfort be named as an assignee of certain patents asserted against Select Comfort by Gentherm or in the alternative that the asserted patents are not enforceable or are invalid or that Select Comfort and its products do not infringe any valid claim of the asserted patents. This complaint was filed after Gentherm asserted in a letter that Select Comfort’s recently introduced DualTemp™ layer product infringed certain patents owned by Gentherm. Subsequently, Gentherm filed counterclaims alleging infringement of its patents and seeking various legal and equitable remedies, including injunctive relief, treble damages and attorney’s fees. We believe the claims asserted by Gentherm are without merit, and we intend to vigorously pursue our claims and defend the claims asserted by Gentherm.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.


17



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 25, 2014, there were approximately 209 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, at closing, as reported by NASDAQ for the two most recent fiscal years.
 
 
First
Quarter
 
Second
Quarter
 
Third
Quarter
 
Fourth
Quarter
Fiscal 2013
 
 
 
 
 
 
 
 
High
 
$
28.22

 
$
25.80

 
$
27.55

 
$
26.02

Low
 
17.16

 
17.56

 
21.01

 
18.04

 
 
 
 
 
 
 
 
 
Fiscal 2012
 
 

 
 

 
 

 
 

High
 
$
33.20

 
$
35.24

 
$
33.58

 
$
33.16

Low
 
22.15

 
19.33

 
21.10

 
24.48


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 2013 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 29, 2013 through October 26, 2013
 
141,996

 
$
22.43

 
141,660

 
$
143,535,000

October 27, 2013 through November 23, 2013
 
164,470

 
19.32

 
164,470

 
140,357,000

November 24, 2013 through December 28, 2013
 
175,102

 
20.87

 
175,102

 
136,702,000

Total
 
481,568

 
$
20.80

 
481,232

 
$
136,702,000

        
(1) 
Under the current Board-approved $290.0 million share repurchase program, we repurchased 481,232 shares of our common stock at a cost of $10.0 million (based on trade dates) during the three months ended December 28, 2013. As of December 28, 2013, the remaining authorization under our Board-approved share repurchase program was $136.7 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 336 shares of our common stock at a cost of $8 thousand, during the three months ended December 28, 2013.

18



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 January 3, 2009. 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
 
 
1/3/2009
 
1/2/2010
 
1/1/2011
 
12/31/2011
 
12/29/2012
 
12/28/2013
Select Comfort Corporation
 
$
100

 
$
2,508

 
$
3,512

 
$
8,342

 
$
9,427

 
$
8,162

S&P 400 Specialty Stores Index
 
100

 
147

 
221

 
253

 
308

 
466

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

 
140

 
166

 
164

 
189

 
269





19



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
 
2013
 
2012
 
2011
 
2010
 
2009
 
2008(1)
Consolidated Statements of Operations Data:
 
 
 
 
 
 
 
 
 
 
Net sales
$
960,171

 
$
934,978

 
$
743,203

 
$
605,676

 
$
544,202

 
$
608,524

Gross profit
601,755

 
596,546

 
470,345

 
378,263

 
335,460

 
358,572

Operating expenses:
 
 
 
 
 

 
 

 
 

 
 

Sales and marketing
439,156

 
398,205

 
317,502

 
269,901

 
259,244

 
332,068

General and administrative
62,840

 
66,617

 
58,106

 
53,572

 
49,560

 
57,994

Research and development
9,478

 
6,194

 
4,175

 
2,147

 
1,973

 
3,374

Asset impairment charges
127

 
148

 
109

 
260

 
686

 
34,594

Other(2)(3)
(534
)
 
5,595

 

 

 
3,324

 

Operating income (loss)
90,688

 
119,787

 
90,453

 
52,383

 
20,673

 
(69,458
)
Net income (loss)
$
60,081

 
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
Net income (loss) as adjusted(8)
$
59,730

 
$
81,748

 
$
60,478

 
$
31,568

 
$
11,169

 
$
(23,174
)
Net income (loss) per share:
 
 
 
 
 

 
 

 
 

 
 

Basic
$
1.10

 
$
1.41

 
$
1.10

 
$
0.58

 
$
0.78

 
$
(1.59
)
Diluted
$
1.08

 
$
1.37

 
$
1.07

 
$
0.57

 
$
0.77

 
$
(1.59
)
Diluted - as adjusted(8)
$
1.07

 
$
1.43

 
$
1.07

 
$
0.57

 
$
0.24

 
$
(0.52
)
Shares used in calculation of net income (loss) per share:
 
 
 
 
 

 
 

 
 

 
 

Basic
54,866

 
55,516

 
55,081

 
54,005

 
45,682

 
44,186

Diluted
55,803

 
57,076

 
56,432

 
55,264

 
46,198

 
44,186

 
 
 
 
 
 
 
 
 
 
 
 
Consolidated Balance Sheet Data:
 
 
 
 
 

 
 

 
 

 
 

Cash, cash equivalents and marketable debt securities(4)
$
145,014

 
$
177,821

 
$
146,317

 
$
76,016

 
$
12,184

 
$
10,987

Working capital
52,357

 
77,517

 
72,145

 
20,053

 
(25,435
)
 
(90,534
)
Total assets
381,765

 
342,021

 
262,657

 
169,957

 
118,240

 
135,413

Borrowings under revolving credit facility

 

 

 

 

 
79,150

Total shareholders’ equity (deficit)
225,220

 
193,697

 
129,391

 
57,977

 
22,458

 
(41,630
)
 
 
 
 
 
 
 
 
 
 
 
 
Selected Operating Data:
 
 
 
 
 

 
 

 
 

 
 

Stores open at period-end
440

 
410

 
381

 
386

 
403

 
471

Stores opened during period
71

 
57

 
19

 
7

 
4

 
19

Stores closed during period
41

 
28

 
24

 
24

 
72

 
26

Average net sales per store (000’s)(5)
$
2,093

 
$
2,164

 
$
1,721

 
$
1,295

 
$
1,046

 
$
984

Percentage of stores with more than $1.0 million in net sales(5)
96
 %
 
98
%
 
93
%
 
70
%
 
48
 %
 
45
 %
Percentage of stores with more than $2.0 million in net sales(5)
46
 %
 
49
%
 
24
%
 
7
%
 
2
 %
 
2
 %
Average net sales per mattress unit - Company-Controlled channel(6)
$
3,245

 
$
3,050

 
$
2,694

 
$
2,424

 
$
2,369

 
$
2,370

Company-Controlled comparable-sales (decrease) increase(7)
(4
)%
 
23
%
 
26
%
 
19
%
 
(4
)%
 
(26
)%
Average square footage per store open during period(5)
1,985

 
1,670

 
1,526

 
1,484

 
1,474

 
1,410

Net sales per square foot(5)
$
1,077

 
$
1,324

 
$
1,135

 
$
873

 
$
710

 
$
703

Average store age (in months at period-end)
102

 
113

 
113

 
113

 
102

 
91

Earnings before interest, depreciation and amortization (“Adjusted EBITDA”)(8)
$
125,020

 
$
150,285

 
$
109,180

 
$
69,675

 
$
42,289

 
$
(9,437
)
Free cash flows(4)(8)
$
11,294

 
$
49,033

 
$
67,519

 
$
64,058

 
$
60,717

 
$
(26,381
)
        
(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 Compensation Committee approved the modification of Mr. McLaughlin's unvested stock awards, including performance-based stock awards. As a result of these modifications, we recorded incremental non-cash compensation of $5.6 million ($3.7 million, net of income tax) in 2012. The performance-based stock awards are subject to applicable performance adjustments (through 2014) based on free cash flow and actual market share growth versus performance targets. During 2013, we recorded a non-cash compensation benefit of $0.5 million ($0.4 million, net of income tax) resulting from performance-based stock award adjustments.
(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 359, 348, 359, 379, 399 and 452 for 2013, 2012, 2011, 2010, 2009 and 2008, 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 21 and 22 for the reconciliation of these non-GAAP measures to the appropriate GAAP measure.



20



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, nor 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 reconciliations of our non-GAAP financial measures to the most comparable GAAP financial measures.
 
 
Year
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
2008
Net income (loss) – as reported
 
$
60,081

 
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
Adjustments – net of income tax (1):
 
 
 
 

 
 

 
 

 
 

 
 

CEO transition (benefit) costs(2)
 
(351
)
 
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
 
$
59,730

 
$
81,748

 
$
60,478

 
$
31,568

 
$
11,169

 
$
(23,174
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income (loss) per share – as adjusted:
 
 
 
 

 
 

 
 

 
 

 
 

Basic
 
$
1.09

 
$
1.47

 
$
1.10

 
$
0.58

 
$
0.24

 
$
(0.52
)
Diluted
 
$
1.07

 
$
1.43

 
$
1.07

 
$
0.57

 
$
0.24

 
$
(0.52
)
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic shares
 
54,866

 
55,516

 
55,081

 
54,005

 
45,682

 
44,186

Diluted shares
 
55,803

 
57,076

 
56,432

 
55,264

 
46,198

 
44,186

        
(1) 
Reflects annual effective income tax rates, before discrete adjustments, of 34.2%, 34.7%, 38.0% and 40.0% for 2013, 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 Compensation Committee approved the modification of Mr. McLaughlin's unvested stock awards, including performance-based stock awards. As a result of these modifications, we incurred incremental non-cash compensation of $5.6 million ($3.7 million, net of income tax) in fiscal year 2012. The performance-based stock awards are subject to applicable performance adjustments (through 2014) based on free cash flow and actual market share growth versus performance targets. During 2013, we recorded a non-cash compensation benefit of $0.5 million ($0.4 million, net of income tax) resulting from performance-based stock award adjustments.
(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.



21



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 as net income plus: income tax expense, interest expense, depreciation and amortization, stock-based compensation and asset impairments (“Adjusted EBITDA”). 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
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
2008
Net income (loss)
 
$
60,081

 
$
78,094

 
$
60,478

 
$
31,568

 
$
35,552

 
$
(70,177
)
Income tax expense (benefit)
 
30,930

 
41,911

 
29,942

 
18,922

 
(20,862
)
 
(2,566
)
Interest expense
 
51

 
91

 
187

 
1,951

 
5,996

 
3,375

Depreciation and amortization
 
29,599

 
19,735

 
13,493

 
13,012

 
17,681

 
21,635

Stock-based compensation
 
4,232

 
10,306

 
4,971

 
3,962

 
3,236

 
3,702

Asset impairments
 
127

 
148

 
109

 
260

 
686

 
34,594

Adjusted EBITDA
 
$
125,020

 
$
150,285

 
$
109,180

 
$
69,675

 
$
42,289

 
$
(9,437
)

Free Cash Flow
(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
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
2008
Net cash provided by operating activities
 
$
88,105

 
$
100,626

 
$
91,046

 
$
71,407

 
$
63,176

 
$
5,821

Subtract: Purchases of property and equipment
 
76,811

 
51,593

 
23,527

 
7,349

 
2,459

 
32,202

Free cash flow
 
$
11,294

 
$
49,033

 
$
67,519

 
$
64,058

 
$
60,717

 
$
(26,381
)




22



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


23



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 new sleep tracking technology, SleepIQTM, and a solutions-focused line of Sleep Number pillows, sheets, adjustable bases, and other bedding products, including the innovative DualTempTM temperature-balancing layer.
 
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/Other channel sells to and through selected retail and wholesale customers in the United States and Australia, and the QVC shopping channel.

Mission, Vision and Goals

Our mission is to improve lives by Individualizing Sleep Experiences.

Our vision is to become one of the world's most beloved brands by delivering an Unparalleled Sleep Experience. We plan to achieve this by executing our consumer brand strategy to advance our long-term goals and strengthen our competitive advantages.

Our long-term goals are:
  
Everyone will know Sleep Number®;
Innovative Sleep Number® products will deliver meaningful benefits;
Customers will easily find and interact with Sleep Number;
Customers will enthusiastically recommend Sleep Number; and
We will leverage our unique business model to fund innovation and growth.

Results of Operations
 
Fiscal 2013 Summary
 
Financial highlights for fiscal 2013 were as follows:
 
Net income decreased 23% to $60.1 million, or $1.08 per diluted share, compared with net income of $78.1 million, or $1.37 per diluted share in 2012.

Financial results for 2012 and 2013 included a $5.6 million charge ($3.7 million, net of income tax) and a $0.5 million benefit ($0.4 million, net of income tax), respectively, associated with the June 1, 2012 chief executive officer transition. See CEO Transition Costs on page 27 for additional details.
 
Net sales increased 3% to $960.2 million, compared with $935.0 million in 2012, primarily due to the addition of 30 net new stores partially offset by a 4% comparable sales decrease in our Company-Controlled channel.
 
Operating income for 2013 declined to $90.7 million, or 9.4% of net sales, compared with $119.8 million, or 12.8% of net sales, for the same period one year ago. Adjusted operating income (operating income excluding CEO transition (benefit) costs) decreased to $90.2 million, or 9.4% of net sales, compared with $125.4 million, or 13.4% of net sales, for the same period one year ago. The decline in operating income was primarily driven by a 1.1 percentage point decrease in our gross profit rate and a 3.1 percentage point increase in our sales and marketing expense rate. Annual retail sales-per-store for 2013 decreased by 3% from one year ago to $2.1 million (for stores open at least one year).
 
Cash provided by operating activities in 2013 totaled $88.1 million, compared with $100.6 million for the prior year.
 
At December 28, 2013, cash, cash equivalents and marketable debt securities totaled $145.0 million compared with $177.8 million at December 29, 2012, and we had no borrowings under our revolving credit facility. In 2013, we repurchased 1,828,811 shares of our common stock under our Board-approved share repurchase program at a cost of $40.0 million ($21.89 per share). As of December 28, 2013, the remaining authorization under our Board-approved share repurchase program was $136.7 million.

24



 
On January 17, 2013, we completed the purchase of the business and assets of Comfortaire Corporation, a manufacturer and marketer of adjustable air-supported sleep systems, for $15.5 million. Comfortaire Corporation was a privately held company with 2012 net sales of $10.5 million. We purchased Comfortaire to advance our innovation leadership in individualized sleep comfort.

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. 
 
 
2013
 
2012
 
2011
 
 
$
 
% of
Net Sales
 
$
 
% of
Net Sales
 
$
 
% of
Net Sales
Net sales
 
$
960.2

 
100.0
 %
 
$
935.0

 
100.0
%
 
$
743.2

 
100.0
%
Cost of sales
 
358.4

 
37.3

 
338.4

 
36.2

 
272.9

 
36.7

Gross profit
 
601.8

 
62.7

 
596.5

 
63.8

 
470.3

 
63.3

 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 

 
 
 
 
 
 
Sales and marketing
 
439.2

 
45.7

 
398.2

 
42.6

 
317.5

 
42.7

General and administrative
 
62.8

 
6.5

 
66.6

 
7.1

 
58.1

 
7.8

Research and development
 
9.5

 
1.0

 
6.2

 
0.7

 
4.2

 
0.6

CEO transition (benefit) costs
 
(0.5
)
 
(0.1
)
 
5.6

 
0.6

 

 
0.0

Asset impairment charges
 
0.1

 
0.0

 
0.1

 
0.0

 
0.1

 
0.0

Total operating expenses
 
511.1

 
53.2

 
476.8

 
51.0

 
379.9

 
51.1

Operating income
 
90.7

 
9.4

 
119.8

 
12.8

 
90.5

 
12.2

Operating income – as adjusted (1)
 
90.2

 
9.4

 
125.4

 
13.4

 
90.5

 
12.2

Other income, net
 
0.3

 
0.0

 
0.2

 
0.0

 

 
0.0

Income before income taxes
 
91.0

 
9.5

 
120.0

 
12.8

 
90.4

 
12.2

Income tax expense
 
30.9

 
3.2

 
41.9

 
4.5

 
29.9

 
4.0

Net income
 
$
60.1

 
6.3
 %
 
$
78.1

 
8.4
%
 
$
60.5

 
8.1
%
Net income – as adjusted (1)
 
$
59.7

 
6.2
 %
 
$
81.7

 
8.7
%
 
$
60.5

 
8.1
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income per share:
 
 

 
 

 
 

 
 
 
 
 
 
Basic
 
$
1.10

 
 

 
$
1.41

 
 
 
$
1.10

 
 
Diluted
 
$
1.08

 
 

 
$
1.37

 
 
 
$
1.07

 
 
Diluted – as adjusted (1)
 
$
1.07

 
 
 
$
1.43

 
 
 
$
1.07

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average number of common shares:
 
 

 
 

 
 
 
 
 
 
Basic
 
54.9

 
 

 
55.5

 
 
 
55.1

 
 
Diluted
 
55.8

 
 

 
57.1

 
 
 
56.4

 
 
        
(1) 
This non-GAAP measure is not in accordance with, nor 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 21 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:
 
 
2013
 
2012
 
2011
Company-Controlled channel
 
96.2
%
 
96.7
%
 
96.2
%
Wholesale/Other channel
 
3.8
%
 
3.3
%
 
3.8
%
Total
 
100.0
%
 
100.0
%
 
100.0
%






25



The components of total net sales growth, including comparable net sales changes, were as follows: 
 
 
Net Sales Increase/(Decrease)
 
 
2013
 
2012
 
2011
 
 
 
 
 
 
 
Retail comparable-store sales(1)
 
(4
%)
 
24
%
 
29
%
Direct and E-Commerce
 
(5
%)
 
9
%
 
(1
%)
Company-Controlled comparable sales change
 
(4
%)
 
23
%
 
26
%
Net store openings/closings
 
6
%
 
3
%
 
(1
%)
Total Company-Controlled channel
 
2
%
 
26
%
 
25
%
Wholesale/Other channel
 
18
%
 
10
%
 
(11
%)
Total net sales change
 
3
%
 
26
%
 
23
%
        
(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: 
 
 
2013
 
2012
 
2011
 
 
 
 
 
 
 
Average sales per store(1) ($ in thousands)
 
$
2,093

 
$
2,164

 
$
1,721

Average sales per square foot(1)
 
$
1,077

 
$
1,324

 
$
1,135

Stores > $1 million in net sales(1)
 
96
%
 
98
%
 
93
%
Stores > $2 million in net sales(1)
 
46
%
 
49
%
 
24
%
Average net sales per mattress unit – Company-Controlled channel(2)
 
$
3,245

 
$
3,050

 
$
2,694

        
(1) Trailing twelve months for stores included in our comparable store sales calculation.
(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:
 
 
2013
 
2012
 
2011
 
 
 
 
 
 
 
Beginning of period
 
410

 
381

 
386

Opened
 
71

 
57

 
19

Closed
 
(41
)
 
(28
)
 
(24
)
End of period
 
440

 
410

 
381


Comparison of 2013 and 2012

Net sales

Net sales in 2013 increased 3% to $960.2 million, compared with $935.0 million for the same period one year ago. The sales increase was primarily driven by sales from 30 net new retail stores opened in the past 12 months, partially offset by a 4% comparable sales decline in our Company-Controlled channel. Company-Controlled mattress units decreased 4% compared to the prior-year period. Average net sales per mattress unit in our Company-Controlled channel increased by 6%.
 
The $25.2 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $53.1 million sales increase resulting from net new retail store openings and (ii) a $5.4 million increase in Wholesale/Other channel sales; partially offset by (iii) $30.0 million decrease in sales from our Company-Controlled comparable retail stores; and (iv) a $3.3 million decrease in Direct and E-Commerce sales.


26



Gross profit

The gross profit rate decreased to 62.7% of net sales in 2013, compared with 63.8% for the prior-year period. The 2013 sales mix shift to lower-margin products, including Memorial Day and Labor Day limited-edition mattresses and the introduction of the DualTemp layer, reduced the gross profit rate by 0.8 percentage points (“ppt.”) compared to the same period one year ago. In addition, higher sales return and exchange costs, including the second quarter 2013 move to more generous return and exchange policies, reduced the gross profit rate by 0.8 ppt. The gross profit rate was favorably impacted by 0.6 ppt. related to supply chain and manufacturing efficiencies. The rate was also impacted by a variety of factors that can fluctuate from year-to-year, including performance-based incentive compensation and warranty expenses.

Sales and marketing expenses

Sales and marketing expenses in 2013 increased 10% to $439.2 million, or 45.7% of net sales, compared with $398.2 million, or 42.6% of net sales, for the same period one year ago. The $41.0 million increase resulted from (i) a $24.6 million increase in fixed selling expenses primarily due to new, repositioned and remodeled stores; (ii) a $17.9 million, or 14%, increase in media spending; and (iii) a $5.4 million increase in customer financing expenses, as a larger percentage of our customers took advantage of promotional financing offers. These increases were partially offset by lower percentage rent of $4.0 million and a net decrease in miscellaneous other expenses. The sales and marketing expense rate increased 3.1 ppt. compared with the same period one year ago due to the increase in expenses noted above and the deleveraging impact of the 4% comparable sales decrease in our Company-Controlled channel.
 
General and administrative expenses

General and administrative (“G&A”) expenses decreased $3.8 million to $62.8 million in 2013, compared with $66.6 million in the prior year and decreased to 6.5% of net sales, compared with 7.1% of net sales one year ago. The $3.8 million decrease in G&A expenses was primarily due to (i) a $7.7 million decrease in performance-based incentive compensation; (ii) a $2.8 million reduction in outside professional fees, partially offset by (iii) a $4.6 million increase in employee compensation resulting from headcount increases to support business growth initiatives, and salary and wage rate increases that were in line with inflation; (iv) $1.9 million of additional depreciation expense resulting from the increase in capital expenditures; and (v) a $0.2 million net increase in miscellaneous other expenses. The G&A expense rate decreased by 0.6 ppt. in the current period compared with the same period one year ago due to the net reduction in expenses and the leveraging impact of the 3% net sales increase.

Research and development expenses

Research and development (R&D) expenses increased to $9.5 million, or 1.0% of net sales in 2013, compared with $6.2 million, or 0.7% of net sales, for the same period one year ago. The $3.3 million increase in R&D expenses was due to increased investments to support product innovations during 2013 and the Company's long-term product innovation roadmap.

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 Compensation Committee approved the modification of Mr. McLaughlin’s unvested stock awards, including performance-based stock awards. As a result of these modifications, we recorded incremental non-cash compensation of $5.6 million ($3.7 million, net of income tax) in 2012. The performance-based stock awards are subject to applicable performance adjustments through 2014 based on free cash flow and actual market share growth versus performance targets. During 2013, we recorded a non-cash compensation benefit of $0.5 million ($0.4 million, net of income tax) resulting from performance-based stock award adjustments.

Asset impairment charges

During 2013 and 2012, we recognized asset impairment charges of $0.1 million related to computer software and certain retail store assets.

Other income, net

Other income, net was $0.3 million for 2013, compared with $0.2 million for the comparable period one year ago. The current-year improvement in other income, net was primarily due to a higher average yield on our portfolio in the current-year period, and a reduction of fees associated with our line of credit.

27



Income tax expense

Income tax expense was $30.9 million in 2013 compared with $41.9 million for the same period one year ago. The effective tax rate for 2013 decreased to 34.0% compared with the prior-year period rate of 34.9%. The decrease in the effective tax rate primarily resulted from the retroactive reinstatement of the 2012 research and development tax credit in the first quarter of 2013. Income tax expense for 2013 includes research and development tax credits for both 2012 and 2013.

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/Other channel sales.

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; and (iv) a $1.6 million net increase in miscellaneous other expenses, partially offset by lower performance-based incentive compensation and stock-based compensation. 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.


28



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 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.

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.

Liquidity and Capital Resources

As of December 28, 2013, cash, cash equivalents and marketable debt securities totaled $145.0 million compared with $177.8 million as of December 29, 2012. The $32.8 million decrease was primarily due to $88.1 million of cash provided by operating activities offset by $76.8 million of cash used to purchase property and equipment, $20.0 million of strategic investments, including the purchase of Comfortaire (see discussion below), and $42.1 million of cash used to repurchase our common stock ($40.0 million under our Board-approved share repurchase program and $2.0 million in connection with the vesting of employee restricted stock grants). Our $86.8 million of marketable debt securities held as of December 28, 2013 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 28, 2013, and December 29, 2012 (dollars in millions). Amounts may not add due to rounding differences:
 
 
2013
 
2012
Total cash provided by (used in):
 
 
 
 
Operating activities
 
$
88.1

 
$
100.6

Investing activities
 
(87.3
)
 
(112.1
)
Financing activities
 
(30.5
)
 
(16.9
)
Net decrease in cash and cash equivalents
 
$
(29.7
)
 
$
(28.3
)
 
Cash provided by operating activities for the fiscal year ended December 28, 2013 was $88.1 million compared with $100.6 million for the fiscal year ended December 29, 2012. The $12.5 million year-over-year decrease in cash from operating activities was comprised of an $18.0 million decrease in our 2013 net income compared with the same period one year ago, and an $5.4 million increase in adjustments to reconcile net income to net cash provided by operating activities, partially offset by a $0.1 million increase in cash from changes in operating assets and liabilities.
 
Investing activities for the fiscal year ended December 28, 2013 consisted of $76.8 million of property and equipment purchases, compared with $51.6 million for the same period one year ago. During 2013, we opened 71 retail stores and repositioned or remodeled 42 retail stores, while in 2012 we opened 57 retail stores and repositioned or remodeled 38 retail stores. Capital expenditures for 2014

29



are projected to be $70 - $80 million compared with $76.8 million in 2013. The capital expenditures for 2014 are primarily for continued investment in customer-management systems and other information technology, new retail stores, repositioned and remodeled retail stores, and investments to support product innovation initiatives. We received net proceeds of $9.4 million in marketable debt securities during the fiscal year ended December 28, 2013 compared with a net investment of $60.6 million during the comparable period one year ago. On January 17, 2013, we completed the purchase of the business and assets of Comfortaire Corporation, a manufacturer and marketer of adjustable air-supported sleep systems, for $15.5 million. Comfortaire Corporation was a privately held company with 2012 net sales of $10.5 million. We purchased Comfortaire to advance our innovation leadership in individualized comfort. See Note 3, Purchase of Comfortaire, of the Notes to Condensed Consolidated Financial Statements for further details. Finally, we made a $4.5 million minority equity investment in one of our strategic product-development partners.

Net cash used in financing activities was $30.5 million for the fiscal year ended December 28, 2013, compared with net cash used in financing activities of $16.9 million for the same period one year ago. During the fiscal year ended December 28, 2013, we repurchased $42.1 million of our stock ($40.0 million under our Board-approved share repurchase program and $2.0 million in connection with the vesting of employee restricted stock grants) compared with $34.9 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. Under the Board-approved $290 million share repurchase program, we repurchased 1,828,811 shares at a cost of $40.0 million ($21.89 per share) during the fiscal year ended December 28, 2013. During 2012, we repurchased 1,140,861 shares at a cost of $30.0 million ($26.32 per share) under our Board-approved share repurchase program during the fiscal year ended December 29, 2012. As of December 28, 2013, the remaining authorization under our Board-approved share repurchase program was $136.7 million. There is no expiration date governing the period over which we can repurchase shares.

Our $20.0 million Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association, as amended, is an unsecured revolving credit facility that matures August 31, 2016. The Credit Agreement 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. As of December 28, 2013 we were in compliance with all financial covenants.

Our business model, which can operate with minimal working capital, does not require significant additional capital to fund operations or organic growth. The $145.0 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 capital expenditures 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 28, 2013 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 28, 2013, 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 28, 2013. 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 8, 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.





30



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)
 
$
216,995

 
$
44,549

 
$
75,816

 
$
51,526

 
$
45,104

Purchase commitments
 
4,784

 
4,784

 

 

 

    Total
 
$
221,779

 
$
49,333

 
$
75,816

 
$
51,526

 
$
45,104

        
(1) Our unrecognized tax benefits, including interest and penalties, of $0.5 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 28, 2013, we had entered into 32 lease commitments for future retail store locations. These lease commitments provide for minimum rentals over the next five to 10 years, which if consummated based on current cost estimates, would approximate $30.9 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 stock-based compensation, asset impairment charges, goodwill and indefinite-lived intangible assets, warranty liabilities and revenue recognition.

31




Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Stock-Based Compensation
 
 
 
 
We have stock-based compensation plans, which includes non-qualified stock options and stock awards. See Note 1, Business and Summary of Significant Accounting Policies, and Note 10, 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 2013, the performance targets are net sales and operating margin and the performance period is fiscal 2015. 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 were actual market share growth and free cash flow and the performance period was from January 2011 through December 2013. The actual number of shares that will ultimately vest upon completion of the service period for the 2011 performance stock awards will be 93% 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 28, 2013, would have affected net income by approximately $278,000 in 2013.

32



Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Asset Impairment Charges
 
 
 
 
Long-lived assets (other than goodwill and indefinite-lived 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 and definite-lived intangible assets, 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 28, 2013, 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 $127,000, $148,000 and $109,000 for 2013, 2012 and 2011, respectively.


33



Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Goodwill and Indefinite-Lived Intangible Assets
 
 
Goodwill represents the excess of cost over the fair value of identifiable net assets of businesses acquired. Our other indefinite-lived intangible assets include trade names/trademarks. See Note 7, Goodwill and Intangible Assets, Net, for a complete discussion of our goodwill and indefinite-lived intangible assets.

Our test for goodwill impairment is performed at least annually or when there are any indicators of impairment. The FASB's guidance allows us to perform either a quantitative assessment or a qualitative assessment before calculating the fair value of a reporting unit. We have elected to perform the quantitative assessment. The quantitative goodwill impairment test is a two-step process. The first step is a comparison of the fair value of the reporting unit with its carrying amount, including goodwill. If this step reflects impairment, then the loss would be measured as the excess of recorded goodwill over its implied fair value. Implied fair value is the excess of fair value of the reporting unit over the fair value of all identified assets and liabilities. Fair value is determined using a market-based approach utilizing widely accepted valuation techniques, including quoted market prices and our market capitalization.
 
Other indefinite-lived intangible assets are assessed for impairment by comparing the carrying value of an asset with its fair value. If the carrying value exceeds fair value, an impairment loss is recognized in an amount equal to the excess.

 
The determination of fair value involves uncertainties because it requires management to make assumptions and to apply judgment to estimate industry and economic factors and the profitability of future business strategies. Management’s assumptions also include projected revenues and operating profit levels, as well as consideration of any other factors that may indicate potential impairment.

 
In the fourth quarter of fiscal 2013, management completed its annual goodwill and other indefinite-lived intangible asset impairment tests and determined there was no impairment. We believe our assumptions and judgments used in estimating cash flows and determining fair value were reasonable. However, making changes to such assumptions and judgments could materially affect our impairment analyses and future results of operations, including an impairment charge that could be material.

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.

A 10% change in our warranty liability at December 28, 2013, would have affected net income by approximately $273,000 in 2013.

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



34



Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
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 during a 100-night trial period. We estimate future projected returns based on historical return rates.
 
Our estimates of sales returns contain uncertainties as actual sales return rates 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 28, 2013 would have affected net income by approximately $621,000 in 2013.

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 28, 2013 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 28, 2013, 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 Stockholders of
Select Comfort Corporation
Minneapolis, Minnesota

We have audited the internal control over financial reporting of Select Comfort Corporation and subsidiaries (the “Company”) as of December 28, 2013, based on criteria established in Internal Control - Integrated Framework (1992) 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 reasonable assurance about whether effective internal control over financial reporting was maintained, in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 28, 2013, based on the criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule listed in the Index at Item 15 as of and for the year ended December 28, 2013, of the Company and our report dated February 21, 2014 expressed an unqualified opinion on those consolidated financial statements and financial statement schedule.

/s/ DELOITTE & TOUCHE LLP

Minneapolis, Minnesota
February 21, 2014


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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Stockholders of
Select Comfort Corporation
Minneapolis, Minnesota

We have audited the accompanying consolidated balance sheets of Select Comfort Corporation and subsidiaries (the “Company”) as of December 28, 2013, and December 29, 2012, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 28, 2013. Our audits also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 28, 2013, and December 29, 2012, and the results of their operations and their cash flows for the three years in the period ended December 28, 2013, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as whole, presents fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 28, 2013, based on the criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 21, 2014 expressed an unqualified opinion on the Company’s internal control over financial reporting.

/s/ DELOITTE & TOUCHE LLP

Minneapolis, Minnesota
February 21, 2014


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SELECT COMFORT CORPORATION
AND SUBSIDIARIES

Consolidated Balance Sheets
December 28, 2013 and December 29, 2012
(in thousands, except per share amounts)
 
2013
 
2012
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
58,223

 
$
87,915

Marketable debt securities – current
52,159

 
51,264

Accounts receivable, net of allowance for doubtful accounts of $425 and $348, respectively
14,979

 
16,613

Inventories
40,152

 
35,564

Prepaid expenses
9,216

 
4,299

Deferred income taxes
6,936

 
5,401

Other current assets
7,874

 
9,522

Total current assets
189,539