-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Jj76QitwZp3E5JcL9KyPWvc6uo0o2O8GusFs1QEZRYWBGSDBR/RTaMckjFsPwk5l SnneCwOKblL9WvG51P6bEg== 0001047469-99-013340.txt : 19990403 0001047469-99-013340.hdr.sgml : 19990403 ACCESSION NUMBER: 0001047469-99-013340 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19990102 FILED AS OF DATE: 19990401 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SELECT COMFORT CORP CENTRAL INDEX KEY: 0000827187 STANDARD INDUSTRIAL CLASSIFICATION: HOUSEHOLD FURNITURE [2510] IRS NUMBER: 410157886 STATE OF INCORPORATION: MN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-25121 FILM NUMBER: 99586136 BUSINESS ADDRESS: STREET 1: 6105 TRENTON LANE NORTH SUITE 100 CITY: PLYMOUTH STATE: MN ZIP: 55442-3240 BUSINESS PHONE: 6125517000 10-K405 1 10-K405 - -------------------------------------------------------------------------------- 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 JANUARY 2, 1999 / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . ---------------- ------------------ COMMISSION FILE NO. 0-25121 -------------------- SELECT COMFORT CORPORATION (Exact name of registrant as specified in its charter) MINNESOTA 41-1597886 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6105 TRENTON LANE NORTH, SUITE 100 MINNEAPOLIS, MINNESOTA 55442 (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (612) 551-7000 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $.01 PAR VALUE Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES /X/ NO / / Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ As of March 1, 1999, 18,568,471 shares of Common Stock of the Registrant were outstanding, and the aggregate market value of the Common Stock of the Registrant as of that date (based upon the last reported sale price of the Common Stock at that date as reported by the Nasdaq National Market System), excluding outstanding shares beneficially owned by directors and executive officers, was $249,599,034. DOCUMENTS INCORPORATED BY REFERENCE Parts II and IV of this Annual Report on Form 10-K incorporate by reference information (to the extent specific pages are referred to herein) from the Registrant's Annual Report to Shareholders for the year ended January 2, 1999 (the "1998 Annual Report"). Part III of this Annual Report on Form 10-K incorporates by reference information (to the extent specific sections are referred to herein) from the Registrant's Proxy Statement for its 1999 Annual Meeting to be held June 8, 1999 (the "1999 Proxy Statement"). - -------------------------------------------------------------------------------- TABLE OF CONTENTS ------------------- PART I.............................................................. 2 ITEM 1. BUSINESS................................................. 2 General....................................................... 2 Business and Growth Strategy.................................. 2 Products...................................................... 3 Retail Stores................................................. 4 Direct Marketing Operations................................... 5 Road Show Events.............................................. 6 Marketing and Advertising..................................... 6 Consumer Education and Customer Service....................... 6 Research and Product Development.............................. 7 Manufacturing and Distribution................................ 7 Suppliers..................................................... 8 Intellectual Property......................................... 8 Competition................................................... 8 Consumer Credit Arrangements.................................. 9 Governmental Regulation....................................... 9 Employees.....................................................10 Certain Important Factors.....................................10 ITEM 2. PROPERTIES...............................................14 ITEM 3. LEGAL PROCEEDINGS........................................14 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......15 ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY.......................17 PART II.............................................................18 ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS......................................18 Number of Record Holders; Dividends...........................18 Previous Sales of Unregistered Securities.....................18 Use of Proceeds from Initial Public Offering..................18 ITEM 6. SELECTED FINANCIAL DATA..................................19 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..............................19 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK......................................................19 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..............19 i ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE..............................19 PART III............................................................20 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......20 Directors, Executive Officers, Promoters and Control Persons..20 Section 16(a) Beneficial Ownership Reporting Compliance.......20 ITEM 11. EXECUTIVE COMPENSATION..................................20 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.......................................................20 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS..........20 PART IV.............................................................21 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K......................................................21 (a) 1. Consolidated Financial Statements.....................21 2. Consolidated Financial Statement Schedules............21 3. Exhibits..............................................22 (b) Reports on Form 8-K...................................22 EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K.........................26
-------------------- OUR FISCAL YEAR ENDS ON THE SATURDAY CLOSEST TO DECEMBER 31, AND UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL REFERENCES TO YEARS IN THIS FORM 10-K REFER TO OUR FISCAL YEARS. ALL REFERENCES TO "SELECT COMFORT," "THE COMPANY," "WE" OR "US" HEREIN INCLUDE OUR WHOLLY OWNED SUBSIDIARIES, SELECT COMFORT DIRECT CORPORATION, SELECT COMFORT RETAIL CORPORATION, DIRECT CALL CENTERS, INC. AND SELECT COMFORT SC CORPORATION. SELECT COMFORT-Registered Trademark-, SLEEP NUMBER-Registered Trademark-, COMFORT CLUB-Registered Trademark-, 90 NIGHT TRIAL, BETTER NIGHT'S SLEEP GUARANTEE, THE AIR BED COMPANY and the Company's stylized logo are trademarks of the Company. ii PART I -------------------- THIS FORM 10-K CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS. FOR THIS PURPOSE, ANY STATEMENTS CONTAINED IN THIS FORM 10-K THAT ARE NOT STATEMENTS OF HISTORICAL FACT MAY BE DEEMED TO BE FORWARD-LOOKING STATEMENTS. WITHOUT LIMITING THE FOREGOING, WORDS SUCH AS "MAY," "WILL," "EXPECT," "BELIEVE," "ANTICIPATE," "ESTIMATE" OR "CONTINUE" OR COMPARABLE TERMINOLOGY ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. THESE STATEMENTS BY THEIR NATURE INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES, AND ACTUAL RESULTS MAY DIFFER MATERIALLY DEPENDING ON A VARIETY OF FACTORS, INCLUDING THOSE SET FORTH UNDER THE HEADING BELOW ENTITLED "CERTAIN IMPORTANT FACTORS." ITEM 1. BUSINESS GENERAL Select Comfort, "The Air Bed Company," is the leading manufacturer, specialty retailer and direct marketer of premium quality, premium priced, innovative air beds and sleep-related products. We believe we are revolutionizing the mattress industry by offering a differentiated product through a variety of service-oriented distribution channels. Our products address broad-based consumer sleep problems, resulting in a better night's sleep. Our proprietary technology allows our air beds to more naturally contour to the body, thereby generally providing: - - better spinal alignment, - - reduced pressure points, - - greater relief of lower back pain, - - greater overall comfort, and - - better quality sleep in comparison with traditional mattress products. A firmness control system allows customers to independently customize the firmness on each side of the Select Comfort air bed to their optimal level of comfort and support. Unlike traditional mattress manufacturers, we sell our products directly to consumers through three controlled, complementary and service-oriented distribution channels, including Company-operated retail stores and leased departments within larger retail stores, direct marketing operations and road show events. Our retail operations included 264 stores in 44 states, including 14 leased departments (13 in Bed Bath & Beyond stores), at January 2, 1999. We plan to open approximately 75 retail stores in 1999, including the expansion of our leased department concept. Select Comfort was incorporated in Minnesota in February 1987. Our principal executive office is located at 6105 Trenton Lane North, Suite 100, Minneapolis, Minnesota 55442. Our telephone number is (612) 551-7000. BUSINESS AND GROWTH STRATEGY We intend to leverage our position as the leading manufacturer, specialty retailer and direct marketer of innovative air beds and sleep-related products by increasing awareness of air bed technology and further establishing the Select Comfort brand to be synonymous with a better night's sleep, premium quality products and superior customer service. Key elements of our business strategy are as follows: - - PROVIDE A SUPERIOR PRODUCT. Our products differ from traditional mattresses by addressing broad-based consumer sleep problems through the greater comfort and support of sleeping on air and through the ability to customize the firmness on each side of the mattress at the touch of a button. - - EDUCATE CONSUMERS AND PROVIDE SUPERIOR CUSTOMER SERVICE. Since consumer education and customer service are critical to convey the features and benefits of our innovative air beds and to achieve high levels of customer acceptance and 2 satisfaction, we seek to provide a more friendly and informative sales environment. In order to ensure superior customer satisfaction, retail, direct marketing and road show sales professionals receive extensive training in sleep technology and our proprietary technology and products, including features and benefits, assembly and service procedures and policies. We also maintain a customer service department of over 35 employees who receive similar training and respond to consumer questions. - - INCREASE PRODUCT AWARENESS AND BRAND RECOGNITION. We believe that the single most important factor in increasing sales is increasing consumer awareness of the features and benefits of Select Comfort air beds. Our highest brand awareness and market share is in Minneapolis, where we have our largest advertising budget and largest number of retail stores. We plan to increase product awareness and brand recognition nationwide through continued investment in advertising and expansion of our retail store base. - - LEVERAGE COMPLEMENTARY DISTRIBUTION CHANNELS. We distribute directly to customers through Company-operated retail stores, direct marketing operations and road show events. Our control over these three complementary distribution channels provides significant competitive advantages, including the ability to: - leverage the Select Comfort brand name to generate inquiries and convert inquiries to sales, - leverage advertising and marketing programs across multiple markets and distribution channels, - interact directly with consumers to enhance customer satisfaction and build brand loyalty, - train sales professionals regarding Select Comfort's products and to provide superior customer service, and - utilize data from direct marketing operations to support retail and road show site selection, new store openings and road show events. - - CAPITALIZE ON VERTICALLY INTEGRATED OPERATIONS. We maintain control over all phases of our business, including the design, manufacturing, marketing, distribution and service of our air beds. This allows us to maintain rigorous product quality standards, establish coordinated and integrated sales and marketing efforts, carefully manage the presentation and pricing of our products and focus on customer satisfaction and service. - - PURSUE ADDITIONAL GROWTH OPPORTUNITIES. We have begun testing an in-home assembly service in selected markets through national providers to enhance customer satisfaction by providing greater convenience to the customer. We continue to evaluate product enhancements and new accessory products, such as the recently initiated test marketing of adjustable frames. There can be no assurance that the level of sales from these growth opportunities will justify the costs associated with their development and marketing. PRODUCTS AIR BEDS Every Select Comfort air bed has a patented air chamber as its functioning core and comes with a patented firmness control system ("FCS") that allows the customer to easily and instantly customize the firmness of the mattress at the touch of a button. All of our air beds, except twin size mattresses, are available with independent air chambers for each side of the mattress, allowing customized firmness for each sleep partner. Our Imperial and Ultra Series of air beds feature a wireless remote control with a digital display of the user's "Sleep Number," which reflects the level of firmness and allows the customer to more easily adjust and readjust the firmness level to the customer's personal 3 preference. Our air beds feature either a traditional cover or a pillowtop style cover that provides extra cushioning. The covers are constructed with sanitized and hypoallergenic Damask ticking made from blends of polyester/polypropylene or cotton/rayon, or from 100% rayon. Our air beds are manufactured in a broad array of sizes and styles, including all standard bed sizes and a waterbed replacement size that fits into a customer's existing waterbed frame. We restaged our product line in the spring of 1998 to include new cover designs as well as the addition of a new zoned foam in our pillowtop models. This restaging also included a newly redesigned, "whisper quiet" air pump for the Imperial and Ultra Series and all new marketing materials. Our air beds can be assembled by customers in a simple process requiring no tools and can be moved more easily than a traditional mattress and box spring. Furthermore, because air is the primary support material of the mattress, Select Comfort air beds do not lose their shape or support over time like traditional mattresses and box springs. Each air bed is accompanied with instructional product brochures and easy to follow assembly instructions, is certified by Underwriter's Laboratories and is backed by a 20-year limited warranty and our 90 Night Trial and Better Night's Sleep Guarantee. FOUNDATIONS AND ACCESSORY PRODUCTS In addition to air beds, we offer matching foundations and a line of accessory products, including a line of bed frames and high quality mattress pads with zoned heating and specialty pillows, all of which are hypoallergenic and designed to provide comfort and better quality sleep. RETAIL STORES Since our first retail stores were opened in 1992, an increasing percentage of our net sales has occurred at our retail stores, and retail store sales now account for a majority of our net sales. At January 2, 1999, we had 264 stores in 44 states, including 14 leased departments (13 in Bed Bath & Beyond stores). We plan to open approximately 75 retail stores in 1999, including the expansion of our leased department concept. STORE ENVIRONMENT. We seek to offer a unique and innovative store environment that attracts consumers, showcases our products and encourages trial of our air beds. Our retail store design is intended to convey a sense of innovation, sophistication and quality that reinforces Select Comfort's brand image and reputation as sleep experts. We are currently testing an updated store design that we believe will further enhance our products to the consumer. Our retail stores are principally showrooms, averaging approximately 900 square feet, with several display models from our line of air beds and a full display of our branded accessories. Our sales professionals play an important role in creating an inviting and informative retail environment. These professionals receive extensive training regarding the features and benefits of our proprietary technology and products as well as on the overall importance of sleep quality. This enables them to more effectively introduce consumers to our innovative air beds, emphasize the features and benefits that distinguish Select Comfort air beds from traditional mattresses, determine the consumers' needs, encourage consumers to experience the comfort and support of the air beds and answer questions regarding our products. SITE SELECTION. In selecting new store sites, we generally seek high-traffic mall locations of approximately 800 to 1,200 square feet within malls in major metropolitan and regional areas. We conduct extensive analyses of potential store sites and base our selection on a number of 4 factors, including the location within the mall, demographics of the trade area, the specifications of the mall (including size, age, sales per square foot and the location of the nearest competitive mall), the perceived strength of the mall's anchor stores, the performance of other specialty retail tenants in the mall and the number of direct marketing inquiries received from the area surrounding the mall. Clustering of retail stores within a metropolitan retail market is also a key consideration in order to leverage our advertising. MARKETING AND ADVERTISING. We support new store openings with local print and radio advertisements and mailings to direct response inquiries in the market. We also use local radio personalities and newspaper advertising in certain of the markets where we have multiple retail stores. We use local radio and print advertisements and promotional offers during high mall traffic periods, such as three-day holiday weekends, and in-store events, including live remote broadcasts and promotional contests. MANAGEMENT AND EMPLOYEES. Stores are currently organized into four regional areas and 34 geographic districts, with approximately eight stores in each district. Each regional sales director oversees approximately eight geographic districts. Each district has a district sales manager who is responsible for the sales and operations and who reports to a regional sales director. The district sales managers frequently visit stores to review merchandise presentation, sales force product knowledge, financial performance and compliance with operating standards. The typical staff of a Select Comfort store consists of one store manager and two full-time sales professionals. In order to maintain high operating standards, we recruit store managers who typically have one to four years of experience as a store manager in specialty retailing. The sales professionals devote substantially all of their efforts to sales and customer service, which includes helping customers and generating and responding to inquiries. In addition, to promote consumer education, ensure customer satisfaction and generate referrals, the sales professionals place follow-up calls to customers who have made recent purchases or inquiries. TRAINING AND COMPENSATION. All store personnel receive comprehensive on-site training on our technology and sleep expertise, the features and benefits of our air beds, sales and customer service techniques and operating policies and guidelines. Initial training programs are reinforced through detailed product and operating manuals and periodic performance appraisals. All store sales professionals receive base compensation and are entitled to commissions based on individual and store-wide performance. Regional sales directors and district sales managers are eligible to receive, in addition to their base compensation, incentive compensation for the achievement of performance objectives by the stores within their respective regions and districts. DIRECT MARKETING OPERATIONS Many consumers' initial exposure to the Select Comfort air bed is through our direct marketing operations. Typically, an interested consumer will respond to one of our advertisements by calling our toll-free number. On this call, one of our direct marketing sales professionals captures information from the consumer, begins the consumer education process, takes orders, or, if appropriate, directs the consumer to our other distribution channels. The direct marketing operations are conducted by knowledgeable and well-trained sales professionals, including a group of over 50 sales professionals who field incoming direct marketing inquiries, and over 40 sales professionals who make outbound calls to consumers who have previously contacted the Company. The direct marketing operations also include a database marketing department that is responsible for mailings of product and promotional information to direct response inquiries. We maintain a database of information on approximately 4.0 million inquiries, including customers who have purchased an air bed from 5 us, from which the direct marketing channel is able to take orders, or, if appropriate, direct the consumer to our other distribution channels. In the direct marketing channel, our advertising message is communicated through targeted print, radio, infomercials and television advertisements, as well as through product brochures, videos and other product and promotional materials mailed in response to consumer inquiries at various intervals. As our advertising budget has expanded over the last few years, the direct marketing channel has relied more heavily on nationally syndicated radio personalities, such as Paul Harvey and Rush Limbaugh, and more recently on 60 and 120-second television commercials and 30-minute infomercials. Our direct marketing operations continually monitor the effectiveness and efficiency of our advertising through tracking the cost per inquiry and cost per order of our advertising, using focus groups to evaluate the effectiveness of our advertising messages and using sophisticated media buying techniques. Our direct marketing operations also support our retail and road show operations through referrals, as well as mailings to direct marketing inquiries in selected markets in advance of retail store openings and road shows. As our base of retail stores has expanded, our direct marketing sales professionals have increasingly been able to refer direct marketing inquiries to a convenient retail store location, improving the process of converting inquiries into sales and providing the consumer with a choice of service venues. ROAD SHOW EVENTS Our third distribution channel is road show events in selected markets where we typically do not have a retail presence, as well as at home shows and consumer product shows, state fairs and similar events. Select Comfort sales professionals, supported by local print and radio advertising and advance mailings to direct marketing inquiries, travel to various cities to demonstrate our products in temporary showrooms or in booths at trade shows and educate consumers about the benefits of Select Comfort air beds. We use inquiries generated from our direct marketing channel to determine road show sites and typically will have approximately 10 road show events, ranging from three days to two weeks in duration, in process at any given time. We have found this distribution channel to be very effective in converting direct response customers who want to see the product before purchasing, but do not live close to a retail store location. MARKETING AND ADVERTISING The primary objective of our marketing and advertising strategy is to create awareness of the features and benefits of Select Comfort air beds and to build recognition of the Select Comfort brand as the leader in innovative air beds, sleep expertise, superior quality and excellent customer service. We continue to spend the majority of our advertising budget on direct marketing, which indirectly drives traffic to our expanding base of retail stores. As our base of retail stores continues to grow, we plan to dedicate more of our advertising budget in direct support of the retail stores. The majority of our advertising budget is devoted to print and long and short-form television advertising, with the balance primarily devoted to radio advertising with well-known national personalities, as well as local radio personalities in selected retail markets. We also intend to continue to pursue various alternative channels, such as catalogs, and targeted marketing programs. We believe the Internet may provide not only a fourth channel of distribution but also may provide an inexpensive name source for our existing distribution channels. CONSUMER EDUCATION AND CUSTOMER SERVICE We are committed to achieving our goal of world class customer satisfaction and service. We intend to achieve this goal through a variety of means designed to: 6 - - educate consumers on the benefits of Select Comfort products, - - deliver superior quality products, - - maximize our direct relationship with consumers, - - maximize convenience for the consumer, and - - respond quickly to consumer needs and inquiries. We believe that educating consumers about the features and benefits of Select Comfort air beds is critical to the success of our marketing and sales efforts, and we devote considerable time and resources to training programs for our retail, direct marketing and road show sales professionals. Our retail stores also have displays that provide customers with the latest information on sleep technology and the features and benefits of our air beds. Our controlled distribution channels optimize our direct contact with customers and allow us to respond quickly to customer service inquiries and enhance customer satisfaction. Our multiple distribution channels also enhance the convenience for the consumer to purchase products through a variety of venues. In addition, we are currently testing the offering of in-home assembly services in selected markets through national providers in order to increase overall sales and enhance customer satisfaction by providing greater convenience to the customer. We maintain an in-house customer service department of over 35 customer service representatives who receive extensive training in sleep technology and all aspects of our products and operations. Our customer service representatives field customer calls and also interact with each of our retail stores to address customer questions and concerns raised with retail sales professionals. The customer service department makes outbound calls to new customers during the 90 Night Trial phase to answer questions and provide solutions to possible problems in order to enhance customer education, build customer satisfaction and reduce returns. RESEARCH AND PRODUCT DEVELOPMENT We maintain an active research and development department that continuously seeks to enhance our knowledge of sleep dynamics and sleep technology, improve current product performance and benefits and develop new products. Our research and development department also conducts clinical studies and product tests to measure the benefits of our air beds, enhance our sleep technology learning, develop product improvements and establish quality and performance standards. Through customer surveys and consumer focus groups, we seek feedback on a regular basis to help enhance existing products and develop new products. Since the introduction of our first air bed, we have continued to improve and expand our product line, including quieter firmness control systems, remote control gauges with digital settings, more luxurious fabrics and covers, new generations of foams and foundation systems and enhanced border walls. Our research and development expenses were $1.6 million for 1998, $1.8 million for 1997 and $1.5 million for 1996. MANUFACTURING AND DISTRIBUTION Our manufacturing operations are located in Minneapolis and in Columbia, South Carolina and consist of quilting and sewing of the fabric covers for our air beds, assembly of firmness control systems and final assembly and packaging of air beds and foundations from contract manufactured components. We currently conduct our manufacturing operations on two shifts and believe we have sufficient capacity to meet anticipated increases in demand through the next 12 months. We plan to open a third manufacturing and distribution facility in Salt Lake City in May 1999, primarily to serve West Coast and Southwest destinations. 7 We manufacture air beds to meet orders rather than to stock inventory, which enables us to maintain lower levels of inventory. Orders are currently shipped from one of our two distribution centers, primarily via UPS, typically within 48 hours following order receipt, and are usually received by the customer within five to seven business days after shipment. When our Salt Lake City distribution center becomes operational, we believe we will be able to reduce the delivery times to approximately three days. We are continually evaluating alternative carriers on a national and regional basis, as well as testing providers of in-home assembly services in selected markets. SUPPLIERS We currently obtain all of the materials and components used to produce our air beds from outside sources. Components for the firmness control systems are obtained from a variety of domestic sources. Quilting and ticking materials are obtained from a supplier in Belgium and components for foundation systems are obtained primarily from two domestic sources. Our proprietary air chambers are produced to our specifications by one Eastern European supplier under a supply contract expiring in August 1999 (subject to automatic renewal if neither party gives 90 days' notice of non-renewal), pursuant to which we are obligated to purchase certain minimum quantities. We expect to continue the relationship with the Eastern European supplier for the foreseeable future. We believe that we would be able to procure an adequate supply of air chambers from other sources on a timely basis if the supply contract is terminated or the Eastern European supplier is otherwise unable to supply air chambers. We completed the development of an air chamber designed with new materials that will be manufactured by a U.S. based company at a foreign manufacturing facility, subject to final testing. Full production of this new air chamber is expected to commence in the first quarter of 2000. The Eastern European supplier is expected to provide a second source of supply of this new air chamber during the first half of 2000. We do not presently have any contract or commitment from either supplier to manufacture the newly developed air chamber. We are continuously searching for alternative designs and materials for all of our components and materials, as well as alternative sources of supply. INTELLECTUAL PROPERTY Certain elements of the design and function of our air beds are the subject of United States and foreign patents and patent applications owned by us. We have 16 U.S. issued patents and eight U.S. patent applications pending. We also held 22 foreign patents and had 20 foreign patent applications pending as of January 2, 1999. The name "Select Comfort" and our logo are trademarks of the Company registered with the United States Patent and Trademark Office. We have a number of other registered marks, including the trademarks "Comfort Club" and "Sleep Number," the service mark "Comfort Club," and a number of unregistered marks, including the trademarks "90 Night Trial," "Better Night's Sleep Guarantee" and "The Air Bed Company." We have registered several of these trademarks in numerous foreign countries and have approximately 41 trademarks registered, or the subject of pending applications, in foreign countries. Each federally registered mark is renewable indefinitely if the mark is still in use at the time of renewal. We are not aware of any material claims of infringement or other challenges to our right to use our marks. COMPETITION The mattress industry is highly competitive. Participants in the mattress industry compete primarily on price, quality, brand name recognition, product availability and product performance, including the perceived levels of comfort and support provided by a mattress. Our air beds compete with a number of different types of mattress alternatives, including 8 innerspring mattresses, waterbeds, futons and other air-supported mattresses that are sold through a variety of channels, including furniture stores, bedding specialty stores, department stores, mass merchants, wholesale clubs, telemarketing programs, television infomercials and catalogs. We believe that our success depends in part on increasing consumer acceptance of existing products and the continuing introduction of products that have qualities and benefits which differentiate our products from those offered by other manufacturers. The traditional mattress industry is characterized by a high degree of concentration among the four largest manufacturers of innerspring mattresses with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand name, Serta, Simmons and Spring Air. The balance of the mattress market is served by over 700 manufacturers, primarily operating on a regional basis. Many of these competitors, and in particular the four largest manufacturers named above, have greater financial, marketing and manufacturing resources and better brand name recognition than us, and sell their products through broader and more established distribution channels. We believe that a number of companies, including two of the four largest manufacturers, have begun to offer air beds. There can be no assurance that these or any other mattress manufacturer will not aggressively pursue the air bed market. Any such competition by the established manufacturers or new entrants into the market could have a material adverse effect on our business, financial condition and operating results. In addition, should any of our competitors reduce prices on premium mattress products, we may be required to implement price reductions in order to remain competitive, which could have a material adverse effect on our business, financial condition and operating results. CONSUMER CREDIT ARRANGEMENTS In May 1997, we entered into an arrangement with Monogram Credit Card Bank of Georgia (the "Bank"), an affiliate of General Electric Capital Corporation, a creditor and warrantholder of the Company, pursuant to which the Bank offers to our qualified customers an unsecured revolving credit arrangement to finance purchases from us. The Bank sets the rate, annual fees, late fees and all other terms and conditions relating to the customers' accounts, including collection policies and procedures, and is the owner of the receivables. The effective interest rate is comparable to rates generally available under similar consumer revolving credit arrangements. The Bank's current commitment extends to a maximum of $85 million of receivables outstanding. In 1998, approximately 51.4% of the Company's net sales were financed by the Bank through these consumer credit arrangements. In March 1999, we notified the Bank of our intent to terminate this consumer credit arrangement. In addition, we have signed a letter of intent with a third party provider to replace the existing arrangement. We anticipate that a new arrangement will be under terms that are no less favorable than under the existing arrangement and that the transition to the new provider will occur during the third quarter of 1999. GOVERNMENTAL REGULATION Our products and our marketing and advertising practices are subject to regulation by various federal, state and local regulatory authorities, including the Federal Trade Commission and the U.S. Food and Drug Administration. The mattress industry also engages in advertising self-regulation through certain voluntary forums, including the National Advertising Division of the Better Business Bureau. We are also subject to various other federal, state and local regulatory requirements, including federal, state and local environmental regulation and regulations issued by the U.S. Occupational Safety and Health Administration. 9 EMPLOYEES At January 2, 1999, we employed 1,520 persons, including 831 retail store employees, 131 direct marketing employees, 41 customer service employees, 19 road show sales professionals, 347 manufacturing and distribution employees and 151 management and administrative employees. Approximately 88 of our employees were employed on a part-time basis at January 2, 1999. Except for managerial employees and professional support staff, all of our employees are paid on an hourly basis plus commissions for sales associates. None of our employees is represented by a labor union or covered by a collective bargaining agreement. We believe that our relations with our employees are good. CERTAIN IMPORTANT FACTORS There are several important factors that could cause our actual results to differ materially from those anticipated by us or which are reflected in any of our forward-looking statements. These factors, and their impact on the success of our operations and our ability to achieve our goals, include the following: HISTORY OF OPERATING LOSSES; UNCERTAIN PROFITABILITY We have only recently achieved profitable operations and have incurred substantial operating losses since our inception, and there can be no assurance that we will sustain profitability on a quarterly or annual basis in future periods. Our future operating results will depend upon a number of factors, including: - the level of consumer acceptance of our products, - our ability to create product and brand name awareness, - the effectiveness and efficiency of our advertising, - the number and timing of new retail store openings, - the performance of our existing and new retail stores, - our ability to manage our planned rapid store expansion, - our ability to successfully identify and respond to emerging trends in the mattress industry, - the level of competition in the mattress industry, - general economic conditions and consumer confidence, and - our ability to maintain cost-effective production and delivery of products. LIMITED HISTORY OF RETAIL OPERATIONS; AGGRESSIVE GROWTH STRATEGY Our net sales have grown significantly in the past several years primarily as a result of the opening of new retail stores, increases in comparable store sales from year to year, and growth of sales from our direct marketing operations. Our ability to continue our growth strategy will be dependent upon many factors, including our ability to: - - successfully open additional retail stores in existing geographic markets, - - successfully enter new geographic markets and store environments in which we have no previous retail experience, - - effectively integrate new retails stores into our existing operations, - - negotiate acceptable lease terms for additional sites, - - effectively hire, train, manage and retain qualified management and other personnel, - - generate additional direct marketing inquiries, - - effectively develop strategic alliances with respect to product development, marketing and distribution, - - maintain a high level of manufacturing quality and efficiency, and - - enhance our operational, financial and management systems. 10 In addition, we plan to lease a third manufacturing and distribution center in Salt Lake City, which is expected to be in operation in May 1999. There can be no assurance that the costs for this new facility will not be greater than the manufacturing costs at our current facilities in Minnesota and South Carolina. In addition, delays or interruptions in the normal supply of products could occur as we attempt to integrate a third manufacturing and distribution center. Any such increases in costs or delays could have a material adverse effect on our business, financial condition and operating results. There can be no assurance that we will be able to grow at historical rates or effectively manage this expansion in any one or more of these areas, and any failure to do so could have a material adverse effect on our business, financial condition and operating results. EFFECTIVENESS AND EFFICIENCY OF ADVERTISING EXPENDITURES Our advertising expenditures increased from $5.5 million in 1994 to $31.6 million in 1998, and are expected to continue to increase for the foreseeable future. Our future growth and profitability will be dependent in part on the effectiveness and efficiency of our advertising expenditures, including our ability to: - - create greater awareness of our products and brand name, - - determine the appropriate creative message and media mix for future advertising expenditures, - - effectively manage advertising costs (including creative and media) in order to maintain acceptable costs per inquiry, costs per order and operating margins, and - - convert inquiries into actual orders. No assurance can be given that our planned increases in advertising expenditures will result in increased sales, will generate sufficient levels of product and brand name awareness or that we will be able to manage such advertising expenditures on a cost effective basis. FLUCTUATIONS IN COMPARABLE STORE SALES RESULTS Our comparable store sales results have fluctuated significantly in the past and such fluctuations are likely to continue. Stores enter the comparable store calculation in their 13th full month of operation. Our comparable store sales increases were 17.9% for 1998, 34.6% for 1997 and 26.1% for 1996.(*) Our comparable store sales results have fluctuated significantly from quarter to quarter with increases ranging from 8.2% to 62.0% on a quarterly basis for 1996 and 1998. There can be no assurance that our comparable store sales results will not fluctuate significantly in the future. A variety of factors affect our comparable store sales results, including: - - the level of consumer awareness of our products and brand name, - - the rate of consumer acceptance of our products, - - the higher levels of sales in the first year of operations as each successive class of new stores is opened, - - the strong comparable store sales performance in recent periods, - - the maturation of our store base, - - the timing and relative success of promotional events, advertising expenditures, new product introductions and product line extensions, - - a change in the sales mix between our distribution channels, and - - general economic conditions and consumer confidence. Changes in comparable store sales results could cause the price of our common stock to fluctuate substantially. - ----------------------------- * Fiscal 1997 was a 53-week year versus 52 weeks for 1996 and 1998. Comparable store sales for 1998 and 1997, adjusted to 52 weeks, would be 23.5% and 27.3%, respectively. 11 QUARTERLY FLUCTUATIONS AND SEASONALITY Our quarterly operating results may fluctuate significantly as a result of a variety of factors, including: - - increases or decreases in comparable store sales, - - the timing, amount and effectiveness of advertising expenditures, - - any increases in return rates, - - the timing of new store openings and related expenses, - - competitive factors, - - net sales contributed by new stores, - - any disruptions in third-party delivery services, and - - general economic conditions and consumer confidence. Our business is also subject to some seasonal influences, with heavier concentrations of sales during the fourth quarter holiday season due to higher mall traffic. The level of spending related to sales and marketing expenses and new store opening costs cannot be adjusted quickly and is based, in significant part, on our expectations of future customer inquiries and net sales. If there is a shortfall in expected net sales or in the conversion rate of customer inquiries, we may be unable to adjust our spending in a timely manner and our business, financial condition and operating results may be materially adversely affected. Our results of operations of any quarter are not necessarily indicative of the results that may be achieved for a full year or any future quarter. RETURN POLICY AND PRODUCT WARRANTY Part of our marketing and advertising strategy focuses on providing a 90 Night Trial in which customers may return the air bed and obtain a refund of the purchase price. An increase in return rates could have a material adverse effect on our business, financial condition and operating results. We also provide our customers with a limited 20-year warranty on our air beds. We have only been selling air beds in significant quantities since 1992. There can be no assurance that our warranty reserves will be adequate to cover future warranty claims, and such failure could have a material adverse effect on our business, financial condition and operating results. PRODUCT DEVELOPMENT AND ENHANCEMENTS Our growth and future success will depend upon our ability to enhance our existing products and to develop and market new products on a timely basis that respond to customer needs and achieve market acceptance. There can be no assurance that we will be successful in developing or marketing enhanced or new products, or that any such products will be accepted by the market. There can also be no assurance that we will be able to establish and maintain profitable strategic alliances. Further, there can be no assurance that the resulting level of sales of any of our enhanced or new products will justify the costs associated with their development and marketing. MARKET ACCEPTANCE The U.S. mattress market is dominated by four large manufacturers of innerspring mattresses. Our air bed technology represents a significant departure from traditional innerspring mattresses. The market for air beds is continuing to evolve and the success of our products will be dependent upon both the continued growth of this market and upon market acceptance of our air beds. The failure of our air beds to achieve market acceptance for any reason would have a material adverse effect on our business, financial condition and operating results. RELIANCE UPON VENDORS; FOREIGN SOURCES OF SUPPLY The inability of our suppliers to meet, for any reason, our requirement for air chambers could have a material adverse effect on our business, 12 financial condition and operating results. In addition, since our air chambers and certain other supplies are manufactured outside the United States, our operations could be materially adversely affected by the risks associated with foreign sourcing of materials, including: - - political instability resulting in disruption of trade, - - existing or potential duties, tariffs or quotas that may limit the quantity of certain types of goods that may be imported into the United States or increase the cost of such goods, and - - any significant fluctuation in the value of the dollar against foreign currencies. With the exception of our air chambers, we have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to components. The inability or failure of one or more key vendors to supply components, the loss of one or more key vendors or a material change in our purchase terms could have a material adverse effect on our business, financial condition and operating results. RELIANCE UPON CARRIERS Historically, we have relied almost exclusively on UPS for delivery of our products to customers. For a significant portion of the third quarter of 1997, UPS was unable to deliver our products within acceptable time periods, causing delays in deliveries to customers and requiring us to use alternative carriers. No assurance can be given that UPS will not experience difficulties in meeting our requirements in the future. We continue to evaluate alternative carriers on a national and regional basis, as well as providers of in-home assembly services. There can be no assurance that alternative carriers will be able to meet our requirements on a timely or cost-effective basis. Any significant delay in deliveries to customers or increase in freight charges may have a material adverse effect on our business, financial condition and operating results. YEAR 2000 COMPLIANCE There can be no assurance that we will be able to effectively address our Year 2000 issues in a timely and cost-efficient manner and without interruption to our business. We have initiated discussions with our significant suppliers regarding their plans to remediate Year 2000 issues where their systems interface with our systems or otherwise impact our operations. There can be no assurance that Year 2000 difficulties encountered by our suppliers and other third parties with whom we do business will not have a material adverse impact on our business, financial condition or operating results. INTELLECTUAL PROPERTY PROTECTION No assurance can be given that our current pending patents will provide substantial protection or that others will not be able to develop products that are similar to or competitive with our air beds. In addition, there can be no assurance that copyright, trademark, trade secret, unfair competition and other intellectual property laws, nondisclosure agreements and other protective measures will preclude competitors from developing products similar to our products or otherwise competing with us. In addition, the laws of certain foreign countries may not protect our intellectual property rights and confidential information to the same extent as the laws of the United States. Although we are unaware of any basis for an intellectual property infringement or invalidity claim against us, there can be no assurance that third parties, including competitors, will not assert such claims against us or that, if asserted, such claims will not be upheld. Intellectual property litigation, which could result in substantial cost to and diversion of effort by management, may be necessary to enforce our patents, to protect our trade secrets and proprietary technology or to defend us against claimed infringement of the rights of others and 13 to determine the scope and validity of the proprietary rights of others. There can be no assurance that we would prevail in any such litigation or that, if it is unsuccessful, we would be able to obtain any necessary licenses on reasonable terms or at all. ITEM 2. PROPERTIES We currently lease all of our existing retail store locations and expect that our policy of leasing, rather than owning, will continue as we expand. Our store leases generally provide for an initial lease term of 10 years with a mutual termination option if we do not achieve certain minimum annual sales thresholds. Generally, the store leases require us to pay minimum rent plus percentage rent based on net sales in excess of certain thresholds, as well as certain operating expenses. We lease 125,000 square feet of space in Minneapolis for one of our manufacturing and distribution centers, one of our direct marketing call centers, a customer service center, a research and development center and corporate offices, which lease expires in 2004. We also lease 105,000 square feet of space in Columbia, South Carolina, for our other manufacturing and distribution center and a direct marketing call center, which lease expires in 2003. We have agreed to lease approximately 100,800 square feet in Salt Lake City for a third manufacturing and distribution center that we expect to open in May of 1999, which lease expires in 2009. ITEM 3. LEGAL PROCEEDINGS We are involved in various legal proceedings incident to the ordinary course of our business. We believe that the outcome of all pending legal proceedings in the aggregate will not have a material adverse effect on our business, financial condition or operating results. 14 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS A Special Meeting of Shareholders of Select Comfort was held on November 30, 1998. The following matters were voted on and approved by our shareholders at the Special Meeting. The tabulation of votes with respect to each of the following matters voted on at the Special Meeting is set forth as follows: 1. Amendment to Article III of the Company's Articles of Incorporation to: - - decrease the public offering price that would cause the automatic conversion of the Series E preferred stock into common stock from $19.95 to $15.00 per share; - - decrease the conversion price at which the Series E preferred stock was converted into common stock from $8.82 to $8.20 per share upon a public offering completed in 1998; and - - decrease the conversion price at which the Series E preferred stock was converted into common stock to the lower of $8.20 per share or 46.02% of the mid-point of the filing range of initial public offering prices upon a public offering completed after 1998. All classes voting together on an as-if-converted basis:
Broker For Against Abstain Non-Vote --- ------- ------- -------- 13,204,151 43,566 60,894 0
Series E preferred stock voting as a separate class:
Broker For Against Abstain Non-Vote --- ------- ------- -------- 706,177 0 0 0
2. Amendment to Article III of the Company's Articles of Incorporation to eliminate the preferred stock provisions and increase the number of authorized shares of capital stock of the Company from 37,123,390 to 100,000,000 shares.
Broker For Against Abstain Non-Vote --- ------- ------- -------- 13,244,151 3,566 60,894 0
3. Amendment to the Company's Articles of Incorporation to provide for the classification of the Board of Directors and related matters.
Broker For Against Abstain Non-Vote --- ------- ------- -------- 13,306,611 0 2,000 0
15 4. Election of Directors. FOR THREE-YEAR TERM EXPIRING AT THE 2001 ANNUAL MEETING OF SHAREHOLDERS
Broker Name of Nominee For Withheld Non-Vote --------------- --- -------- -------- Thomas J. Albani 13,306,611 2,000 0 H. Robert Hawthorne 12,757,611 551,000 0 David T. Kollat 13,306,611 2,000 0
FOR TWO-YEAR TERM EXPIRING AT THE 2000 ANNUAL MEETING OF SHAREHOLDERS
Broker Name of Nominee For Withheld Non-Vote --------------- --- -------- -------- Patrick A. Hopf 13,306,611 2,000 0 Ervin R. Shames 12,757,611 551,000 0
FOR ONE-YEAR TERM EXPIRING AT THE 1999 ANNUAL MEETING OF SHAREHOLDERS
Broker Name of Nominee For Withheld Non-Vote --------------- --- -------- -------- Christopher P. Kirchen 13,306,611 2,000 0 Kenneth A. Macke 12,757,611 551,000 0 Jean-Michel Valette 13,306,611 2,000 0
5. Amendment to the Company's Articles of Incorporation to require the affirmative vote of at least two-thirds of the outstanding voting power of the Company entitled to vote for the approval of certain business combinations of the Company.
Broker For Against Abstain Non-Vote --- ------- ------- -------- 13,306,499 0 2,112 0
16 ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company, their ages and the offices held, as of March 1, 1999, are as follows:
NAME AGE TITLE ---- --- ----- H. Robert Hawthorne 53 President and Chief Executive Officer Daniel J. McAthie 48 Executive Vice President, Chief Operating Officer, Chief Financial Officer and Secretary Charles E. Dorsey 48 Senior Vice President of Direct Marketing and President of Select Comfort Direct Corporation Ronald E. Mayle 40 Senior Vice President of Retail and President of Select Comfort Retail Corporation Gregory T. Kliner 60 Senior Vice President of Operations
Information regarding the business experience of the executive officers is set forth below. H. ROBERT HAWTHORNE has served as the President, Chief Executive Officer and a Director of the Company since April 1997. From February 1992 to April 1997, he served as President of The Pillsbury Brands Group, a subsidiary of The Pillsbury Company, which is a subsidiary of Diageo PLC. From June 1990 to January 1992, he was President and Chief Executive Officer of Alpo Petfoods, then a subsidiary of Grand Metropolitan PLC. Prior to joining Alpo Petfoods, Mr. Hawthorne was President and Chief Executive Officer of Pillsbury Canada, a subsidiary of Diageo PLC. DANIEL J. MCATHIE has served as Executive Vice President, Chief Financial Officer and Secretary since October 1995. Mr. McAthie also served as Chief Administrative Officer from October 1995 to October 1998, at which time he was named Chief Operating Officer. From May 1990 to April 1995, Mr. McAthie held the positions of Senior Vice President, Chief Financial Officer, Vice President and Treasurer of Fingerhut Companies, Inc., a mail order catalog company. CHARLES E. DORSEY has served as Senior Vice President of Direct Marketing since January 1992 and President of Select Comfort Direct Corporation since March 1996. From March 1988 to December 1991, Mr. Dorsey served as Chief Operating Officer for DM Shelter, Inc., a custom packaged home company. RONALD E. MAYLE has served as Senior Vice President of Retail of the Company and President of Select Comfort Retail Corporation since December 1997. From October 1996 to December 1997, Mr. Mayle served as Managing Member of Management & Capital, a retail consulting firm. From May 1995 to October 1996, Mr. Mayle served as an independent retail marketing consultant, primarily to a variety of privately owned, start-up retail enterprises, advising on infrastructure and sales and marketing strategies. From April 1992 to May 1995, Mr. Mayle was Vice President of Operations of Petstuff, Inc., a subsidiary of PetsMart Inc. GREGORY T. KLINER has served as Senior Vice President of Operations since August 1995. From October 1986 to August 1995, Mr. Kliner served as Director of Operations of the Irrigation Division for The Toro Company, a manufacturer of lawn care and snow removal products and irrigation systems. 17 PART II -------------------- ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information under the caption "Common Stock" on the inside back cover of the Company's 1998 Annual Report is incorporated herein by reference. NUMBER OF RECORD HOLDERS; DIVIDENDS As of March 1, 1999, there were 157 record holders of the Company's common stock. We did not declare or pay any cash dividends on the Common Stock during the fiscal years ended January 3, 1998 or January 2, 1999. PREVIOUS SALES OF UNREGISTERED SECURITIES During the fiscal year ended January 2, 1999, we issued the following securities without registration under the Securities Act: 1. From January 3, 1998 through January 2, 1999, we issued an aggregate of 526,880 shares of common stock to employees and directors of the Company pursuant to the exercise of stock options and warrants by such individuals at a weighted average exercise price of $3.23 per share. 2. In November 1998, we issued a warrant to General Electric Capital Corporation to purchase 5,513 shares of common stock at an exercise price of $8.82. No underwriting commissions or discounts were paid with respect to the sales of the unregistered securities described above. In addition, all of the above sales were made in reliance on Rule 701, Regulation D and Section 4(2) under the Securities Act. With regard to our reliance upon the exemptions set forth in the previous sentence, we made certain inquiries to establish that such sales qualified for such exemptions from the registration requirements. In particular, we confirmed that: - - all offers of sales and sales were made by personal contact from officers or directors of the Company or other persons closely associated with the Company; - - each investor made representations that he or she was sophisticated in relation to this investment (and we have no reason to believe such representations were incorrect); - - each purchaser gave assurance of investment intent and the certificates for the shares bear a legend accordingly; and - - offers and sales within any offering were made to a limited number of persons. USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING On September 3, 1998, we filed a Registration Statement on Form S-1 (File No. 333-62793) with the Securities and Exchange Commission (the "SEC"), pursuant to which we registered the offer and sale under the federal securities laws of 4,600,000 shares of common stock, including 1,677,650 shares sold by certain selling shareholders. The SEC declared our Registration Statement effective on December 3, 1998, and the closing of the initial public offering was held on December 9, 1998. The managing underwriters were Hambrecht & Quist LLC, BankBoston Robertson Stephens Inc., Piper Jaffray Inc. and Charles Schwab & Co., Inc. The aggregate offering price of the offering was $78,200,000. The net proceeds to the Company from the sale of the shares of common stock offered by the Company was $44,643,353, after deducting the underwriting discount of $3,477,597 and the estimated offering expenses of approximately $1,559,000. All of the expenses incurred in connection with the initial public offering were paid to unrelated parties or entities, except for underwriting discount which were given to, among others, Hambrecht & 18 Quist LLC. Jean-Michel Valette, a director of the Company, is a member of the general partner of H&Q Select Comfort Investors, L.P., a related party to Hambrecht & Quist LLC. From December 9, 1998 to January 2, 1999, we have spent the net proceeds from the offering as follows: Repayment of long-term debt $15,325,480 Fund the build-out, start-up and leasing of our third manufacturing and distribution facility 222,400 Fund expansion of our retail store base 2,760 ----------- $15,550,640 ----------- -----------
ITEM 6. SELECTED FINANCIAL DATA The financial information under the caption "Selected Consolidated Financial Data" on page 16 of the Company's 1998 Annual Report is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 17 to 22 of the Company's 1998 Annual Report is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Not Applicable. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's Consolidated Financial Statements and Independent Auditors' Report thereon on pages 23 to 38 of the Company's 1998 Annual Report are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 19 PART III -------------------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS The information under the captions "Election of Directors -- Information About Nominees and Directors" and "Election of Directors -- Other Information About Nominees and Directors" in the Company's 1999 Proxy Statement is incorporated herein by reference. The information concerning executive officers of the Company is included in this Report under Item 4a, "Executive Officers of the Company." SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE The information under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's 1999 Proxy Statement is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information under the captions "Election of Directors -- Director Compensation" and "Executive Compensation and Other Benefits" in the Company's 1999 Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the caption "Principal Shareholders and Beneficial Ownership of Management" in the Company's 1999 Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption "Certain Transactions" in the Company's 1999 Proxy Statement is incorporated herein by reference. 20 PART IV -------------------- ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. CONSOLIDATED FINANCIAL STATEMENTS The following Consolidated Financial Statements of the Company and its subsidiaries are incorporated herein by reference from the pages indicated in the Company's 1998 Annual Report: CONSOLIDATED FINANCIAL STATEMENTS: Independent Auditors' Report................................................ 23 Consolidated Balance Sheets as of January 2, 1999 and January 3, 1998....... 24 Consolidated Statements of Operations for the years ended January 2, 1999, January 3, 1998 and December 28, 1996....................................... 25 Consolidated Statements of Shareholders' Equity for the years ended January 2, 1999, January 3, 1998 and December 28, 1996...................... 26 Consolidated Statements of Cash Flows for the years ended January 2, 1999, January 3, 1998 and December 28, 1996...................... 27 Notes to Consolidated Financial Statements.................................. 28-38
2. CONSOLIDATED FINANCIAL STATEMENT SCHEDULES Attached to this Report on page 25 is the Independent Auditors' report together with Schedule II--Valuation and Qualifying Accounts. 21 3. EXHIBITS The exhibits to this Report are listed in the Exhibit Index on pages 26 to 29 below. We will furnish a copy of the exhibits referred to above at a reasonable cost to any person who was a shareholder of Select Comfort Corporation as of April 14, 1999, upon receipt from any such person of a written request for any such exhibit. Such request should be sent to: Select Comfort Corporation, 6105 Trenton Lane North, Suite 100, Minneapolis, Minnesota 55442; Attn: Shareholder Information. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Annual Report on Form 10-K Pursuant to Item 13(a): 1. Omnibus Stock Option Plan, as amended 2. 1997 Stock Incentive Plan 3. Form of Incentive Stock Option Agreement under the 1997 Stock Incentive Plan 4. Form of Performance Based Stock Option Agreement under the 1997 Stock Incentive Plan 5. Employment Letter Agreement dated April 3, 1997 between the Company and H. Robert Hawthorne 6. Employment Letter Agreement dated October 20, 1995 between the Company and Daniel J. McAthie 7. Employment Letter Agreement dated July 11, 1995 between the Company and Gregory T. Kliner 8. Consulting Agreement and Stock Option Agreement dated April 1, 1996 between the Company and Ervin R. Shames 9. Employment Letter Agreement dated November 12, 1997 between the Company and Ronald E. Mayle (b) REPORTS ON FORM 8-K We did not file any Current Reports on Form 8-K during the quarter ended January 2, 1999. 22 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SELECT COMFORT CORPORATION Dated: March 25, 1999 By: /s/ H. Robert Hawthorne --------------------------------------- H. Robert Hawthorne President and Chief Executive Officer (principal executive officer) By: /s/ Daniel J. McAthie ----------------------------------------- Daniel J. McAthie Executive Vice President, Chief Operating Officer, Chief Financial Officer and Secretary (principal financial and accounting officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below on March 25, 1999 by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. NAME TITLE - ---- ----- /s/ H. Robert Hawthorne President, Chief Executive Officer and - ------------------------------- Director (principal executive officer) H. Robert Hawthorne /s/ Ervin R. Shames Chairman of the Board - ------------------------------- Ervin R. Shames /s/ Thomas J. Albani Director - ------------------------------- Thomas J. Albani /s/ Patrick A. Hopf Director - ------------------------------- Patrick A. Hopf /s/ Christopher P. Kirchen Director - ------------------------------- Christopher P. Kirchen 23 /s/ David T. Kollat Director - ------------------------------- David T. Kollat /s/ Kenneth A. Macke Director - ------------------------------- Kenneth A. Macke /s/ Jean-Michel Valette Director - ------------------------------- Jean-Michel Valette 24 Independent Auditors' Report on Financial Statement Schedule The Board of Directors and Stockholders Select Comfort Corporation Under date of January 22, 1999 we reported on the consolidated balance sheets of Select Comfort Corporation and subsidiaries as of January 2, 1999 and January 3, 1998, and the related statements of operations, stockholders' equity, and cash flows for each of the years in the three-year period ended January 2, 1999, as contained in the Annual Report on Form 10-K for the year 1998. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedule as listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in the all material aspects, the information set forth therein. /s/ KPMG Peat Marwick LLP Minneapolis, Minnesota January 22, 1999 SELECT COMFORT CORPORATION AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS BALANCE AT CHARGED TO DEDUCTIONS BALANCE AT BEGINNING COSTS AND FROM END OF DESCRIPTION OF PERIOD EXPENSES RESERVES PERIOD - ---------------------------- ---------- ---------- ----------- ---------- Allowance for doubtful accounts - 1998 $1,901 $2,794 $1,945 $2,750 - 1997 200 2,101 400 1,901 - 1996 261 63 124 200 Accrued warranty costs - 1998 $3,257 $4,807 $3,578 $4,486 - 1997 2,036 3,274 2,053 3,257 - 1996 1,390 1,936 1,290 2,036
25 SELECT COMFORT CORPORATION EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED JANUARY 2, 1999
EXHIBIT NO. DESCRIPTION METHOD OF FILING - ------- ----------- ---------------- 3.1 Restated Articles of Incorporation of the Company.............. Incorporated by reference to Exhibit 3.1 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 3.2 Restated Bylaws of the Company................................. Incorporated by reference to Exhibit 3.2 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 4.1 Form of Warrant issued in connection with the sale of Incorporated by reference to Exhibit Convertible Preferred Stock, Series E.......................... 4.2 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 4.2 Form of Warrant issued in connection with the November 1996 Incorporated by reference to Exhibit Bridge Financing............................................... 4.3 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 4.3 Amended and Restated Registration Rights Agreement dated Incorporated by reference to Exhibit December 28, 1995.............................................. 4.4 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 4.4 First Amendment to Series E Stock Purchase Agreement and Incorporated by reference to Exhibit Amended and Restated Registration Rights Agreement dated 4.5 contained in the Company's April 25, 1996................................................. Registration Statement on Form S-1, as amended (File No. 333-62793) 4.5 Second Amendment to Amended and Restated Registration Rights Incorporated by reference to Exhibit Agreement dated as of November 1, 1996........................ 4.6 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 4.6 Second (sic) Amendment to Amended and Restated Registration Incorporated by reference to Exhibit Rights Agreement dated March 24, 1997......................... 4.7 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 26 4.7 Series A Warrant effective as of March 31, 1998 issued to Incorporated by reference to Exhibit General Electric Capital Corporation.......................... 4.8 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.1 Net Lease Agreement dated December 3, 1993 between the Company Incorporated by reference to Exhibit and Opus Corporation.......................................... 10.1 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.2 Amendment of Lease dated August 10, 1994 between the Company Incorporated by reference to Exhibit and Opus Corporation.......................................... 10.2 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.3 Second Amendment to Lease dated May 10, 1995 between the Incorporated by reference to Exhibit Company and Rushmore Plaza Partners Limited Partnership 10.3 contained in the Company's (successor to Opus Corporation)................................ Registration Statement on Form S-1, as amended (File No. 333-62793) 10.4 Letter Agreement dated as of October 5, 1995 between Incorporated by reference to Exhibit the Company and Rushmore Plaza Partners Limited Partnership... 10.4 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.5 Third Amendment of Lease, Assignment and Assumption of Lease Incorporated by reference to Exhibit and Consent dated as of January 1, 1996 among the Company, 10.5 contained in the Company's Rushmore Plaza Partners Limited Partnership and Select Registration Statement on Form S-1, as Comfort Direct Corporation.................................... amended (File No. 333-62793) 10.6 Sublease dated as of March 27, 1997 between Select Comfort SC Incorporated by reference to Exhibit Corporation and Bellsouth Telecommunications, Inc. ........... 10.6 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.7 Master Lease Agreement dated August 27, 1996 between Incorporated by reference to Exhibit Comdisco, Inc. and the Company and Equipment 10.7 contained in the Company's Schedules VL-1 dated August 27, 1996 and VL-2 and VL-3 dated Registration Statement on Form S-1, as November 11, 1996............................................. amended (File No. 333-62793) 10.8 Supply Agreement dated August 23, 1994 between the Company Incorporated by reference to Exhibit and Supplier (1).............................................. 10.8 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 27 10.9 Equipment Purchase and Software License Agreement dated Incorporated by reference to Exhibit February 6, 1996 between the Company and Supplier (1)......... 10.9 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.10 Consumer Credit Card Program Agreement dated as of May 22, 1997 among the Company, Select Comfort Retail Corporation, Select Comfort Direct Corporation, Select Comfort SC Incorporated by reference to Exhibit Corporation and Monogram Credit Card Bank of Georgia; 10.12 contained in the Company's amended in First Amendment to Consumer Credit Card Registration Statement on Form S-1, as Program Agreement dated November 18, 1987 (1) ................ as amended (File No. 333-62793) 10.11 Major Merchant Agreement dated December 19, 1997 Incorporated by reference to Exhibit among First National Bank of Omaha and the Company, Select 10.13 contained in the Company's Comfort SC Corporation, Select Comfort Retail Corporation Registration Statement on Form S-1, as and Select Comfort Direct Corporation......................... amended (File No. 333-62793) 10.12 1990 Omnibus Stock Option Plan, as amended.................... Incorporated by reference to Exhibit 10.14 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.13 1997 Stock Incentive Plan..................................... Incorporated by reference to Exhibit 10.15 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.14 Form of Incentive Stock Option Agreement under the 1997 Stock Incorporated by reference to Exhibit Incentive Plan................................................ 10.16 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.15 Form of Performance Based Stock Option Agreement under the Incorporated by reference to Exhibit 1997 Stock Incentive Plan..................................... 10.17 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.16 Employment Letter Agreement dated April 3, 1997 between the Incorporated by reference to Exhibit Company and H. Robert Hawthorne............................... 10.18 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.17 Employment Letter Agreement dated October 20, 1995 between the Incorporated by reference to Exhibit Company and Daniel J. McAthie................................. 10.19 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 28 10.18 Employment Letter Agreement dated July 11, 1995 between the Incorporated by reference to Exhibit Company and Gregory T. Kliner................................. 10.20 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.19 Consulting Agreement and Stock Option Agreement dated Incorporated by reference to Exhibit April 1, 1996 between the Company and Ervin R. Shames......... 10.21 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 10.20 Employment Letter Agreement dated November 12, 1997 between the Company and Ronald E. Mayle........................ Filed herewith electronically 10.21 Lease Agreement dated September 30, 1998 between the Company Incorporated by reference to Exhibit and ProLogis Development Services Incorporated................. 10.28 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 13.1 Excerpts from the 1998 Annual Report to Shareholders........... Filed herewith electronically 21.1 Subsidiaries of the Company.................................... Incorporated by reference to Exhibit 21.1 contained in the Company's Registration Statement on Form S-1, as amended (File No. 333-62793) 23.1 Independent Auditors' Consent ................................. Filed herewith electronically 27.1 Financial Data Schedule........................................ Filed herewith electronically
- ---------------------- (1) Confidential treatment has been granted by the Securities and Exchange Commission with respect to designated portions contained within document. Such portions have been omitted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2 of the Securities and Exchange Act of 1934, as amended. 29 EX-10.20 2 EXHIBIT 10.20 [Select Comfort Letterhead] November 12, 1997 Mr. Ron Mayle 4565 Landover Way Suwanee, GA 30024 Dear Ron: As a follow up to our conversation, following is a revised summary of our offer to you: - - The starting salary will be $160,000 annually with a start date of December 1, 1997. - - You will participate in the Management Incentive Plan, which in 1997 provides a payout target of up to 50%, with a maximum of up to 80% of base salary on a prorated basis if certain performance criteria are met. - - As an employee of Select Comfort, you will be eligible for our company benefits beginning December 1, 1997. Our benefits include: medical, dental, flex account, life insurance, supplemental life insurance, short-term disability, long-term disability, travel accident insurance, Paid Time Off (PTO) and 401(k). The details of your benefits package will be reviewed in a new hire orientation. - - We will provide an annual payment of $3,600 to cover your portable disability plan which you will, in turn, pay for yourself. - - You will also be eligible for stock options of 135,000 shares at $10.00 per share vested monthly over 24 months of employment - - You will spend approximately two to three days per week at Home Office in Minneapolis and the balance of the week working from your home in Atlanta. Select Comfort will pay for all of your travel to and from Atlanta, plus lodging during time spent in Minneapolis. Also, Select Comfort will pay for any modifications to your home office computer in Atlanta and overall communications set-up that will enable you to work with our data bases. If you decide Mr. Ron Mayle November 12, 1997 Page 2 to move to Minneapolis during your first twelve months of employment, Select Comfort will pay for your household moving expenses as outlined in our corporate relocation policy. I am extremely enthusiastic about your joining Select Comfort to help lead us into the next century, when we will be recognized as the most successful mattress company ever. Additionally, I stand ready to help you in any way as you work to take our retail company to a "world class" level. Any questions you have, please feel free to contact me directly. I look forward to a successful and rewarding working relationship. Sincerely, /s/ Rob Hawthorne Rob Hawthorne President & CEO kkj Accepted by: /s/ Ronald E. Mayle Date: 11/13/97 ------------------------ -------------------- EX-13 3 EXHIBIT 13.1 SELECTED CONSOLIDATED FINANCIAL DATA The data presented below has been derived from the Company's consolidated financial statements and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's consolidated financial statements and notes thereto:
JAN. 2, 1999 JAN. 3, 1998 DEC. 28, 1996 DEC. 30, 1995 DEC. 31, 1994 YEAR ENDED(1) (IN THOUSANDS, EXCEPT PER SHARE AND SELECTED OPERATING DATA) CONSOLIDATED STATEMENTS OF OPERATIONS DATA: Net sales $246,269 $184,430 $102,028 $68,629 $30,472 Gross margin 161,082 117,801 63,507 39,796 19,420 Operating income (loss) 11,465 2,078 (3,764) (4,589) (3,297) Net income (loss) before extraordinary item 6,636 (2,846) (3,685) (4,560) (3,371) Net income (loss) 5,195 (2,846) (3,685) (4,560) (3,371) Net income (loss) per share - diluted (2): Net income (loss) per share before extraordinary item 0.28 (1.59) (2.61) (3.16) (2.65) Net income (loss) per share 0.19 (1.59) (2.61) (3.16) (2.65) Weighted average common shares - diluted 15,928 2,353 1,753 1,444 1,274 Dividends paid per share - - - - - SELECTED OPERATING DATA: Stores open at period-end (3) 264 200 143 68 35 Average square footage of stores open during period (4) 895 866 768 703 642 Sales per square foot (4) 742 666 622 611 442 Average store age (in months at period end) 27 22 15 15 12 Comparable store sales increase (5) 23.5% 27.3% 26.1% 59.8% 57.6% CONSOLIDATED BALANCE SHEET DATA: Cash and cash equivalents $45,561 $12,670 $2,422 $6,862 $3,770 Working capital 42,249 757 (7,809) 2,734 2,614 Total assets 106,234 57,241 29,794 23,838 14,243 Long-term debt, less current maturities 29 19,511 1,162 40 77 Mandatorily redeemable preferred stock - 27,612 27,612 27,625 18,669 Total common shareholders' equity (deficit) 70,691 (21,038) (18,216) (14,779) (10,592)
(1) Except for the year ended January 3, 1998, which included 53 weeks, all years presented included 52 weeks. (2) See Note 11 of Notes to Consolidated Financial Statements. (3) Includes Select Comfort stores operated in leased departments within larger retail stores (14 at January 2, 1999 and one at January 3, 1998). (4) For stores open during the entire period indicated. (5) Stores enter the comparable store calculation in their 13th full month of operation. The number of comparable stores used to calculate such data were 199, 138, 65, 32 and 13 for 1998, 1997, 1996, 1995 and 1994, respectively. Reflects adjustment for an additional week of sales in 1997. Without adjusting for the additional week, comparable store sales would have been 17.9% in 1998 and 34.6% in 1997. 16 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO INCLUDED HEREIN. THE DISCUSSION IN THIS ANNUAL REPORT CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES, SUCH AS STATEMENTS OF THE COMPANY'S PLANS, OBJECTIVES, EXPECTATIONS AND INTENTIONS. THE CAUTIONARY STATEMENTS MADE IN THIS ANNUAL REPORT SHOULD BE READ AS BEING APPLICABLE TO ALL RELATED FORWARD-LOOKING STATEMENTS WHEREVER THEY APPEAR IN THIS ANNUAL REPORT. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE DISCUSSED HERE. OVERVIEW Select Comfort was founded in 1987 and has become the leading vertically integrated manufacturer, specialty retailer and direct marketer of innovative air beds and sleep-related products. Management's initial focus was on its direct marketing operations, which have grown in depth and sophistication and now provide critical support for retail and road show distribution channels. Since the first retail stores were opened in 1992, an increasing percentage of net sales has occurred at the retail stores, which now account for a majority of net sales. In 1994, the road show distribution channel was established and focuses primarily on markets where retail stores have not been established. Vertically integrated operations and control over three separate but complementary distribution channels enable us to develop and maintain direct customer relationships as well as leverage advertising dollars. Sales generation is driven by targeted print, radio and television media which generate customer inquiries that historically were pursued primarily through direct marketing operations. As the retail store base has expanded, we believe the direct marketing infrastructure has been leveraged and the process of converting inquiries into sales has been improved. Marketing programs at retail stores have been enhanced to focus more on increasing customer traffic, including a number of in-store activities and promotions. We believe that direct marketing operations will also continue to play a significant role in building consumer awareness and product sales. We believe that sales will continue to grow for the foreseeable future as advertising expenditures are increased and as additional retail stores are opened, and as consumer awareness of our products and brand name increases. The magnitude of future sales growth will depend on our ability to create product and brand name awareness, the level of consumer acceptance of the Company's products, the effectiveness and efficiency of the Company's advertising, the ability of the Company to successfully identify and respond to emerging trends in the mattress industry, the level of competition in the mattress industry, and general economic conditions and consumer confidence. Retail operations included 264 stores at January 2, 1999 including 14 leased departments within larger retail stores (13 in Bed Bath & Beyond stores), 200 stores at January 3, 1998 and 143 stores at December 28, 1996. We plan to open approximately 75 additional retail stores in 1999 including the expansion of the leased department concept. Approximately 46% of the 1998 retail store openings, including leased departments, were in new markets. As of January 2, 1999, we had closed five stores. Historically, we have experienced strong comparable store sales growth, reporting increases of 23.5%, 27.3% and 26.1% in 1998, 1997 and 1996, respectively (comparable store sales amounts have been adjusted to reflect 52 weeks in fiscal 1997 consistent with all other periods). We believe this performance is due to increased awareness of our brand and product benefits, the relatively young age of the store base and various initiatives implemented in recent periods related to increased emphasis on the retail distribution channel. These initiatives include (i) a change in focus of advertising toward brand awareness, (ii) the evolution of retail store operations, including improvements in store design, and (iii) the closer integration of direct marketing and retail distribution channels. Comparable store sales results in the future will be influenced by factors similar to those which will impact overall sales growth. Advertising expenditures increased from $5.5 million in 1994 to $31.6 million in 1998. Advertising costs are expensed as incurred as a component of sales and marketing expenses, although we believe that advertising expenditures provide significant benefits beyond the period in which they are expensed. Future advertising expenditures will depend on the effectiveness and efficiency of the advertising in creating awareness of our products and brand name, generating consumer inquiries and driving consumer traffic to retail stores. Advertising expenditures are expected to continue to increase in the foreseeable future. 17 We believe historical operating losses have been primarily the result of an aggressive retail store opening strategy, a relatively immature store base, significant marketing, advertising and research and development expenditures, and the development of a substantial corporate infrastructure to support future growth. Future increases in net sales and the achievement of long-term profitability will depend upon greater consumer awareness and acceptance of air bed products, the opening and successful performance of new retail stores, and continued improvement in the performance of current stores as they mature. Furthermore, a substantial portion of operating expenses is related to sales and marketing expenses, including costs associated with opening new stores and advertising and marketing expenditures. The level of such spending cannot be adjusted quickly and is based, in significant part, on expectations of future customer inquiries and net sales. If we experience a shortfall in expected net sales or in the conversion rate of customer inquiries, we may be unable to adjust spending in a timely manner and our business, financial condition and operating results may be materially adversely affected. In addition, quarterly and annual operating results may fluctuate significantly as a result of a variety of factors, including increases or decreases in comparable store sales, the timing, amount and effectiveness of advertising expenditures, any changes in return rates, the timing of new store openings and related expenses, competitive factors, net sales contributed by new stores, any disruptions in third-party delivery services and general economic conditions and consumer confidence. Our business is also subject to some seasonal influences, with heavier concentrations of sales during the fourth quarter holiday season due to increased mall traffic. There can be no assurance that we will be able to achieve or sustain our historical sales growth or profitability in the future, on a quarterly or annual basis. In connection with our March 1997 $15.0 million debt financing, a warrant with a put feature was issued. This put feature required that the warrant be recorded at fair value as long-term debt. Furthermore, any change in the fair value of this warrant has been reflected as interest expense, resulting in non-cash interest expense of $5.6 million and $3.3 million during 1998 and 1997, respectively. The put feature of this warrant was eliminated upon the closing of our initial public offering in December 1998, resulting in the reclassification of the warrant liability from long-term debt to common shareholders' equity. There will be no further interest expense associated with the warrant. In November 1998, we agreed to reduce the conversion price of the Series E Preferred Stock from $8.82 to $8.20 per share. This reduction of the conversion price had no impact on net income (loss). However, for purposes of calculating net income (loss) per share, net income available to common shareholders was reduced by $1.3 million, an amount equal to the 77,155 incremental shares issuable as a result of this change multiplied by $17.00, the Companies IPO price. Net income (loss) as reported was $5.2 million and ($2.8) million for 1998 and 1997, respectively resulting in net income (loss) per share of $0.19 and ($1.59), respectively. Pro forma net income, was $7.6 million and $0.4 million in 1998 and 1997, respectively. Pro forma net income reflects adjustments for non-recurring, non-cash items associated with put warrant interest expense referred to above, a $1.4 million extraordinary charge associated with early repayment of $15.0 million debt, as well as an income tax benefit of $4.7 million associated with the elimination of the Company's deferred tax valuation allowance. Pro forma net income per share, which reflects these non-recurring non-cash adjustments as well as adjustments related to undeclared and unpaid dividends, was $0.45 and $0.03 in 1998 and 1997, respectively. In addition, as a result of the repayment of the $15.0 million debt financing in December 1998, we anticipate a reduction of interest expense in future periods. Interest expense associated with this debt totaled $1.6 million in 1998. At January 2, 1999, the Company had net operating loss carryforwards for federal income tax purposes of approximately $1.6 million, of which it expects to be able to use approximately $200,000. The Company's effective tax rate will increase from that experienced in prior years as a result of the elimination of substantially all of its net operating loss carry forwards. 18 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the Company's results of operations expressed as percentages of net sales. Percentage amounts may not total due to rounding.
JAN. 2, 1999 JAN. 3, 1998 DEC. 28, 1996 YEAR ENDED PERCENTAGE OF NET SALES Net sales 100.0% 100.0% 100.0% Cost of sales 34.6 36.1 37.8 ................................................................................................ Gross margin 65.4 63.9 62.2 ................................................................................................ Operating expenses: Sales and marketing 52.7 53.8 53.7 General and administrative 8.0 8.9 12.2 ................................................................................................ Total operating expenses 60.8 62.7 65.9 ................................................................................................ Operating income (loss) 4.7 1.1 (3.7) Other income (expense), net (2.9) (2.6) 0.1 ................................................................................................ Income (loss) before income taxes 1.8 (1.5) (3.6) Income tax expense (benefit) (0.9) 0.1 0.0 ................................................................................................ Net income (loss) before extraordinary item, net 2.7 (1.5) (3.6) Extraordinary item (0.6) 0.0 0.0 ................................................................................................ Net income (loss) 2.1% (1.5)% (3.6)% - ------------------------------------------------------------------------------------------------
COMPARISON OF YEAR ENDED JANUARY 2, 1999 AND JANUARY 3, 1998 NET SALES Net sales increased 33.5% to $246.3 million for 1998 from $184.4 million for 1997, primarily due to an increase in unit sales. The components of the increase in net sales were (i) a $29.1 million increase associated with the opening of 64 new retail stores during 1998, (ii) a $22.0 million increase associated with an increase of 23.5% in comparable store sales over the comparable period of the prior year, resulting primarily from the continuing maturation of stores, offset by an estimated $4.4 million in comparable store sales in the 53rd week in 1997 and (iii) a $14.6 million increase in direct marketing sales. For a significant portion of the third quarter of 1997, due to a UPS work stoppage, UPS was unable to deliver the Company's products within acceptable time periods, causing delays in deliveries to customers and requiring the Company to use alternative carriers. Also, during this period, the Company converted its manufacturing and financial operations to a new integrated information system. These factors resulted in higher than normal customer returns and canceled orders, lower order volumes and substantially increased freight charges, which the Company estimates negatively impacted its operating income by approximately $3.9 million in the second half of 1997, principally incurred in the third quarter. GROSS MARGIN Gross margin increased to 65.4% in 1998 from 63.9% in 1997 primarily due to improved purchasing through volume discounts and better relationships with key suppliers and improved leverage of fixed manufacturing costs over higher unit volumes as well as reduced costs in 1998 compared with 1997 when the UPS strike occurred. SALES AND MARKETING Sales and marketing expenses increased 30.9% to $129.9 million in 1998 from $99.2 million in 1997, and decreased slightly as a percentage of net sales to 52.7% in 1998 from 53.8% in 1997. The increase in the dollar amount of sales and marketing expenses was primarily due to the opening of 64 new retail stores during 1998, increased advertising expenditures to support the Company's growth, and higher commissions, percentage rents and freight expense related to the higher net sales. The decrease in sales and marketing expenses as a percentage of net sales was primarily due to improved leverage on advertising expenditures. 19 GENERAL AND ADMINISTRATIVE General and administrative expenses increased 19.5% to $19.7 million in 1998 from $16.5 million in 1997, but decreased as a percentage of net sales to 8.0% in 1998 from 8.9% in 1997. The increase in the dollar amount of general and administrative expenses was primarily due to increased spending to provide infrastructure to support overall net sales growth. The decrease in general and administrative expenses as a percentage of net sales was primarily due to improved leverage of fixed costs over the increase in net sales. OTHER INCOME (EXPENSE), NET Other expense increased $2.3 million to $7.1 million in 1998 from $4.8 million in 1997 primarily due to the inclusion of $5.6 million of non-cash interest expense in 1998 relating to the change in the fair value of an outstanding put warrant compared with $3.3 million in 1997. The put provision associated with the warrant was eliminated effective on completion of the IPO. Future periods will not require the recording of non-cash interest expense associated with the put warrant. INCOME TAX EXPENSE (BENEFIT) Income tax expense decreased to a $2.2 million benefit in 1998 from a $0.1 million expense in 1997 primarily due to a $4.7 million benefit in 1998 associated with the recognition of deferred tax assets. This benefit is a non-recurring item that should not impact future year operating results. The benefit was partially offset by income tax expense associated with taxable income in 1998. Income tax expense in 1997 was limited due to the utilization of net operating losses to offset taxable income in 1997. EXTRAORDINARY ITEM 1998 net income includes an extraordinary charge, net of income tax benefits, of $1.4 million. The charge relates to the write-off of certain deferred assets and issuance costs associated with our $15.0 million debt financing, which was repaid in December 1998. COMPARISON OF YEARS ENDED JANUARY 3, 1998 AND DECEMBER 28, 1996 NET SALES Net sales increased 80.8% to $184.4 million in 1997 from $102.0 million in 1996, primarily due to an increase in unit sales. The components of the net sales increase were (i) a $36.6 million increase associated with the opening of 58 new retail stores in 1997, (ii) a $27.4 million increase in direct marketing sales, and (iii) a $12.3 million increase associated with an increase of 27.3% in comparable store sales over the comparable period of the prior year, resulting primarily from the continuing maturation of stores and an estimated $3.3 million in comparable store sales in the 53rd week of 1997. For a significant portion of the third quarter of 1997, due to a UPS work stoppage, UPS was unable to deliver the Company's products within acceptable time periods, causing delays in deliveries to customers and requiring the Company to use alternative carriers. Also, during this period, the Company converted its manufacturing and financial operations to a new integrated information system. These factors resulted in higher than normal customer returns and canceled orders, lower order volumes and substantially increased freight charges, which the Company estimates negatively impacted its operating income by approximately $3.9 million in the second half of 1997. GROSS MARGIN Gross margin increased to 63.9% in 1997 from 62.2% in 1996, primarily due to improved purchasing through volume discounts and better relationships with key suppliers and improved leverage of fixed manufacturing costs over higher unit volumes. SALES AND MARKETING Sales and marketing expenses increased 81.0% to $99.2 million in 1997 from $54.8 million in 1996, and increased slightly as a percentage of net sales to 53.8% in 1997 from 53.7% in 1996. The increase in the dollar amount of sales and marketing expenses was primarily due to the opening of 58 new retail stores in 1997, higher commissions, percentage rents and freight expenses related to the higher level of net sales, increased advertising expenditures to support the Company's growth, and an increase in freight charges due to the UPS strike. GENERAL AND ADMINISTRATIVE General and administrative expenses increased 32.5% to $16.5 million in 1997 from $12.5 million in 1996, but decreased as a percentage of net sales to 8.9% in 1997 from 12.2% in 1996. The increase in the dollar amount of general and administrative expenses was primarily due to increased infrastructure to support overall net sales growth. The decrease in general and administrative expenses as a percentage of net sales was primarily due to improved leverage of fixed costs over the increase in net sales. 20 OTHER INCOME (EXPENSE), NET Other income (expense) decreased to $4.8 million of other expense in 1997 from $0.1 million of other income in 1996 primarily due to (i) the inclusion of $3.3 million of non-cash interest expense relating to the change in the fair value of an outstanding put warrant and (ii) interest expense associated with the Company's March 1997 $15.0 million debt issuance, offset in part by the interest income associated with the proceeds thereof. LIQUIDITY AND CAPITAL RESOURCES Our primary source of liquidity has been the sale of equity securities, including the completion of our initial public offering in December 1998, a $15.0 million senior subordinated debt financing transaction completed in March 1997, and cash generated from operations. The initial public offering resulted in net proceeds of $44.6 million, which were partially used for the December 1998 repayment of the $15.0 million debt. Primary uses of cash have been for the development and manufacturing of the Company's air bed product line, sales and marketing expenses, costs associated with the opening of new retail stores and manufacturing facilities and other required infrastructure and general corporate purposes, including working capital. The Company had working capital of approximately $42.2 million at January 2, 1999. Net cash provided by operating activities in 1998 was approximately $11.0 million and consisted primarily of net income adjusted for non-cash expenses and increases in accruals, partially offset by increases in accounts receivables and inventories. Net cash provided by operating activities in 1997 was approximately $7.3 million and consisted primarily of increases in accounts payable, accruals and net loss adjusted for non-cash expenses, partially offset by increases in accounts receivable, inventories and prepaid expenses. Net cash provided by operating activities in 1996 was approximately $3.1 million and consisted primarily of increases in accounts payable and accruals, partially offset by a net loss adjusted for non-cash expenses and increases in inventories, accounts receivable and prepaid expenses. Beginning in May 1997, we began offering an unsecured revolving credit arrangement to finance purchases through a third-party bank. Amounts owed to the bank by the Company's customers aggregated $73.8 million at January 2, 1999. The bank's current commitment extends to a maximum of $85.0 million of receivables outstanding. In connection with all purchases financed under these arrangements, the bank pays an amount equal to the total amount of purchases net of promotional related discounts and less amounts retained for limited recourse on bad debts. The bank had retained $11.3 million and $3.9 million as of January 2, 1999 and January 3, 1998, respectively. In March 1999, we notified the bank of our intent to terminate this consumer credit arrangement. In addition, we have signed a letter of intent with a third-party provider to replace the existing arrangement. We anticipate that the new arrangement will be under terms that are no less favorable than under the existing arrangement and that the transition to the new provider will occur near the beginning of the third quarter of 1999. In addition, amounts retained under the existing agreement will likely be returned to the Company shortly following termination and are not anticipated to be replaced by similar retainage amounts under the new agreement. Net cash used in investing activities was approximately $8.8 million, $10.7 million, and $10.1 million in the years 1998, 1997 and 1996, respectively. Investing activities consisted of purchases of property and equipment for new retail stores in all periods as well as for a new manufacturing and distribution facility and the conversion to a new information system in 1997. Net cash provided by financing activities for 1998, 1997 and 1996 was approximately $30.7 million, $13.6 million and $2.6 million, respectively. Net cash provided by financing activities for 1998 consisted primarily of proceeds from completion of our IPO, partially offset by debt repayments. Net cash provided by financing activities for 1997 and 1996 consisted primarily of proceeds from debt issuances, partially offset by debt repayments. At January 2, 1999, we had 264 retail stores, including 13 leased departments in Bed Bath & Beyond stores. We plan to open approximately 75 retail stores in 1999 including expansion of the leased department concept. Management expects that new stores will be leased on terms generally comparable to those of existing store leases. In addition, we plan to open a third manufacturing and distribution facility in Salt Lake City during the first half of 1999. Capital expenditures in 1999 will be approximately $15.0 million based on currently planned store openings, the planned new manufacturing and distribution facility and the central office facilities and systems necessary to support such additional stores. We believe cash generated from operations will be sufficient to satisfy anticipated working capital needs and that capital expenditure requirements through at least the end of 1999 will be funded primarily by January 2, 1999 cash balances. Cash generated from operations and cash remaining at the end of 1999 will be used to meet long-term liquidity needs, although additional financing may be required. 21 IMPACT OF YEAR 2000 STATE OF READINESS Beginning in early 1996, we included certain Year 2000 initiatives and remediation plans in our broader information systems strategic plan. In early 1998 an independent consultant was retained to assess the adequacy of Year 2000 initiatives and remediation plans. All essential information technology ("IT") systems have been inventoried and remediation plans for any Year 2000 issues have been implemented. Remediation plans included the development of Year 2000 compliant applications for order entry, customer service and point of sale systems in fall 1996. In the third quarter of 1997, to facilitate and manage our growth, we purchased and implemented an enterprise information system used in manufacturing operations, material planning, inventory management, order processing, financial management and human resources applications, which system was upgraded to be Year 2000 compliant in February, 1999. We purchased Year 2000 compliant upgrades to our payroll applications in 1997 and our telephone system in 1998. Year 2000 compliant upgrades for software applications for customer inquiries and for processing and tracking warranty claims and returns have been purchased. We anticipate these upgrades will be completed in the third quarter of 1999. With the implementation of these applications and upgrades, we expect that all core applications and IT systems will be Year 2000 compliant by the end of the second quarter of 1999. In August 1998, we formed a Year 2000 project team ("Year 2000 Project Team") to identify and address Year 2000 compliance matters, including significant non-IT systems which are comprised of the embedded technology used in our buildings, plant, equipment and other infrastructure. The Year 2000 Project Team is currently in the process of inventorying all material Year 2000 issues in non-IT systems. We expect that remedial action for all non-IT systems will be completed by the end of the second quarter of 1999. During the first quarter of 1998, we initiated discussions with significant suppliers regarding their plans to remediate Year 2000 issues. We sent each of the significant suppliers a questionnaire inquiring as to the magnitude of their Year 2000 issues and the status of their readiness. We have received assurances from a majority of these suppliers that they will become Year 2000 compliant in a timely manner. We have not received responses from all of the third parties with which we do business. In addition to the questionnaires, a supplier certification program has been established under which suppliers must meet rigorous standards relating to quality, service, the ability to deliver materials on a timely basis and Year 2000 compliance. To date, nine key suppliers were certified and other authorized suppliers are in the process of seeking certification. Our key suppliers, including the supplier of our air chambers, have notified us that they are or will be Year 2000 compliant during 1999. In addition to suppliers, we also rely upon governmental agencies, utility companies, telecommunication service companies and other service providers outside of our control. There can be no assurance that such governmental agencies or other third parties will not suffer a Year 2000 business disruption that could have a material adverse effect on our business, financial condition and operating results. COSTS TO ADDRESS THE YEAR 2000 ISSUE We estimate approximately $165,000 has been incurred, through January 2, 1999, to address Year 2000 issues. We estimate that by mid-1999 an additional $100,000 will be incurred to complete our remediation plans required for IT systems, including systems software costs and consulting fees. We do not have an estimate on Year 2000 remediation costs that may be required for non-IT systems, but we believe that such costs will not have a material adverse effect on our business, financial condition and operating results. RISKS PRESENTED BY THE YEAR 2000 ISSUE As the process of inventorying non-IT systems proceeds, we may identify systems that present a Year 2000 risk. In addition, if any third parties who provide goods or services essential to our business activities fail to appropriately address their Year 2000 issues, such failure could have a material adverse effect on our business, financial condition and operating results. For example, a Year 2000 related disruption on the part of the financial institutions which process credit card sales would have a material adverse effect on our business, financial condition and operating results. CONTINGENCY PLANS The Year 2000 Project Team's initiatives include the development of contingency plans in the event we have not completed all remediation plans in a timely manner. In addition, the Year 2000 Project Team is in the process of developing contingency plans in the event that any third parties who provide goods or services essential to our business fail to appropriately address their Year 2000 issues. The Year 2000 Project Team expects to conclude the development of these contingency plans by the end of the second quarter of 1999. 22 INDEPENDENT AUDITORS' REPORT We have audited the accompanying consolidated balance sheets of Select Comfort Corporation and subsidiaries (the Company) as of January 2, 1999 and January 3, 1998 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended January 2, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Select Comfort Corporation and subsidiaries as of January 2, 1999 and January 3, 1998, and the results of their operations and their cash flows for each of the years in the three-year period ended January 2, 1999 in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick LLP Minneapolis, Minnesota January 22, 1999 23 CONSOLIDATED BALANCE SHEETS JANUARY 2, 1999 AND JANUARY 3, 1998 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
ASSETS 1998 1997 Current assets: Cash and cash equivalents $45,561 $12,670 Accounts receivable, net of allowance for doubtful accounts of $2,750 and $1,901, respectively (note 2) 10,624 5,961 Inventories (note 3) 10,136 7,749 Prepaid expenses 4,048 4,256 Deferred tax assets (note 10) 5,448 - ............................................................................................. Total current assets 75,817 30,636 Property and equipment, net (note 4) 29,125 25,183 Deferred tax assets (note 10) 440 - Other assets 852 1,382 ............................................................................................. Total assets $106,234 $57,201 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt (note 6) $930 $999 Accounts payable 12,079 12,199 Accruals: Sales returns 6,021 5,324 Warranty costs 4,486 3,257 Compensation, taxes and benefit 4,843 3,149 Income taxes (note 10) 648 125 Other 4,561 4,826 ............................................................................................. Total current liabilities 33,568 29,879 Long-term debt, less current maturities (note 6) 29 13,841 Warrants subject to put provision (note 7) - 5,670 Other liabilities 1,946 1,237 ............................................................................................. Total liabilities 35,543 50,627 - --------------------------------------------------------------------------------------------- Series A-E mandatorily redeemable preferred stock, $1.00-$1.25 par value; none and 12,123,390 shares authorized, none and 12,091,962 shares issued and outstanding, respectively (note 8) - 12,692 Additional paid-in capital - 14,920 ............................................................................................. - 27,612 ............................................................................................. Common shareholders' equity (notes 7, 8 and 9): Undesignated preferred stock; 5,000,000 shares authorized, no shares issued and outstanding - - Common stock, $.01 par value; 95,000,000 shares authorized, 18,435,687 and 2,477,660 shares issued and outstanding, respectively 184 25 Additional paid-in capital 87,619 1,662 Accumulated deficit (17,112) (22,307) Notes receivable investors (note 14) - (418) ............................................................................................. Total common shareholders' equity (deficit) 70,691 (21,038) ............................................................................................. Commitments (notes 5 and 15) Total liabilities and shareholders' equity $106,234 $57,201 - --------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 24 CONSOLIDATED STATEMENTS OF OPERATIONS JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996 (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
1998 1997 1996 Net sales $246,269 $184,430 $102,028 Cost of sales 85,187 66,629 38,521 ............................................................................................. Gross margin 161,082 117,801 63,507 ............................................................................................. Operating expenses: Sales and marketing 129,894 99,218 54,814 General and administrative 19,723 16,505 12,457 ............................................................................................. Total operating expenses 149,617 115,723 67,271 ............................................................................................. Operating income (loss) 11,465 2,078 (3,764) ............................................................................................. Other income (expense): Interest income 825 682 244 Interest expense (note 6 and 7) (7,834) (5,234) (88) Other, net (52) (231) (77) ............................................................................................. Other income (expense), net (7,061) (4,783) 79 ............................................................................................. Income (loss) before income taxes and extraordinary item 4,404 (2,705) (3,685) Income tax expense (benefit) (note 10) (2,232) 141 - ............................................................................................. Net income (loss) before extraordinary item 6,636 (2,846) (3,685) Extraordinary item, net of tax benefit (note 6) (1,441) - - ............................................................................................. Net income (loss) $5,195 $(2,846) $(3,685) - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Deemed dividend from revision of preferred stock conversion rate (note 8) $(1,312) $ - $ - Cumulative preferred dividends (821) (900) (900) ............................................................................................. Net income (loss) available to common shareholders $3,062 $(3,746) $(4,585) - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Net income (loss) per share - basic (note 11) Net income (loss) before extraordinary item $1.09 (1.59) (2.61) Net income (loss) 0.74 (1.59) (2.61) - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Net income (loss) per share - diluted (note 11) Net income (loss) before extraordinary item 0.28 (1.59) (2.61) Net income (loss) 0.19 (1.59) (2.61) - --------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 25 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996 (DOLLARS IN THOUSANDS)
ADDITIONAL NOTES PAID-IN ACCUMULATED RECEIVABLE- SHARES AMOUNT CAPITAL DEFICIT INVESTORS TOTAL Balance at December 30, 1995 1,586,808 $ 16 $ 981 $(15,776) $ - $(14,779) Exercise of common stock options 260,338 3 245 - - 248 Net loss - - - (3,685) - (3,685) ................................................................................................................... Balance at December 28, 1996 1,847,146 19 1,226 (19,461) - (18,216) Exercise of common stock options 630,514 6 436 - - 442 Issuance of investor notes - - - - (418) (418) Net loss - - - (2,846) - (2,846) ................................................................................................................... Balance at January 3, 1998 2,477,660 25 1,662 (22,307) (418) (21,038) Issuance of shares in initial public offering (note 9) 2,922,350 29 44,614 - - 44,643 Conversion of manditorily redeemable preferred stock (note 8) 12,332,364 123 27,489 - - 27,612 Exercise of common stock options and warrants 703,313 7 4,639 - - 4,646 Issuance of investor notes - - - - (487) (487) Payment of investor notes - - - - 905 905 Elimination of put provision on warrant (note 7) - - 9,215 - - 9,215 Net income - - - 5,195 - 5,195 ................................................................................................................... Balance at January 2, 1999 18,435,687 $184 $87,619 $(17,112) $ - $70,691 - ------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 26 CONSOLIDATED STATEMENTS OF CASH FLOWS JANUARY 2, 1999, JANUARY 3, 1998 AND DECEMBER 28, 1996 (IN THOUSANDS)
1998 1997 1996 Cash flows from operating activities: Net income (loss) $5,195 $(2,846) $(3,685) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 5,351 4,030 2,094 Loss on disposal of property and equipment 50 264 66 Extraordinary item 1,441 - - Deferred tax assets (5,888) - - Interest expense from put warrant valuation 5,625 3,250 - Change in operating assets and liabilities: Accounts receivable, net (4,663) (4,799) (421) Inventories (2,387) (2,167) (500) Prepaid expenses 208 (2,567) (781) Accounts payable (120) 3,026 4,039 Accrued sales returns 697 2,529 888 Accrued warranty costs 1,229 1,221 646 Accrued compensation, taxes and benefits 1,694 1,426 393 Accrued income taxes 1,856 125 - Other accrued liabilities (265) 3,829 158 Other assets 252 (565) (91) Other liabilities 709 705 270 .............................................................................................. Net cash provided by operating activities 10,984 7,336 3,076 .............................................................................................. Cash flows used in investing activities - Purchases of property and equipment (8,812) (10,727) (10,122) .............................................................................................. Cash flows from financing activities: Proceeds from issuance of debt - 16,184 2,850 Principal payments on debt (15,999) (2,203) (523) Debt issuance costs - (781) - Proceeds from issuance of common stock 46,702 439 292 Proceeds from issuance of redeemable preferred stock 16 - (13) .............................................................................................. Net cash provided by financing activities 30,719 13,639 2,606 .............................................................................................. Increase (decrease) in cash and cash equivalents 32,891 10,248 (4,440) Cash and cash equivalents, at beginning of year 12,670 2,422 6,862 .............................................................................................. Cash and cash equivalents, at end of year $45,561 $12,670 $2,422 - ---------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------
See accompanying notes to consolidated financial statements. 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS Select Comfort Corporation and its wholly owned subsidiaries (the Company) develop, manufacture, and market air beds and sleep-related products. The Company's fiscal year ends on the Saturday closest to December 31. Fiscal years 1998 and 1996 had 52 weeks. Fiscal year 1997 had 53 weeks. Certain prior-year amounts have been reclassified to conform to the current-year presentation. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation. CASH AND CASH EQUIVALENTS Cash and cash equivalents include highly liquid investments with initial maturities of three months or less. INVENTORIES Inventories includes material, labor, and overhead and is stated at the lower of cost or market. Cost is determined by the first-in, first-out method. PROPERTY AND EQUIPMENT Property and equipment, carried at cost, are depreciated using the straight-line method over the estimated useful lives of the assets, which range from three to seven years. Leasehold improvements are amortized over the shorter of the life of the lease or ten years. OTHER ASSETS Other assets include security deposits, patents, trademarks, and debt issuance costs. Patents and trademarks are amortized using the straight-line method over 17-year and 15-year periods, respectively. Debt issuance costs are amortized using the straight-line method over the term of the debt. NEW ACCOUNTING PRONOUNCEMENTS During 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No 133, "Accounting for Derivative Instruments and Hedging Activities". This pronouncement is not expected to have a material impact on the Company's consolidated financial statements. ACCOUNTING ESTIMATES The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. ACCRUED WARRANTY COSTS The Company provides a 20-year warranty on air beds, the last 15 years of which are on a prorated basis. Estimated warranty costs are provided at the time of sale of the warranted products. Estimates are based upon historical warranty claims incurred by the Company. Given the limited history available, actual results could differ from these estimates. 28 (1) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) ACCRUED SALES RETURNS Estimated sales returns are provided at the time of sale based upon historical sales returns. Returns are allowed by the Company for 90 nights following the sale. IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED The Company reviews its long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed are reported at the lower of the carrying amount or fair value less costs to sell. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying value of cash and cash equivalents and accounts receivable approximate fair value because of the short-term maturity of those instruments. The fair value of long-term debt approximates carrying value based on the Company's estimate of rates that would be available to it for debt of the same remaining maturities. REVENUE RECOGNITION Revenue is recognized when products are shipped to customers net of estimated returns. STOCK COMPENSATION The Company records compensation expense for option grants under its stock option plan if the current market value of the underlying stock at the grant date exceeds the stock option exercise price. Pro forma disclosure of the net income impact of applying an alternative method of recognizing stock compensation expense over the vesting period based on the fair value of all stock-based awards on the date of grant is presented in Note 9. RESEARCH AND DEVELOPMENT COSTS Costs incurred in connection with research and development are charged to expense as incurred. Research and development expense was $1,638,000, $1,819,000 and $1,464,000 in 1998, 1997 and 1996, respectively. PRE-OPENING COSTS Costs associated with the opening of new stores are expensed as incurred. DIRECT RESPONSE ADVERTISING COSTS The Company incurs direct response advertising costs associated with print and broadcast advertisements. Such costs are charged to expense as incurred. Advertising expense was $31,648,000, $28,281,000 and $16,224,000 in 1998, 1997 and 1996, respectively. INCOME TAXES The Company recognizes deferred tax assets and liabilities for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. 29 EARNINGS PER SHARE Basic earnings per share excludes dilution and is computed by dividing the income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share includes common stock equivalents consisting of stock options and warrants determined by the treasury stock method and dilutive convertible securities. (2) ACCOUNTS RECEIVABLE In June 1997, the Company began utilizing a third-party bank to offer its qualified customers an unsecured revolving credit arrangement to finance purchases from the Company. The bank sets the rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures, and is the owner of the accounts. In connection with all purchases financed under these arrangements, the bank pays the Company an amount equal to the total amount of such purchases, net of promotional related discounts and less amounts retained for recourse related to returned products and limited recourse related to bad debts. The bank's recourse for bad debts is limited to a specified percent of receivables generated. The bank had retained $11,350,000 and $3,882,000 as of January 2, 1999 and January 3, 1998, respectively, under terms of the agreement. The Company has included such amounts in its accounts receivable net of estimated allowance for doubtful accounts. (3) INVENTORIES Inventories consist of the following (in thousands):
JANUARY 2, 1999 JANUARY 3, 1998 Raw materials $6,533 $5,891 Work in progress 67 39 Finished goods 3,536 1,819 ............................................................................. $10,136 $7,749 ----------------------------------------------------------------------------- -----------------------------------------------------------------------------
(4) PROPERTY AND EQUIPMENT Property and equipment are summarized as follows (in thousands):
JANUARY 2, 1999 JANUARY 3, 1998 Leasehold improvements $24,865 $18,164 Office furniture and equipment 3,079 2,698 Production machinery and computer equipment 8,610 7,062 Property and equipment under capital lease 2,963 2.971 Other 1,446 1,256 Less accumulated depreciation and amortization (11,838) (6,968) ............................................................................. $29,125 $25,183 ----------------------------------------------------------------------------- -----------------------------------------------------------------------------
30 (5) LEASES The Company rents office and manufacturing space under three operating leases which, in addition to the minimum lease payments, require payment of a proportionate share of the real estate taxes and building operating expenses. The Company also rents retail space under operating leases which, in addition to the minimum lease payments, require payment of percentage rents based upon sales levels. Rent expense was as follows:
1998 1997 1996 Minimum rents $11,127 $8,465 $4,875 Percentage rents 1,522 892 237 .......................................................................... Total $12,649 $9,357 $5,112 -------------------------------------------------------------------------- Equipment rent $952 $683 $402 -------------------------------------------------------------------------- --------------------------------------------------------------------------
The aggregate minimum rental commitments under operating leases for subsequent years are as follows (in thousands): 1999 $11,939 2000 11,696 2001 11,731 2002 11,490 2003 10,765 Thereafter 31,278 .......................................................................... $88,899 -------------------------------------------------------------------------- --------------------------------------------------------------------------
(6) NOTES PAYABLE AND CAPITAL LEASE OBLIGATIONS In March 1997, the Company completed a financing under which it issued a senior subordinated promissory note in the principal amount of $15,000,000, a warrant to purchase 1,100,000 shares of the Company's common stock at $10.50 per share and a warrant to purchase 1,000,000 shares of common stock at $0.01 per share. These warrants were subsequently adjusted and combined with the issuance of anti-dilution shares, resulting in a single warrant to purchase 1,315,096 shares of common stock at $8.82 per share, exercisable at any time prior to March 31, 2005. (see Note 7). In December 1998, the Company repaid the promissory note resulting in an extraordinary loss of $1,441,000 from early repayment. The loss was comprised of unamortized debt discount and issuance costs totaling $2,281,000, and net of income tax benefits of $840,000. 31 Long-term obligations under notes and capital leases are as follows (in thousands):
JANUARY 2, 1999 JANUARY 3, 1998 Senior subordinated note payable to financing company due March 2003 with interest payable quarterly at 11% per annum. Face amount of $15,000,000 net of $1,815,000 debt discount with an effective interest rate of 13.7%, paid in full in 1998 $ - $12,882 Notes payable under capital lease agreements, payable in monthly installments through March 2000, with interest at 9.75% - 12.5% per annum. Financing available under these agreements aggregates $3,000,000, of which $2,963,000 had been utilized at January 2, 1999. In connection with these notes, the Company granted the vendor warrants to acquire 31,428 shares of the Company's Series E convertible preferred stock (note 9) 959 1,958 .......................................................................... 959 14,840 Less current maturities 930 999 .......................................................................... $29 $13,841 -------------------------------------------------------------------------- --------------------------------------------------------------------------
Aggregate maturities of long-term debt subsequent to January 2, 1999 are due in 2000. (7) WARRANTS SUBJECT TO PUT PROVISION In connection with the financing completed in March 1997 (see Note 6), the Company issued a warrant to purchase 1,100,000 shares of Common Stock at $10.50 per share (Series A Warrant) and a warrant to purchase 1,000,000 shares of Common Stock at $0.01 per share (Series B Warrant). The Series B Warrant provided that the number of shares exercisable could be reduced based on future earnings levels or in the event the Company completed an initial public offering. Effective March 31, 1998, the warrants were adjusted and combined, resulting in a single warrant to purchase 1,309,583 shares of Common Stock at $8.82 per share, exercisable at any time prior to March 31, 2005. In addition, in connection with antidilution provisions included in the warrant agreement, the Company agreed to issue an additional warrant to purchase 5,513 shares of common stock exercisable at $8.82 per share. Warrants for 1,076,098 shares remained outstanding at January 2, 1999. The original warrant agreement provided the holder could require repurchase of the warrant if an IPO had not been completed prior to March 27, 2002. The repurchase amount would have been equal to the excess of the estimated fair market value of the Company's common stock, as determined by the warrant agreement, over the exercise price of the warrant. The Company also has an option to repurchase the warrant if the warrant has not been exercised prior to March 27, 2004. As required by Emerging Issues Task Force Issue 96-13 (EITF 96-13), the warrant was recorded at fair value and recorded as long-term debt. In addition, EITF 96-13 requires that any change in fair value of the warrant be reflected as interest expense. Accordingly, the financial statements reflect interest expense of $5,625,000 and $3,250,000 for 1998 and 1997, respectively. Upon completion of the Company's initial public offering the put option on the warrants expired and the warrants were reclassified into $9,215,000 of additional paid-in-capital. In addition, effective upon completion of the Company's initial public offering, warrant revaluation is no longer required and accordingly interest expense will no longer be recorded. 32 (8) MANDATORILY REDEEMABLE PREFERRED STOCK Prior to completion of the Company's initial public offering in December 1998, the Company had issued and outstanding 12,091,962 shares of mandatorily redeemable preferred stock. The holders of the Series A, B, C, D, and E mandatorily redeemable preferred stock had certain rights and preferences, including those involving dividend participation, special voting, liquidation preferences, antidilution rights, redemption rights and in certain cases, those involving cumulative dividends. In November 1998, the Company adjusted the conversion price of the Series E Mandatorily Redeemable Preferred Stock from $8.82 per share to $8.20. The adjustment was made in accordance with the Series E Stock Purchase Agreement and was effective on the closing of the Company's initial public offering. The adjustment resulted in the issuance of an additional 77,155 shares of common stock upon conversion. For purposes of calculating net income (loss) per share in the period in which the initial public offering is completed, net income available to common shareholders has been reduced by $1,312,000 for the estimated value of additional shares issued under these antidilution provisions (note 11). Upon completion of the Company's initial public offering in December 1998, the Series A, B, C, D, and E mandatorily redeemable preferred stock converted into an aggregate of 12,332,364 shares of common stock. In addition, all rights and preferences, including those involving cumulative dividends expired. Cumulative but undeclared and unpaid dividends have been deducted from net income available to common shareholders in determining net income (loss) per share (note 11). As of January 2, 1999, there were no remaining shares of mandatory redeemable shares outstanding. The following summarizes mandatorily redeemable preferred stock as of January 3, 1998 (in thousands):
ADDITIONAL PAR VALUE PAID-IN CAPITAL Series A, $1.00 par value; 4,458,852 shares authorized, issued, and outstanding $4,459 $ - Series B, $1.25 par value; 2,400,000 shares authorized, issued, and outstanding 3,000 - Series C, $1.00 par value; 2,292,635 shares authorized, issued, and outstanding 2,293 2,972 Series D, $1.00 par value; 2,083,332 shares authorized, issued, and outstanding 2,083 3,862 Series E, $1.00 par value; 888,571 shares authorized and 857,143 shares issued and outstanding 857 8,086 .......................................................................... Total mandatorily redeemable preferred stock $12,692 $14,920 --------------------------------------------------------------------------
Changes in mandatorily redeemable preferred stock are as follows (dollars in thousands):
ADDITIONAL PAID-IN SHARES AMOUNT CAPITAL TOTAL Balance at December 28, 1996 and January 3, 1998 12,091,962 $12,692 $14,920 $27,612 Conversion to common stock (12,091,962) (12,692) (14,920) (27,612) .......................................................................... Balance at January 2, 1999 - $ - $ - $ - --------------------------------------------------------------------------
33 (9) SHAREHOLDERS' EQUITY Effective December 3, 1998, the Company issued 2,922,350 shares of common stock in completion of its initial public offering resulting in net proceeds of $46,702,000. STOCK OPTIONS The Board of Directors has reserved 5,300,000 shares of common stock for options that may be granted to key employees, directors, or others under the Company's stock option plans. A summary of the changes in the Company's stock option plans for each of the years in the three year-period ended January 2, 1999 is as follows:
AVERAGE EXERCISE SHARES PRICE Outstanding at December 30, 1995 (including 947,193 shares exercisable) 1,635,183 $1.59 Granted 443,850 5.25 Exercised (260,338) 1.09 Canceled (139,522) 2.29 .......................................................................... Outstanding at December 28, 1996 (including 1,105,468 shares exercisable) 1,679,173 2.58 Granted 1,073,750 6.20 Exercised (630,514) 0.70 Canceled (26,800) 4.29 .......................................................................... Outstanding at January 3, 1998 (including 931,319 shares exercisable) 2,095,609 4.98 Granted 443,075 14.70 Exercised (526,880) 3.18 Canceled (208,070) 5.82 .......................................................................... Outstanding at January 2, 1999 (including 884,807 shares exercisable) 1,803,734 $7.77 -------------------------------------------------------------------------- --------------------------------------------------------------------------
The following table summarizes information about options outstanding at January 2, 1999:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------- ------------------- AVERAGE RANGE OF REMAINING AVERAGE AVERAGE EXERCISE CONTRACTUAL LIFE EXERCISE EXERCISE PRICE SHARES (YEARS) PRICE SHARES PRICE $ 0.45 - 1.00 81,678 5.62 $0.90 81,678 $0.90 4.80 - 6.50 1,100,573 7.73 5.26 634,866 5.22 7.50 - 11.00 352,075 9.02 10.24 158,469 10.02 14.00 - 17.00 269,408 9.86 16.92 9,794 16.36 ................................................................................................ $ 0.45 - 17.00 1,803,734 8.21 $7.77 884,807 $5.80 - ------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------
34 (9) SHAREHOLDERS' EQUITY (CONTINUED) No compensation cost has been recognized in the consolidated financial statements for employee stock option grants. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under an alternative accounting method, the Company's net income (loss) would have been adjusted as indicated below (in thousands):
1998 1997 1996 Net income (loss): As reported $5,195 $(2,846) $(3,685) Pro forma $4,144 $(3,563) $(4,253)
The fair value of each option grant is estimated on the date of grant using the Black-Sholes option-pricing model with the following assumptions: expected dividend yield-0%; expected stock price volatility-40%; risk-free interest rate-4.6% for 1998, and 6.4% for 1997 and 1996; expected life of options-3.0 years, 4.2 years, 3.0 years for 1998, 1997, 1996, respectively. The per share weighted-average fair value of stock options granted during 1998, 1997, 1996 was $4.72, $1.92, $2.03, respectively. WARRANTS In April 1996, the Company issued warrants to the holders of Series E preferred stock (note 8) to purchase an aggregate of 171,429 shares of common stock at an exercise price of $5.25 per share. During 1998, warrants for 54,430 shares of common stock were exercised. Warrants for 116,999 shares remained outstanding at January 2, 1999. In connection with a capital lease transaction with a vendor in 1997, the Company granted the vendor warrants to acquire 31,428 shares of the Company's Series E convertible preferred stock at a purchase price of $10.50 per share. The warrants are exercisable for five years beginning December 3, 1998. In December 1998, the Preferred Stock warrants were converted into warrants exercisable into 40,243 shares of common stock at $8.20 per share. In connection with short-term debt issued to related parties in 1996, the Company granted warrants to purchase 71,525 shares of the Company's common stock at a purchase price of $5.25 per share. The warrants are exercisable for ten years from the grant date. During December 1998, warrants for 7,003 shares of common stock were exercised. Warrants for 64,522 shares remained outstanding at January 2, 1999. 35 (10) INCOME TAXES The provision (benefit) for income taxes consists of the following (in thousands):
1998 1997 1996 Current: Federal $2,969 $125 $ - State 687 16 - ............................................................................... 3,656 141 ------------------------------------------------------------------------------- ------------------------------------------------------------------------------- Deferred: Federal (5,803) - - State (85) - - ............................................................................... (5,888) - - ------------------------------------------------------------------------------- Income tax expense (benefit) $(2,232) $141 $ - ------------------------------------------------------------------------------- -------------------------------------------------------------------------------
Effective tax rates differ from statutory federal income tax rates as follows:
1998 1997 1996 Statutory federal income tax rate 35.0% (34.0)% (34.0)% Nondeductible interest expense, put warrants 44.7 40.8 0.0 Change in valuation allowance (147.0) (2.7) 33.0 Effect of change in tax rate on deferred tax asset 6.7 0.0 8.6 State income taxes, net of federal benefit 8.9 0.4 (4.0) General business credits 0.0 0.0 (2.6) Other 1.0 0.7 (1.0) ............................................................................................ (50.7) 5.2 % 0.0 % - --------------------------------------------------------------------------------------------
The tax effects of temporary differences that give rise to deferred tax assets at January 2, 1999 and January 3, 1998 are as follows (in thousands):
1998 1997 Deferred tax assets: Current: Inventory, warranty, and returns reserves $4,371 $3,361 Allowance for doubtful accounts 117 722 Other 960 214 Long term: Net operating loss carryforwards 602 2,842 Other 361 344 ............................................................................. Total gross deferred tax assets 6,411 7,483 Valuation allowance (523) (7,483) ............................................................................. Total net deferred tax assets $5,888 $ - -----------------------------------------------------------------------------
In 1998 the Company reduced the valuation allowance applied against the deferred tax assets by $6.9 million based upon tax planning strategies and future income projections. At January 2, 1999, the Company had net operating loss carryforwards for federal income tax purposes of approximately $1,600,000 expiring between the years 2003 and 2006. The Company expects that approximately $1,400,000 of these carryforwards will expire unutilized due to an Internal Revenue Code (IRC) Section 382 limitation resulting from a prior ownership change. 36 (11) NET INCOME (LOSS) PER COMMON SHARE The following computations reconcile net income (loss) with net income (loss) per common share-basic and diluted (dollars in thousands, except per share amounts).
NET PER SHARE 1998 LOSS SHARES AMOUNT Net income before extraordinary item $ 6,636 - Less: Deemed dividend from revision of preferred stock (1,312) - Cumulative preferred dividends (821) - ............................................................................... BASIC EPS Net income available to common shareholders $4,503 4,114,219 $1.09 ............................................................................... EFFECT OF DILUTIVE SECURITIES Options - 912,448 Warrants - 654,436 Convertible preferred stock - 10,247,143 ............................................................................... DILUTED EPS Net income available to common shareholders plus assumed conversion $4,503 15,928,246 $0.28 ------------------------------------------------------------------------------ NET PER SHARE 1997 LOSS SHARES AMOUNT Net loss $(2,846) Less cumulative preferred dividends (900) - ............................................................................... BASIC AND DILUTED EPS Net loss available to common shareholders $(3,746) 2,352,947 $(1.59) ------------------------------------------------------------------------------ NET PER SHARE 1996 LOSS SHARES AMOUNT Net loss $(3,685) Less cumulative preferred dividends (900) - ............................................................................... BASIC AND DILUTED EPS Net loss available to common shareholders $(4,585) 1,753,484 $(2.61) ------------------------------------------------------------------------------
The following is a summary of those securities outstanding during the respective periods which have been excluded from the calculations because the effect on net income (loss) per common share would not have been dilutive:
1998 1997 1996 Options - 1,679,173 2,095,609 Common stock warrants - 154,023 2,342,954 Preferred stock warrants - 31,428 31,428 Convertible preferred stock - 12,091,962 12,091,962
Convertible preferred stock and preferred stock warrants were convertible into 12,292,623 shares of common stock during 1997 and 1996. 37 (12) SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION Total cash paid for interest during 1998, 1997, and 1996 was $1,719,000, $1,598,000 and $44,000 respectively. Income tax payments during 1998 and 1997 totaled $1,800,000 and $16,000, respectively. There were no cash payments for income taxes during 1996. Exercises of common stock options and warrants in the Consolidated Statement of Shareholders' Equity includes a cashless exercise of $2,035,000 and tax benefits related to stock option exercises totaling $552,000 in 1998. (13) EMPLOYEE BENEFIT PLANS Effective January 1, 1994, the Company adopted a profit sharing and 401(k) plan for eligible employees. The plan allows employees to defer up to 15% of their compensation on a pretax basis. Each year, the Company may make a discretionary contribution equal to a percentage of the employee's contribution. During 1998 and 1997, the Company expensed $375,000 and $78,000, respectively, relating to its contribution to the 401(k) plan. The Company did not make a contribution for 1996. (14) RELATED PARTY TRANSACTIONS At December 28, 1996, the Company had a $50,000 note receivable due from a former director and executive officer of the Company. The note plus interest at 6% per annum was due on August 31, 1997. On February 20, 1997, the former director and executive officer signed a promissory note for $387,000, which replaced the $50,000 note receivable. The note, with interest at 9.25% per annum, is due and payable to the Company on the earlier of (1) six months following the completion of an initial public offering of the Company's securities, or (2) April 30, 1999. The full recourse note is secured by a pledge of 150,000 shares of the Company's common stock. In April 1998, the former director and executive officer borrowed an additional $425,000 from the Company under the same terms as the February 1997 note. On December 10, 1998 the former director and executive officer repaid the outstanding balance of the notes. (15) COMMITMENTS AND CONTINGENCIES The Company is a party to various claims, legal actions, sales tax disputes, and other complaints arising in the ordinary course of business. In the opinion of management, any losses that may occur are adequately covered by insurance or are provided for in the consolidated financial statements and the ultimate outcome of these matters will not have a material effect on the consolidated financial position or results of operations of the Company. (16) SUMMARY OF QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a condensed summary of actual quarterly results for 1998 and 1997:
1998 Fourth Third Second First Net sales $67,434 $60,034 $60,129 $58,672 Gross margin 44,537 39,291 39,663 37,591 Operating income 4,083 2,679 3,666 1,037 Net income (loss) before extraordinary item 7,047 (1,903) 1,910 (418) Net income (loss) 5,606 (1,903) 1,910 (418) Net income (loss) per share before extraordinary item - diluted 0.32 (0.72) 0.11 (0.26) Net income (loss) per share - diluted 0.24 (0.72) 0.11 (0.26) 1997 Fourth Third Second First Net sales $57,961 $44,391 $46,074 $36,004 Gross margin 36,218 28,502 29,917 23,164 Operating income (loss) 1,563 (742) 3,081 (1,824) Net income (loss) before extraordinary item (319) (1,916) 1,295 (1,906) Net income (loss) (319) (1,916) 1,295 (1,906) Net income (loss) per share before extraordinary item - diluted (0.22) (0.88) 0.07 (1.02) Net income (loss) per share - diluted (0.22) (0.88) 0.07 (1.02)
COMMON STOCK Select Comfort's common stock trades on the Nasdaq Stock Market-Registered Trademark- under the symbol AIRB, since the Company's initial public offering on December 3, 1998. The high and low closing prices for the Company's common stock, as reported by the Nasdaq Stock Market-Registered Trademark-, for the period from December 3, 1998 to January 2, 1999 was $29.19 and $19.63 respectively. The foregoing prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions. Select Comfort has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends on its common stock in the foreseeable future. 38 EX-23.1 4 EXHIBIT 23.1 Exhibit 23.1 Independent Auditors' Consent The Board of Directors Select Comfort Corporation: We consent to incorporation by reference in the registration statement on Form S-8 (No. 333-70493) of Select Comfort Corporation, of our reports dated January 22, 1999 relating to the consolidated balance sheets of Select Comfort Corporation and subsidiaries, as of January 2, 1999 and January 3, 1998, and the related consolidated statements of operations, stockholders' equity and cash flows and the related financial statement schedule for each of the years in the three-year period ended January 2, 1999, which reports appear in the January 2, 1999, Annual Report on Form 10-K of Select Comfort Corporation, which is incorporated by reference in the registration statement. /s/ KPMG Peat Marwick LLP Minneapolis, Minnesota March 31, 1999 EX-27.1 5 EXHIBIT 27.1
5 1,000 12-MOS 12-MOS 12-MOS JAN-02-1999 JAN-03-1998 DEC-28-1996 JAN-04-1998 DEC-29-1996 DEC-31-1995 JAN-02-1999 JAN-03-1998 DEC-28-1996 45,561 12,670 0 0 0 0 13,374 7,862 0 2,750 1,901 0 10,136 7,749 0 75,817 30,636 0 40,963 32,151 0 11,838 6,968 0 106,234 57,201 0 33,568 29,879 0 0 0 0 0 27,612 0 0 0 0 184 25 0 70,507 21,063 0 106,234 57,201 0 246,269 184,430 102,028 246,269 184,430 102,028 85,187 66,629 38,521 85,187 66,629 38,521 52 231 77 2,794 2,101 63 7,834 5,234 88 4,404 (2,705) (3,685) (2,232) 141 0 6,636 (2,846) (3,685) 0 0 0 (1,441) 0 0 0 0 0 5,195 (2,846) (3,685) .74 (1.59) (2.61) .19 (1.59) (2.61)
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