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SELECT COMFORT CORP filed this Form 10-K on 02/24/2011
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

(Mark one)
T
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended January 1, 2011

£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________.

Commission File No. 0-25121

SELECT COMFORT CORPORATION
(Exact name of registrant as specified in its charter)

MINNESOTA
41-1597886
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
9800 59th Avenue North
 
Minneapolis, Minnesota
55442
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code: (763) 551-7000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Name of each exchange on which registered
Common Stock, par value $.01 per share
The NASDAQ Stock Market LLC
 
(NASDAQ Global Select Market)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act.
YES £   NO T

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
YES £   NO T

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x   NO £

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES £   NO £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. T

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer   
£
Accelerated filer
T
Non-accelerated filer
£ (Do not check if a smaller reporting company)
Smaller reporting company   
£

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). YES £   NO x

The aggregate market value of the common equity held by non-affiliates of the Registrant as of July 3, 2010, was $314,102,000 (based on the last reported sale price of the Registrant’s common stock on that date as reported by NASDAQ).

As of January 29, 2011, there were 55,452,000 shares of the Registrant’s common stock outstanding.
 


 
 

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement to be furnished to shareholders in connection with its 2011 Annual Meeting of Shareholders are incorporated by reference in Part III, Items 10-14 of this Annual Report on Form 10-K.

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

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

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

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

 
i

 

TABLE OF CONTENTS

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

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

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

ITEM 1. BUSINESS

Our Business

Overview

Select Comfort Corporation, based in Minneapolis, Minnesota, was founded in 1987 and is now one of the nation's leading bed manufacturers and retailers. We design, manufacture, market and distribute premium quality, adjustable-firmness beds and other sleep-related accessory products. Select Comfort has evolved from a specialty, niche direct marketer, to a nationwide multi-channel business with fiscal 2010 net sales of $606 million.

The air-chamber technology of our proprietary Sleep Number bed allows adjustable firmness on each side of the mattress and provides a sleep surface that is clinically proven to provide better sleep quality and greater relief of back pain compared to traditional mattress products. In addition, we market and sell accessories and other sleep-related products which focus on providing personalized comfort to complement the Sleep Number bed and provide a better night’s sleep. We have a mission-driven culture focused on serving the individual needs of our customers.

Our mission is to improve lives by individualizing sleep experiences. From our revolutionary series of beds to our exclusive SLEEP NUMBER® Bedding Collection, our vision is to set a new standard in sleep through product innovation and integrated experiences delivered by our sales professionals who have been trained to be knowledgeable in sleep and sleep-related products.

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


Competitive Strengths

Differentiated, Superior Product

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

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

Distinctive Brand

In 2001, we created the Sleep Number brand. This branding strategy allows our marketing communications to focus on our bed’s distinguishing and proprietary features – adjustable firmness and support for personalized comfort. This is represented by the digital Sleep Number setting displayed on the bed remote, with a brand message hierarchy as follows:

Only bed with SLEEP NUMBER® settings for personalized comfort;

Adjustable firmness on each side for couples;

Clinically proven back-pain relief, improved sleep quality; and

Exclusive head-to-toe sleep solutions to meet your unique comfort needs.

At Sleep Number, we believe that every body is unique. Unlike ordinary mattresses, the Sleep Number bed offers a revolutionary choice—personalized comfort that can be controlled at the touch of a button. The Sleep Number bed can be made firmer or softer on each side, making it the perfect bed for couples. It’s the only bed clinically proven to relieve back pain and provide better sleep quality in comparison with traditional mattress products. With ongoing adjustability, it’s finally a bed that can meet people’s changing needs over time.

Controlled Selling Environment

Over 90% of our sales are generated through our company-controlled distribution channels – Retail, Direct Marketing and E-Commerce. Our nationwide chain of retail stores provides a unique mattress shopping experience and offers a relaxed environment designed to provide education on the importance of sleep and the products that best fit customers’ needs. Controlling the selling process enables us to ensure that the unique benefits of our products are effectively communicated to customers. Our multiple touch-points of service, including sales, delivery and post-sale service, provide several opportunities to communicate with our customers, reinforcing the sale and enabling us to understand and respond quickly to consumer trends and preferences.

Integrated Business Process

We are a vertically integrated business from production through sales and delivery of our products, which allows us to control quality, cost, price and presentation, as well as the unique opportunity to establish ongoing relationships with our customers. The modular design of our Sleep Number bed allows a just-in-time, build-to-order production process which requires minimal inventory in our manufacturing plants and stores, resulting in reduced working capital requirements. Our build-to-order production process also allows our stores to serve primarily as showrooms, without requiring significant product storage capacity, and provides us significant flexibility in changing our product models.

Vision and Strategy

Our vision is to become the new standard in sleep by providing individualized sleep experiences and elevating people’s expectations above the “one-size-fits-all” solutions offered by other mattress brands.


For 2011, we are executing against a defined strategy which focuses on the following key components:

Know our customers as no one else can…use that insight to set new standards in end-to-end customer experience;
 
Broaden awareness and consideration…to take share; earn leadership in premium sleep; and
 
Leverage our core business to achieve new levels of margin…to fund acceleration and innovation.
 
Know Our Customers as No One Else Can

As the only major mattress brand that is both a manufacturer and a multi-channel retailer, we have the opportunity to know our customers and the capability to enhance their entire customer experience from researching products, to the sale, delivery, set-up and post-sales follow-up. Our sales professionals and customer service specialists are trained to be knowledgeable in sleep and sleep-related products and their mission is to assist each customer to individualize their sleep experiences through fast, friendly and accessible service.

We have historically introduced new features and benefits to our Sleep Number beds every two to three years, through a pipeline of research and development activities. We continually focus on improving the reliability and quality of all the products that we sell. Our latest models emphasize enhanced comfort-layer materials, and several feature advancements in temperature balancing technology. We believe our current line represents the most technologically advanced beds we have ever produced and provides ideal comfort and quality sleep for each individual.
 
Broaden Awareness and Consideration

Our most significant growth driver has been building brand awareness. The Sleep Number brand has been integrated into all of our sales channels and throughout our internal and external communication programs. We utilize a media mix that includes television, radio and print advertising in support of our Sleep Number marketing campaign, with increasing use of digital advertising in our media mix.

As of January 1, 2011 we operated 386 company-owned stores in the U.S., and expect to end 2011 with approximately 380 stores. In 2010, we migrated from a mix of Sleep Number and Select Comfort store marquees to 100% branded as Sleep Number.  We are taking both a national and local market-based approach to our growth — increasing our national advertising and focusing on local marketing, real estate optimization and sales execution. We believe that through marketing and sales execution we can increase average sales per store to better leverage the profitability of our fixed cost store base. Beyond 2011, we plan to expand our retail store base to drive sales and profit growth.

We have begun a non-mall store pilot to help build store and brand awareness. The non-mall format will be targeted to highly-visible, well-traveled locations and is intended to complement our existing mall store base. The non-mall design allows us to increase store square footage to display and sell our entire line of Sleep Number beds and bedding collection, and provide a more differentiated, interactive customer experience.

In 2005, we expanded our distribution network outside the U.S. with a retail partner relationship in Canada.  During 2007, we formed a strategic alliance with two Australian-based companies to manufacture and distribute Sleep Number beds in Australia and New Zealand. Our international distribution network was not a significant part of our total distribution network in 2010 and we do not plan to expand our international distribution during 2011.

We also sell to key commercial partners which strategically increases awareness of our brand through unique channels. These commercial partners include the QVC television shopping channel, the luxury motor home market, and leading home furnishing retailers in Alaska and Hawaii.
 
Leverage Our Core Business to Achieve New Levels of Margin

We generated positive net income for six consecutive years from 2002 through 2007. In 2008 our operating results were significantly affected by a decrease in consumer spending and we generated a net loss. In 2009 and 2010, we returned to profitability and generated operating income of $20.7 million and $52.4 million, respectively. The expansion of profitability over the last two years is the result of aggressive cost reductions and disciplined cost controls, leveraging our advantaged business model which generates significant variable profit contribution on modest sales gains. As of January 1, 2011, we had no borrowings under our $20 million revolving credit facility and increased our cash balance to $81 million from $18 million one year ago.


As we enter 2011, our plan is to continue to expand our margins to enhance profitability and provide greater flexibility to invest in growth opportunities. We plan to build on the learnings of recent years, targeting efficient sales gains while maintaining the expense and cash disciplines to grow operating margins and increase net income.

Our Products

Mattresses

We offer Sleep Number beds in three series to help customers choose the bed that is best for them.

The Classic Series is the classic design with personal adjustability at an affordable price. The series includes the Sleep Number c2, c3 and c4 beds.

The Performance Series includes our most popular beds, featuring enhanced performance, comfort and a great value. The series includes the Sleep Number p5, p6 and p7 beds.

The Innovation Series is the premier experience in personalized comfort combined with leading-edge innovations in sleep technology. The series includes the Sleep Number i8 and i10 beds.

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

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

Our U.S. mattress price points range from approximately $699 for the entry-level c2 queen-size mattress to $3,999 for the luxurious Sleep Number i10 queen-size mattress. Our most popular model is the p5 queen-size mattress which sells for approximately $1,699. Actual prices are at times lower than those quoted due to promotional offerings.

Our unique product design allows us to ship our beds in a modular format to customers throughout the U.S. by United Parcel Service (“UPS”). For an additional fee, customers can take advantage of our home delivery service, which includes bed assembly and optional mattress removal services.

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

Sleep Number Bedding Collection

Like our SLEEP NUMBER® beds, our exclusive SLEEP NUMBER® Bedding Collection offers a line of products to meet each individual’s needs. Our sales professionals have the expertise to guide our customers to sleep solutions that are just right for them. From the way their pillow fits, to the weight of their comforter, we offer the latest innovations. We also offer a number of products that allow for unique personalization, including “Create your Perfect Pillow” and “Create your Perfect Comforter.”

Adjustable Bases/FlexFit

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


Sales Distribution

Unlike traditional mattress manufacturers, which primarily sell through third-party retailers, over 90% of our net sales are through one of three company-controlled distribution channels – Retail, Direct Marketing and E-Commerce. These channels enable us to control the selling process to ensure that the unique benefits of our products are effectively presented to customers. Our direct-to-consumer business model enables us to understand and respond quickly to consumer trends and preferences.

Our retail stores accounted for 84% of our net sales in 2010. Average net sales per company-owned store were $1,295,000 in 2010 versus $1,046,000 in 2009, $984,000 in 2008, $1,318,000 in 2007 and $1,493,000 in 2006, with average sales per square foot of $873 in 2010 versus $710 in 2009, $703 in 2008, $1,024 in 2007 and $1,244 in 2006. In 2010, 70% of our stores generated net sales of over $1,000,000.

Our direct marketing call center and E-Commerce Web site provide national sales coverage, including markets not yet served by one of our retail stores, and accounted for 11% of our net sales in 2010. In addition, these channels provide a cost-effective way to market our products, are a source of information on our products and refer customers to our stores if there is one near the customer.

Beginning in 2002, we supplemented our sales through semi-exclusive relationships with selected home furnishing retailers and specialty bedding retailers. In August 2009, we discontinued distribution through non-company-owned mattress retailers in the contiguous United States. This change was part of the Company’s efforts to reignite the Sleep Number brand and did not have a significant impact on sales or profit in 2010. At the end of 2010, our retail partner program included three retail partners in Hawaii, Alaska and Canada.

In late 2007, we began distribution in Australia and New Zealand through relationships with an Australian-based manufacturer and an Australian-based retailer. Our total net sales attributable to foreign countries were $2.3 million in 2010, $3.7 million in 2009 and $5.4 million in 2008.

Marketing and Advertising

Awareness among the broad consumer audience of our brand, product benefits and store locations has been our most significant opportunity for growth. The Sleep Number advertising campaign was introduced early in 2001 to support our retail stores in selected markets through our first comprehensive multi-media advertising campaign using prime-time TV, national cable television, infomercials, drive-time radio and newspaper advertisements.

Since 2001, the Sleep Number brand positioning has been integrated into our marketing messages across all of our distribution channels, advertising vehicles and media types. We look to our direct response advertising on national cable TV as an economical means to generate leads for our stores. Through our dedicated call center, we are able to provide the inquiring customer more information including the nearest store location, and/or send a video and brochure. We also leverage local advertising, as well as digital and social media, to increase both awareness and consideration of the Sleep Number brand and products. Our total media spending was approximately $70 million in 2010, $61 million in 2009 and $92 million in 2008.

Owners of Sleep Number beds purchased through company-controlled channels are considered Insiders in our InnerCircle rewards program. The program is designed primarily to increase referrals and repeat purchases by strengthening our ongoing relationship with our owners. Each time a referred customer purchases a bed, the referring Insider receives a $50 coupon for purchase of our products, with increasing benefits for multiple referrals. In 2010, approximately 29,000 new customers bought beds after receiving referrals from our Insiders, and existing owners bought approximately 33,000 additional beds.

Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Money Bank. Approximately 23% of our net sales in 2010 were financed by GE Money Bank. In 2005, we entered into an amended and restated agreement with GE Money Bank that extends this consumer credit arrangement through February 15, 2012, subject to earlier termination upon certain events and subject to automatic extensions. Under the terms of our agreement, GE Money Bank sets the minimum acceptable credit ratings, the interest rates, fees and all other terms and conditions of the customer accounts, including collection policies and procedures. As the receivables are owned by GE Money Bank, at no time are the receivables purchased or acquired from us. We are not liable to GE Money Bank for our customers’ credit defaults. In connection with all purchases financed under these arrangements, GE Money Bank pays us an amount equal to the total amount of such purchases, net of promotional related discounts, upon delivery to the customer. Customers that do not qualify for credit under our agreement with GE Money Bank may apply for credit under a secondary program that we offer through another provider.


Operations

Manufacturing and Distribution

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

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

We obtain all of the raw materials and components used to produce our beds from outside sources. A number of components, including our proprietary air chambers, our proprietary blow-molded bases, and various components for our Firmness Control Systems, as well as fabrics and zippers, are sourced from suppliers who currently serve as our sole source of supply for these components. We believe we can obtain these raw materials and components from other sources of supply, although an unexpected loss of supply over a short period of time may not allow us to replace these sources in the ordinary course of business. In 2005, we began identifying secondary sources in order to provide continuity of supply for various components. We will continue to utilize dual sourcing on targeted components when effective.

Our proprietary air chambers are produced to our specifications by an Eastern European supplier, which has been our sole source of supply of air chambers since 1994. Our agreement with this supplier runs through December 2012 and is thereafter subject to automatic annual renewal unless either party gives 365 days’ notice of its intention not to renew the agreement. We expect to continue this supplier relationship for the foreseeable future.

Our proprietary blow-molded bases are produced to our specifications by a single domestic supplier under an agreement that expires in December 2012. We expect to continue this supplier relationship for the foreseeable future.

All of the suppliers that produce unique or proprietary products for us have in place either contingency or disaster recovery plans or redundant production capabilities in other locations in order to safeguard against any unforeseen disasters. We review these plans and sites on a regular basis to ensure the supplier’s ability to maintain an uninterrupted supply of materials and components.

Home Delivery Service

Select Comfort’s home delivery, assembly and mattress removal service has contributed to improving the overall customer experience. Our home delivery technicians can effectively communicate the benefits of the bed, reinforcing the sales process and helping to ensure satisfied customers. In some markets on the East Coast, we provide home delivery, assembly and mattress removal services through a third-party provider. Approximately 58% of beds sold through our company-owned channels in 2010 were delivered by our full-service home delivery team or by our third-party provider.

In 2003, we expanded the availability of our company-controlled delivery, assembly and removal services to all of our retail markets. In 2007, we continued improving our home delivery efficiency and service by consolidating over 100 individually managed cross-dock distribution locations into a Hub and Spoke network organized around regional hubs. At the end of 2010, we operated 11 regional hubs.

Customer Service

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


Research and Development

Our research and development team continuously seeks to improve product performance and benefits based on sleep science. Through customer surveys and consumer focus groups, we seek feedback on a regular basis to enhance our products. Since the introduction of our first bed, we have continued to improve and expand our product line, including new bed models, quieter and higher quality Firmness Control Systems, wireless remote controls, more luxurious fabrics and covers, and new generations of foams and base systems. Our research and development expenses were $2.1 million in 2010, $2.0 million in 2009 and $3.4 million in 2008.

Information Systems

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

Intellectual Property

We hold various U.S. and foreign patents and patent applications regarding certain elements of the design and function of our products, including air control systems, remote control systems, air chamber features, border wall and corner piece systems, foundation systems, as well as other technology. We have 19 issued U.S. patents, expiring at various dates between December 2011 and June 2022, and three U.S. patent applications pending. We also hold 35 foreign patents and have nine foreign patent applications pending. Notwithstanding these patents and patent applications, we cannot ensure that these patent rights will provide substantial protection or that others will not be able to develop products that are similar to or competitive with our products. To our knowledge, no third party has asserted a claim against us alleging that any element of our product infringes or otherwise violates any intellectual property rights of any third party.

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

Industry and Competition

The U.S. bedding manufacturing industry is a mature and generally stable industry. According to the International Sleep Products Association (“ISPA”), since 1984 the industry has consistently demonstrated growth on a dollar basis, with a 0.3% decline in 2001, 9.1% decline in 2008 and 9.0% decline in 2009 being the only exceptions. According to ISPA, industry wholesale shipments of mattresses and foundations were estimated to be $6.0 billion in 2010, a 6.6% increase compared to $5.7 billion in 2009. We estimate that traditional innerspring mattresses represent approximately 78% of total U.S. bedding sales (based on 2009 sales). Furniture/Today, a furniture industry trade publication, has ranked Select Comfort as the fifth largest mattress manufacturer and third largest U.S. bedding retailer for 2009, with a 4.2% market share of industry revenue and 1.4% market share of industry units.


Over the 5-year, 10-year and 20-year periods ended 2010, the value of U.S. wholesale bedding shipments (decreased)/increased at compound annual growth rates of (2.3%), 2.8% and 4.8%, respectively. We believe that industry unit growth has been primarily driven by population growth, and an increase in the number of homes (including secondary residences) and the increased size of homes. We believe growth in average wholesale prices resulted from a shift to both larger and higher quality beds, which are typically more expensive.

The bedding industry is very competitive. Participants in the bedding industry compete primarily on price, quality, brand name recognition, product availability and product performance, including the perceived levels of comfort and support provided by a mattress. There is a high degree of concentration among the three largest manufacturers of innerspring bedding with nationally recognized brand names, including Sealy, which also owns the Stearns & Foster brand name, Serta, and Simmons. Numerous other manufacturers, primarily operating on a regional or niche basis, serve the balance of the innerspring bedding market. Tempur-Pedic International, Inc., the fourth largest bedding manufacturer (based on 2009 sales), and a number of other mattress manufacturers, offer foam mattress products.  Simmons and Sealy, as well as a number of smaller manufacturers, have offered air-bed products in recent years. The bedding retailer business is also highly competitive. Our distribution channels, including our retail stores, compete against regional and local specialty bedding retailers, home furnishing stores, mass merchants and national discount stores. We compete principally on the differentiation and quality of our products, customer service and value pricing.

Governmental Regulation and Environmental Matters

Our operations are subject to federal and state consumer protection and other regulations relating to the bedding industry. These regulations vary among the jurisdictions in which we do business, but generally impose requirements as to the proper labeling of bedding merchandise.

The bedding industry is subject to federal fire retardancy standards developed by the U.S. Consumer Product Safety Commission, which became effective nationwide in July 2007. Compliance with these requirements has increased the cost and complexity of manufacturing our products. These regulations also result in higher product development costs as new products must undergo rigorous flammability testing.

Federal regulations adopted in 2010 restrict the types of credit-based promotional offerings that retailers are allowed to make available to consumers.

Our direct marketing and E-Commerce operations are or may become subject to various adopted or proposed federal and state “do not call” and “do not mail” list requirements, limiting our ability to market our products directly to consumers over the telephone, by e-mail or by regular mail.

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

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

We are subject to federal and state laws and regulations relating to pollution and environmental protection. We will also be subject to similar laws in foreign jurisdictions if we further expand distribution of our products internationally.

Our retail pricing policies and practices are subject to antitrust regulations in the U.S., Canada, Australia, New Zealand and other jurisdictions where we may sell our products in the future.

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


We are not aware of any national or local provisions which have been enacted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, that have materially affected, or will materially affect, our net income or competitive position, or will result in material capital expenditures. During fiscal 2010, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.

Customers

No single customer accounts for 10% or more of our net sales. The loss of distribution through QVC, however, could adversely impact our sales and profitability.

Seasonality

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

Working Capital

Selling direct to our customers, with a just-in-time, build-to-order production process in our plants, and with stores that serve primarily as showrooms, allows us to maintain low inventory levels and operate with minimal working capital requirements. We have historically generated sufficient cash flows to self-fund operations through an accelerated cash-conversion cycle. As of January 1, 2011, we had $3.0 million in letters of credit outstanding under our credit facility, with an additional $17.0 million available under the $20.0 million credit facility.

Employees

At January 1, 2011, we employed 2,165 persons, including 1,265 retail sales and support employees, 128 direct marketing and customer service employees, 559 manufacturing and logistics employees, and 213 management and administrative employees. Approximately 112 of our employees were employed on a part-time basis at January 1, 2011. Except for managerial employees and professional support staff, all of our employees are paid on an hourly basis plus commissions for sales professionals. None of our employees is represented by a labor union or covered by a collective bargaining agreement. In recent periods we have focused on and improved our employee engagement levels, which we believe is important to driving both organizational productivity and employee satisfaction.


Executive Officers of the Registrant

William R. McLaughlin, 54, joined our Company in March 2000 as President and Chief Executive Officer. Mr. McLaughlin also served as Chairman of our Board of Directors from May 2004 to February 2008. From December 1988 to March 2000, Mr. McLaughlin served as an executive of PepsiCo Foods International, Inc., a snack food company and subsidiary of PepsiCo, Inc., in various capacities, including from September 1996 to March 2000 as President of Frito-Lay Europe, Middle East and Africa, and from June 1993 to June 1996 as President of Grupo Gamesa, S.A. de C.V., a cookie and flour company based in Mexico. Mr. McLaughlin serves on the boards of Select Comfort, Orion Safety Products, Minnesota Public Radio, Carleton College, The Division of Sleep Medicine at Harvard Medical School and the Museum of Russian Art.  He is an Aspen Institute Crown Fellow.

Shelly R. Ibach, 51, has served as Executive Vice President, Sales & Merchandising since October 2008. Ms. Ibach joined Select Comfort as Senior Vice President, U.S. Sales - Company Owned Channels in April 2007. From 1982 to 2007, she held various leadership positions within Marshall Field’s Department Stores - Target Corporation. From 2004 to 2007, Ms. Ibach served as Senior Vice President and General Merchandise Manager for the Home division, within Macy’s North, formally Marshall Field's. Other key positions included Vice President - Divisional Merchandise Manager, Director of Planning and Regional Director of Stores.

Mark A. Kimball, 52, has served as Senior Vice President, General Counsel, Chief Administrative Officer and Secretary since May 1999. From July 2000 to August 2003, Mr. Kimball also assumed responsibility for the Company’s human resources function.  For more than five years prior to joining us, Mr. Kimball was a partner in the law firm of Oppenheimer Wolff & Donnelly LLP practicing in the area of corporate finance.

James C. Raabe, 50, has served as Senior Vice President and Chief Financial Officer since April 1999. From September 1997 to April 1999, Mr. Raabe served as our Controller. From May 1992 to September 1997, he served as Vice President – Finance of ValueRx, Inc., a pharmacy benefit management provider. Mr. Raabe held various positions with KPMG LLP from August 1982 to May 1992.

Karen R. Richard, 40, has served as Senior Vice President, Chief Human Resource & Strategy Officer for Select Comfort Corporation since March 2009. From January 2006 through February 2009, Ms. Richard served as Vice President, Human Resources and prior to that she served as Vice President, Finance supporting Select Comfort’s Consumer Channels and Marketing. Ms. Richard also held a variety of positions in the Company’s finance department after joining Select Comfort in May of 1996. From 1993 to 1996, Ms. Richard held various accounting positions with TCF Mortgage Corporation, an affiliate of TCF Financial Corporation.

Kathryn V. Roedel, 50, has served as Executive Vice President, Product and Service since October 2008. Ms. Roedel joined our Company as Senior Vice President, Global Supply Chain in April 2005. From 1983 to 2005, she held leadership positions within two divisions of General Electric Company, in Sourcing, Manufacturing, Quality and Service. From 2003 to March 2005, Ms. Roedel served as the General Manager, Global Supply Chain Strategy for GE Medical Systems. Other key positions included General Manager, Global Quality and Six Sigma; Vice President – Technical Operations and Director/Vice President – Quality Programs for GE Clinical Services, a division of GE Medical Systems.

Wendy L. Schoppert, 44, has served as Senior Vice President and Chief Information Officer since March 2008, and added Chief Marketing Officer to her responsibilities in January 2011 until such time as a permanent Chief Marketing Officer is identified. She joined our Company in April 2005 and previously served as Senior Vice President – New Channel Development and International. From 2002 to March 2005, Ms. Schoppert led various departments within U.S. Bancorp Asset Management, most recently serving as Head of Private Asset Management and Marketing. From 1996 to 2000, she held several positions with America West Holdings Corporation, including Vice President of America West Vacations and head of the airline’s Reservations division. Prior to 1996, Ms. Schoppert held various finance-related positions at both Northwest Airlines and American Airlines. Ms. Schoppert serves on the board of the Children’s Theatre Company.

Tim Werner, 47, had served as Senior Vice President and Chief Marketing Officer since March 2009. Effective January 2011, Tim relinquished the duties of Chief Marketing Officer and is currently serving as Senior Vice President, Marketing Advisor.  From October 2008 through February 2009 he served as Vice President, Marketing. Mr. Werner served as Vice President, Direct and E-Commerce from October 2007 to September 2008 and as Vice President, Retail Partners developing our Wholesale business from October 2002 to July 2006. Mr. Werner also held a variety of positions in our Direct Marketing business channel after joining us in May 1996. From 1986 to 1996, Mr. Werner held marketing positions with L.L. Bean, Inc. and Fingerhut Corporation.


Available Information

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

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

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

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

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

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

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


ITEM 1A. RISK FACTORS

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

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

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

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

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

GE Money Bank provides credit to our customers through a private label credit card program that expires on February 15, 2012, subject to earlier termination upon certain events and subject to automatic extensions.  GE Money Bank has discretion to set minimum credit standards under which credit is extended to customers.

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

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

We are highly dependent on the effectiveness of our marketing messages and the efficiency of our advertising expenditures in generating consumer awareness and sales of our products.  In recent periods, including in particular 2007 and 2008, our marketing messages were not as effective as in prior periods.  We continue to evolve our marketing strategies, adjusting our messages, the amount we spend on advertising and where we spend it, and no assurance can be given that we will be successful in developing effective messages and in achieving efficiency in our advertising expenditures.

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

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


Our future growth and profitability depends on our ability to execute our retail store distribution strategy.

Our company-controlled retail store distribution channel is our largest distribution channel and represents our largest opportunity for growth in sales and improvement in profitability.  Our stores carry significant fixed costs.  We are highly dependent on our ability to maintain and increase sales per store to improve our operating margins.

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

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

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

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

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

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

As a consumer products company, we face an inherent risk of exposure to product liability claims in the event that the use of any of our products is alleged to have resulted in personal injury or property damage.  In the event that any of our products proves to be defective, we may be required to recall or redesign such products.  In 2004 and in 2008, we experienced increased returns and adverse impacts on sales, as well as product liability litigation, as a result of media reports related to the alleged propensity of our products to develop mold.  We may experience additional adverse impacts on sales and additional litigation in the event any similar media reports were to occur in the future.  We maintain insurance against some forms of product liability claims, but such coverage may not be adequate for liabilities actually incurred.  A successful claim brought against us in excess of available insurance coverage, or any claim or product recall that results in significant adverse publicity against us, may have a material adverse effect on our sales, profitability, cash flows and financial condition.

Significant competition in our industry could adversely affect our business.

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

The mattress industry is characterized by a high degree of concentration among the three largest manufacturers of innerspring mattresses and the largest manufacturer of viscoelastic foam mattresses.  We believe that many of our competitors have greater financial, marketing and manufacturing resources and better brand name recognition than we do and sell products through broader and more established distribution channels.  A number of mattress manufacturers, including several of these larger competitors, have offered air beds that compete with our products.

Our stores and other company-controlled distribution channels compete with other retailers who often provide a wider selection of mattress alternatives than we offer.  A number of these retailers also have more points of distribution and greater brand name recognition than we do.


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

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

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

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

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

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

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

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

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

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


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

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

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

Our air chambers and some of our other components are manufactured outside the United States, and therefore are subject to risks associated with foreign sourcing of materials, including but not limited to:

 
Ÿ
Political instability resulting in disruption of trade;
 
 
Ÿ
Existing or potential duties, tariffs or quotas on certain types of goods that may be imported into the United States;
 
 
Ÿ
Disruptions in transportation due to acts of terrorism, shipping delays, foreign or domestic dock strikes, customs inspections or other factors;
 
 
Ÿ
Foreign currency fluctuations; and
 
 
Ÿ
Economic uncertainties, including inflation.

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

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

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

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

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

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


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

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

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

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

We depend on our management information systems for many aspects of our business.  Our current information systems architecture includes some off-the-shelf programs as well as some key software that has been developed by our own programmers, using legacy programming languages that are no longer vendor-supported.  Our business may be adversely affected if our management information systems are disrupted or if we are unable to improve, upgrade, integrate or expand our systems to meet the evolving needs of our business and existing and emerging regulatory requirements.  Any failure of our systems and processes to adequately protect employee and customer information from theft or loss could adversely impact our business, reputation, sales, profitability, cash flows and financial condition.

The loss of the services of any members of our executive management team could adversely impact our ability to execute our business strategy.

We are currently dependent upon the continued services, ability and experience of our executive management team.  The loss of the services of any member of our executive management team could have an adverse effect on our ability to execute our business strategy and growth initiatives and on our sales, profitability, cash flows and financial condition.  Our future growth and success will also depend upon our ability to attract, retain and motivate other qualified personnel.

Our charter and corporate documents and Minnesota law make a takeover of our company more difficult and expensive, which may prevent certain changes in control and limit the market price of our common stock.

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


Risks of certain global events, such as terrorist attacks or a pandemic outbreak, could adversely impact our sales, profitability, financial condition or stock price.

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

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

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

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.



Distribution Locations

We currently lease all of our existing retail store locations and expect that our policy of leasing, rather than owning stores, will continue. Our store leases generally provide for an initial lease term of five to seven 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.

The following table summarizes the geographic location of our 386 company-owned stores and 150 retail partner doors as of January 1, 2011:

 
 
Company-
Owned
Stores
   
Retail
Partner
Doors
 
 
 
Company
Owned
Stores
   
Retail
Partner
Doors
 
Alabama
    5        
Missouri
    12        
Alaska
          3  
Montana
    2        
Arizona
    11        
Nebraska
    3        
Arkansas
    3        
Nevada
    3        
California
    41        
New Hampshire
    4        
Colorado
    11        
New Jersey
    12        
Connecticut
    5        
New Mexico
    2        
Delaware
    2        
New York
    10        
Florida
    25        
North Carolina
    13        
Georgia
    12        
North Dakota
    2        
Hawaii
          7  
Ohio
    16        
Idaho
    1        
Oklahoma
    3        
Illinois
    19        
Oregon
    4        
Indiana
    12        
Pennsylvania
    19        
Iowa
    5        
South Carolina
    4        
Kansas
    3        
South Dakota
    2        
Kentucky
    4        
Tennessee
    5        
Louisiana
    5        
Texas
    30        
Maine
    2        
Utah
    3        
Maryland
    11        
Vermont
    1        
Massachusetts
    4        
Virginia
    10        
Michigan
    11        
Washington
    10        
Minnesota
    13        
Wisconsin
    9        
Mississippi
    2        
Canada
          140  
                 
Total
    386       150  

Manufacturing and Headquarters

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

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

We lease two manufacturing and distribution centers in Irmo, South Carolina and Salt Lake City, Utah of approximately 105,000 square feet and approximately 101,000 square feet, respectively. We lease the Irmo facility through February 2013, and the Salt Lake City facility through July 2015, with a five-year renewal option thereafter.


ITEM 3. LEGAL PROCEEDINGS

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, product liability, employment and intellectual property claims. In accordance with generally accepted accounting principles in the United States, we record a liability in our consolidated financial statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. At January 1, 2011, our consolidated financial statements include reserves of $1.6 million with respect to contingent liabilities that we determined to be both probable and reasonably estimable. With respect to these pending legal proceedings, we believe that we have valid defenses to claims asserted against us and we do not expect the outcome of these matters to have a material effect on our consolidated results of operations, financial position or cash flows. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our results of operations, financial position or cash flows. We expense legal costs as incurred.

ITEM 4. (REMOVED AND RESERVED)



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

Our common stock trades on The NASDAQ Stock Market LLC (NASDAQ Global Select Market) under the symbol “SCSS.” As of January 29, 2011, there were approximately 502 holders of record of our common stock. The following table sets forth the quarterly high and low sales prices per share of our common stock as reported by NASDAQ for the two most recent fiscal years. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions.

   
Fourth
Quarter
   
Third
Quarter
   
Second
Quarter
   
First
Quarter
 
Fiscal 2010
                       
High
  $ 9.27     $ 8.82     $ 11.78     $ 8.65  
Low
    6.64       4.95       8.09       6.45  
                                 
Fiscal 2009
                               
High
  $ 6.79     $ 5.00     $ 1.25     $ 0.98  
Low
    4.76       0.79       0.55       0.20  

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

Information concerning stock repurchases completed during the fourth quarter of fiscal 2010 is set forth below:

Fiscal Period
 
Total Number of Shares Purchased
   
Average Price Paid per Share
   
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1)
   
Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs
 
October 3, 2010 through October 30, 2010
                   
 
 
October 31, 2010 through November 27, 2010
                   
 
 
November 28, 2010 through January 1, 2011
                    $ 206,762,000  
Total
                         
_____________________

(1)
On April 20, 2007, our Board of Directors authorized the Company to repurchase up to an additional $250.0 million of our common stock. As of January 1, 2011, the amount remaining under this authorization was $206.8 million. There is no expiration date with respect to this repurchase authority. We may terminate or limit the stock repurchase program at any time. We currently have no plans to repurchase shares under this authorization.


Comparative Stock Performance

The graph below compares the total cumulative shareholder return on our common stock over the last five years to the total cumulative return on the Standard and Poor’s (“S&P”) 400 Specialty Stores Index and The NASDAQ Stock Market (U.S.) Index assuming a $100 investment made on December 31, 2005. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance. The information contained in this “Comparative Stock Performance” section shall not be deemed to be “soliciting material” or “filed” or incorporated by reference in future filings with the SEC, or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended, except to the extent that we specifically request that it be treated as soliciting material or incorporate it by reference into a document filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.

COMPARISON OF FIVE-YEAR CUMULATIVE TOTAL RETURN
AMONG SELECT COMFORT CORPORATION, S&P 400 SPECIALTY STORES INDEX,
AND THE NASDAQ STOCK MARKET (U.S.) INDEX

Image 1
 
   
12/31/2005
   
12/30/2006
   
12/29/2007
   
1/3/2009
   
1/2/2010
   
1/1/2011
 
Select Comfort Corporation
  $ 100     $ 95     $ 39     $ 1     $ 36     $ 50  
S&P 400 Specialty Stores Index
    100       113       94       56       82       123  
The NASDAQ Stock Market (U.S.) Index
    100       112       125       74       107       126  


Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information about our equity compensation plans as of January 1, 2011:

EQUITY COMPENSATION PLAN INFORMATION

Plan Category
 
Number of securities to be issued upon exercise of outstanding options, warrants and rights(1)
   
Weighted average exercise price of outstanding options, warrants and rights
   
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in the first column)
 
Equity compensation plans approved by security holders
    3,985,000     $ 11.72       1,952,000  
                         
Equity compensation plans not approved by security holders
 
None
   
Not applicable
   
None
 
                         
Total
    3,985,000     $ 11.72       1,952,000  

(1)
Includes the Select Comfort Corporation 1997 Stock Incentive Plan, the Select Comfort Corporation 2004 Stock Incentive Plan and the Select Comfort Corporation 2010 Omnibus Incentive Plan.


ITEM 6. SELECTED FINANCIAL DATA

(in thousands, except per share and selected operating data, unless otherwise indicated)

The Consolidated Statements of Operations Data and Consolidated Balance Sheet Data presented below have been derived from our Consolidated Financial Statements and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and Notes thereto included in this Annual Report on Form 10-K.

   
Year
 
   
2010
   
2009
   
2008(2)
   
2007
   
2006(1)
   
2005
 
Consolidated Statements of Operations Data:
                                   
Net sales
  $ 605,676     $ 544,202     $ 608,524     $ 799,242     $ 806,038     $ 689,548  
Gross profit
    378,263       335,460       358,572       486,415       490,508       406,476  
Operating expenses:
                                               
Sales and marketing
    269,901       259,244       332,068       372,467       341,630       286,206  
General and administrative
    53,572       49,560       57,994       64,351       65,401       49,300  
Research and development
    2,147       1,973       3,374       5,682       4,687       2,219  
Asset impairment charges
    260       686       34,594       409       5,980       162  
Terminated equity financing costs
          3,324                          
Operating income (loss)
    52,383       20,673       (69,458 )     43,506       72,810       68,589  
Net income (loss)
  $ 31,568     $ 35,552     $ (70,177 )   $ 27,620     $ 47,183     $ 43,767  
Net income (loss) as adjusted(6)
  $ 31,568     $ 11,169     $ (23,174 )   $ 27,620     $ 50,525     $ 43,767  
                                                 
Net income (loss) per share:
                                               
Basic
  $ 0.58     $ 0.78     $ (1.59 )   $ 0.59     $ 0.89     $ 0.82  
Diluted
  0.57     $ 0.77     (1.59 )   0.57     $ 0.85     $ 0.76  
Diluted – as adjusted(6)
  0.57     0.24     (0.52 )   0.57     0.91     0.76  
Shares used in calculation of net income (loss) per share:
                                               
Basic
    54,005       45,682       44,186       46,536       52,837       53,357  
Diluted
    55,264       46,198       44,186       48,292       55,587       57,674  
                                                 
Consolidated Balance Sheet Data:
                                               
Cash, cash equivalents and marketable debt securities
  $ 81,361     $ 17,717     $ 13,057     $ 7,279     $ 90,175     $ 123,091  
Working capital
    20,053       (25,435 )     (90,534 )     (70,000 )     5,637       10,158  
Total assets
    169,957       118,240       135,413       190,489       228,961       239,838  
Borrowings under revolving credit facility
                79,150       37,890              
Total shareholders’ equity (deficit)
    57,977       22,458       (41,630 )     24,126       115,694       121,347  
                                                 
Selected Operating Data:
                                               
Stores open at period-end
    386       403       471       478       442       396  
Stores opened during period
    7       4       19       45       51       40  
Stores closed during period
    24       72       26       9       5       14  
Retail partner doors(3)
    150       146       801       891       822       353  
Average net sales per store (000’s)(4)
  $ 1,295     $ 1,046     $ 984     $ 1,318     $ 1,493     $ 1,417  
Percentage of stores with more than $1.0 million in net sales(4)
    70 %     48 %     45 %     73 %     81 %     77 %
Comparable-store sales increase (decrease)(5)
    21 %     0 %     (25 %)     (11 %)     7 %     15 %
Average square footage per store open during period(4)
    1,484       1,474       1,410       1,315       1,200       1,121  
Net sales per square foot(4)
  $ 873     $ 710     $ 703     $ 1,024     $ 1,244     $ 1,264  
Average store age (in months at period end)
    113       102       91       84       81       79  
Earnings before interest, depreciation and amortization (“EBITDA”) (6)
  $ 69,675     $ 42,289     $ (9,437 )   $ 75,768     $ 109,821     $ 87,465  
Free cash flows(6)
  $ 63,870     $ 64,180     $ (29,229 )   $ 517     $ 28,297     $ 61,658  
                                                 
(1)
In the first quarter of fiscal 2006, we adopted the fair value recognition method for our stock-based compensation awards. We elected the modified prospective transition method and, accordingly, financial results for fiscal years prior to 2006 have not been restated. Stock-based compensation expense for fiscal 2010, 2009, 2008, 2007 and 2006 was $3,962, $3,236, $3,702, $6,252 and $8,325, respectively. Prior to the adoption of the fair value recognition method, we followed the intrinsic value method to account for our employee stock options and employee stock purchase plan. Accordingly, no compensation expense was recognized for share purchase rights granted in connection with the issuance of stock options under our employee stock option plan or employee stock purchase plan; however, compensation expense was recognized in connection with the issuance of restricted and performance shares granted. See Note 7 of the Notes to the Consolidated Financial Statements for additional information regarding stock-based compensation. In 2005, prior to the adoption of the fair value recognition method, we recognized $793 of stock-based compensation expense (pre-tax).

(2)
Fiscal year 2008 had 53 weeks. All other fiscal years presented had 52 weeks.

(3)
In August 2009, we announced our decision to discontinue distribution through non-company owned mattress retailers in the contiguous United States.

(4)
For stores open during the entire period indicated.

(5)
Stores are included in the comparable-store calculation in the 13th full month of operation. Stores that have been remodeled or relocated within the same shopping center remain in the comparable-store base. The number of comparable-stores used to calculate such data was 379, 399, 452, 432, 391 and 354 for 2010, 2009, 2008, 2007, 2006 and 2005, respectively. Fiscal 2008 included 53 weeks, as compared to 52 weeks for the other periods presented. Comparable-store sales have been adjusted and reported as if all years had the same number of weeks.

(6)
These non-GAAP measures are not in accordance with, or preferable to, GAAP financial data. However, we are providing this information as we believe it facilitates annual and year-over-year comparisons for investors and financial analysts. See page 25 and 26 for the reconciliation of these non-GAAP measures to the appropriate GAAP measure.

 
Non-GAAP Data Reconciliations

Reported to Adjusted Statements of Operations
(in thousands, except per share amounts)
 
In addition to disclosing results that are determined in accordance with GAAP, we also disclose non-GAAP results that exclude certain significant charges or credits that are important to an understanding of our ongoing operations. We have provided reconciliations of our non-GAAP measures to the most comparable GAAP measures. We believe that discussion of results excluding certain significant charges or credits provides additional insights into underlying business performance. Adjusted earnings per share is not a measure recognized under GAAP. The determination of significant charges or credits may not be comparable to similarly titled measures used by other companies.
 
   
Year
 
   
2010
   
2009
   
2008
   
2007
   
2006
   
2005
 
                                     
Net income (loss) – as reported
  $ 31,568     $ 35,552     $ (70,177 )   $ 27,620     $ 47,183     $ 43,767  
Adjustments – net of income tax (1)
                                               
Terminated equity financing costs (2)
          2,061                          
Impairments (3)
                20,163             3,342        
Income tax valuation (4)
          (26,444 )     26,840                    
Net income (loss) – as adjusted
  $ 31,568     $ 11,169     $ (23,174 )   $ 27,620     $ 50,525     $ 43,767  
                                                 
Net income (loss) per share – as adjusted:
                                               
Basic
    0.58       0.24       (0.52 )     0.59       0.96       0.82  
Diluted
    0.57       0.24       (0.52 )     0.57       0.91       0.76  
                                                 
Basic shares
    54,005       45,682       44,186       46,536       52,837       53,357  
Diluted shares
    55,264       46,198       44,186       48.292       55,587       57,674  

(1)
Reflects annual effective tax rates, before discrete adjustments, of 38.0%, 40.0% and 37.8% for the fiscal years ended January 2, 2010; January 3, 2009; and December 30, 2006, respectively.

(2)
For the fiscal year ended January 2, 2010, we expensed $3.3 million ($2.1 million, net of income tax) of direct, incremental costs incurred in connection with a terminated equity financing transaction.

(3)
Fiscal year ended January 3, 2009 includes impairment charges for the abandonment of our plan to implement SAP®-based applications and impairment charges in excess of $1.0 million for underperforming stores. Fiscal year ended December 30, 2006 includes impairment charges for the abandonment of software projects in connection with our decision to implement an SAP enterprise resource planning system.

(4)
For the fiscal year ended January 3, 2009, we established a $26.8 million valuation allowance against deferred taxes based on uncertainty regarding future taxable income.  For the fiscal year ended January 2, 2010, we reversed the valuation allowance against deferred taxes based on all available positive and negative evidence.

Note -
Our “as adjusted” data is considered a non-GAAP financial measure and is not in accordance with, or preferable to, “as reported,” or GAAP financial data.  However, we are providing this information as we believe it facilitates annual and year-over-year comparisons for investors and financial analysts.

GAAP -
generally accepted accounting principles
 

Non-GAAP Data Reconciliations (continued)

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

We define earnings before interest, taxes, depreciation and amortization (“EBITDA”) as net income (loss) plus: income tax expense (benefit), interest expense, depreciation and amortization, stock-based compensation and asset impairments consistent with the definition used in our debt covenant calculations. Management believes EBITDA is a useful indicator of our financial performance.  Our definition of EBITDA may not be comparable to similarly titled definitions used by other companies. The tables below reconcile EBITDA, which is a non-GAAP financial measure, to comparable GAAP financial measures.

 
 
Year
 
 
 
2010
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
 
   
 
   
 
   
 
   
 
       
Net income (loss)
  $ 31,568     $ 35,552     $ (70,177 )   $ 27,620     $ 47,183     $ 43,767  
Income tax expense (benefit)
    18,922       (20,862 )     (2,566 )     15,846       28,645       26,996  
Interest expense
    1,951       5,996       3,375       849       4        
Depreciation and amortization
    13,012       17,681       21,635       24,792       19,684       15,747  
Stock-based compensation
    3,962       3,236       3,702       6,252       8,325       793  
Asset impairments
    260       686       34,594       409       5,980       162  
EBITDA
  $ 69,675     $ 42,289     $ (9,437 )   $ 75,768     $ 109,821     $ 87,465  

Free Cash Flows
(in thousands)

Our “free cash flows” data is considered a non-GAAP financial measure and is not in accordance with, or preferable to, “net cash provided by operations,” or GAAP financial data.  However, we are providing this information as we believe it facilitates analysis for investors and financial analysts.

 
 
Year
 
 
 
2010
   
2009
   
2008
   
2007
   
2006
   
2005
 
   
 
   
 
   
 
   
 
   
 
       
Net cash provided by operating activities
  $ 71,219     $ 66,639     $ 2,973     $ 44,031     $ 59,376     $ 87,498  
Subtract:  Purchases of property and equipment
    7,349       2,459       32,202       43,514       31,079       25,840  
Free cash flows
  $ 63,870     $ 64,180     $ (29,229   $ 517     $ 28,297     $ 61,658  


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

Forward-Looking Statements

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

Current and future general and industry economic trends and consumer confidence;
Availability of attractive and cost-effective consumer credit options;
The effectiveness of our marketing messages;
The efficiency of our advertising and promotional efforts;
Our ability to execute our retail distribution strategy, including our ability to cost-effectively close under-performing store locations and to find suitable new store locations;
Our ability to continue to improve our product line and service levels, and consumer acceptance of our products, product quality, innovation and brand image;
Our ability to achieve and maintain acceptable levels of product quality and acceptable product return and warranty claims rates;
Pending and potentially unforeseen litigation;
Industry competition and the adequacy of our intellectual property rights to protect our products and brand from competitive or infringing activities;
Our “just-in-time” manufacturing processes with minimal levels of inventory, which may leave us vulnerable to shortages in supply;
Our dependence on significant suppliers and our ability to maintain relationships with key suppliers, including several sole source suppliers;
Rising commodity costs and other inflationary pressures;
Risks inherent in global sourcing activities;
Risks of disruption in the operations of either of our two manufacturing facilities;
Increasing government regulations, including flammability standards for the bedding industry;
The adequacy of our management information systems to meet the evolving needs of our business and existing and evolving regulatory standards applicable to data privacy and security;
Our ability to attract and retain senior leadership and other key employees, including qualified sales professionals; and
Global events, such as terrorist attacks or a pandemic outbreak, or the threat of such events.

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

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

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


Overview

Business Overview

Select Comfort designs, manufactures, markets and supports a line of adjustable-firmness mattresses featuring air-chamber technology. The air-chamber technology of our proprietary Sleep Number® bed allows adjustable firmness on each side of the mattress and provides a sleep surface that is clinically proven to provide better sleep quality and greater relief of back pain compared to traditional mattress products. In addition, we market and sell accessories and other sleep-related products which focus on providing personalized comfort to complement the Sleep Number bed and provide a better night’s sleep for consumers.

We generate revenue by selling our products through four complementary distribution channels. Three of these channels: Retail, Direct Marketing and E-Commerce, are company-controlled and sell directly to consumers. Our wholesale channel sells to and through the QVC shopping channel and wholesale customers in Alaska, Hawaii, Canada and Australia.

Mission, Vision and Strategy

Our mission is to improve lives by individualizing sleep experiences. Our vision is to become the new standard in sleep by providing individualized sleep experiences and elevating people’s expectations above the “one-size-fits-all” solution offered by other mattress brands.

We are executing against a defined strategy which focuses on the following key components:
 
Know our customers as no one else can…use that insight to set new standards in end-to-end customer experience;
 
Broaden awareness and consideration…to take share; earn leadership in premium sleep; and
 
Leverage our core business to achieve new levels of margin…to fund acceleration and innovation.

Results of Operations

Fiscal 2010 Summary

Key financial highlights for fiscal 2010 and financial outlook for fiscal 2011 are as follows:

 
Net income totaled $31.6 million, or $0.57 per diluted share, compared with net income of $35.6 million, or $0.77 per diluted share in 2009. The 2009 net income included the benefit from the reversal of a $26.8 million valuation allowance for deferred taxes offset by $3.3 million of terminated equity financing costs. On a comparable basis, excluding the valuation allowance and the costs associated with the terminated financing, net income per diluted share would have been $0.24 in 2009.

 
Net sales increased 11% to $605.7 million, compared with $544.2 million for the prior year, primarily due to a 21% comparable-store sales increase in our company-controlled retail stores, partially offset by a decrease in sales resulting from both a reduction in our store base and the termination of retail partner relationships during the third quarter of 2009.

 
Operating income improved to $52.4 million, or 8.6% of net sales, for 2010, compared with $20.7 million, or 3.8% of net sales, for the same period one year ago. The operating income improvement was driven by strong comparable-store sales growth and efficiency enhancements. Sales-per-store, on a trailing twelve-month basis, increased by 24% to $1.3 million.

 
Cash provided by operating activities in 2010 totaled $71.2 million, compared with $66.6 million for the prior year. Operating cash flows for 2009 included $26.1 million of income tax refunds associated with our 2008 pre-tax loss.

 
As of January 1, 2011, cash and cash equivalents totaled $81.4 million compared with $17.7 million one year ago, and we had no borrowings under our revolving credit facility.

 
Our outlook is for modest improvement in macro-economic trends and comparable-store sales growth higher than industry growth as we increase investments against programs designed to expand market share. We expect to end 2011 with approximately 380 stores after the consolidation of planned store openings and closings, compared with 386 at the end of 2010.


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

   
2010
   
2009
   
2008
 
   
$
   
% of
Net Sales
   
$
   
% of
Net Sales
   
$
   
% of
Net Sales
 
Net sales
  $ 605.7       100.0 %   $ 544.2       100.0 %   $ 608.5       100.0 %
Cost of sales
    227.4       37.5       208.7       38.4       250.0       41.1  
Gross profit
    378.3       62.5       335.5       61.6       358.6       58.9  
Operating expenses:
                                               
Sales and marketing
    269.9       44.6       259.2       47.6       332.1       54.6  
General and administrative
    53.6       8.8       49.6       9.1       58.0       9.5  
Research and development
    2.1       0.4       2.0       0.4       3.4       0.6  
Asset impairment charges
    0.3       0.0       0.7       0.1       34.6       5.7  
Terminated equity financing costs
          0.0       3.3       0.6              
Total operating expenses
    325.9       53.8       314.8       57.8       428.0       70.3  
Operating income (loss)
    52.4       8.6       20.7       3.8       (69.5 )     (11.4 )
Other expense, net
    1.9       0.3       6.0       1.1       3.3       0.5  
Income (loss) before income taxes
    50.5       8.3       14.7       2.7       (72.7 )     (12.0 )
Income tax expense (benefit)
    18.9       3.1       (20.9 )     (3.8 )     (2.6 )     (0.4 )
Net income (loss)
  $ 31.6       5.2 %   $ 35.6       6.5 %   $ (70.2 )     (11.5 %)
                                                 
 
  2010           2009           2008        
Net income (loss) per share:
                                         
Basic
  $ 0.58             $ 0.78             $ (1.59 )        
Diluted
    0.57               0.77               (1.59 )        
Diluted - as adjusted(1)
                                               
Weighted-average number of common shares:
                                               
Basic
    54.0               45.7               44.2          
Diluted
    55.3               46.2               44.2          
 
(1)
This non-GAAP measure are not in accordance with, or preferable to, GAAP financial data.  However, we are providing this information as we believe it facilitates annual and year-over-year comparisons for investors and financial analysts.  See page 25 for reconciliation of this non-GAAP measure to the appropriate GAAP measure.
 
The percentage of our total net sales, by dollar volume, from each of our channels during the last three years was as follows:

   
2010
   
2009
   
2008
 
Retail
    84.0 %     81.2 %     78.2 %
Direct and E-Commerce
    10.8 %     11.5 %     13.8 %
Wholesale
    5.2 %     7.3 %     8.0 %
Total
    100.0 %     100.0 %     100.0 %


The components of total net sales change, including comparable-store net sales changes, were as follows:

   
Channel increase/(decrease)
 
   
2010
   
2009
   
2008
 
Retail same-store sales
    21 %     0 %     (25 %)
Direct and E-Commerce
    5 %     (26 %)     (29 %)
Company-Controlled same-store sales change
    19 %     (4 %)     (26 %)
Net store openings/closings
    (5 %)     (6 %)     4 %
Total Company-Controlled channels
    14 %     (10 %)     (22 %)
Wholesale
    (21 %)     (19 %)     (38 %)
Total net sales change
    11 %     (11 %)     (24 %)

 
(1)
Stores are included in the comparable-store calculation in the 13th full month of operation. Stores that have been remodeled or relocated within the same shopping center remain in the comparable-store base. Fiscal 2008 included 53 weeks, as compared to 52 weeks in fiscal 2010 and 2009. Comparable-store sales have been adjusted and reported as if all years had the same number of weeks.

The number of controlled-owned retail stores during the last three years, and independently owned and operated retail partner stores, was as follows:

   
2010
   
2009
   
2008
 
Company-controlled retail stores:
                 
Beginning of year
    403       471       478  
Opened
    7       4       19  
Closed
    (24 )     (72 )     (26 )
End of year
    386       403       471  
                         
Retail partner stores(1)  end of year
    150       146       801  

 
(1)
In August 2009, we announced our decision to discontinue distribution through non-company owned mattress retailers in the contiguous United States.

Comparison of 2010 and 2009

Net Sales

Net sales in 2010 increased 11% to $605.7 million, compared with $544.2 million for the same period one year ago. The sales increase was driven by a 21% comparable-store sales increase in our company-controlled retail stores and a 5% increase in our direct and E-Commerce channel sales. These increases were partially offset by the decrease in sales resulting from the 4% year-over-year decline in the number of retail stores we operated and a decrease in wholesale channel sales due in large part to our decision in the third quarter of 2009 to discontinue distribution through retail partners operating approximately 700 stores in the contiguous United States. Total sales of mattress units increased 5% compared to the same period one year ago, with mattress units in company-controlled distribution channels increasing by 11%. Sales of other products and services increased by 16%.

The $61.5 million net sales increase compared with the same period one year ago was comprised of the following: (i) an $86.4 million increase in sales from our company-controlled comparable retail stores, partially offset by a $19.7 million sales decrease resulting from the net decline in the number of stores we operated and (ii) a $3.1 million increase in direct and E-Commerce channel sales, partially offset by (iii) an $8.3 million decrease in wholesale channel sales.

Gross Profit

The gross profit rate increased to 62.5% in 2010 compared with 61.6% in 2009. Approximately 1.2 ppt. of the gross profit rate improvement was due to logistics and manufacturing efficiencies, including material cost reductions, an increase in the percentage of net sales from our higher margin company-controlled distribution channels and leverage from the higher sales volume. The gross profit rate also improved due to a reduction in warranty costs per unit, driven by product quality enhancements. These improvements were partially offset by increased performance-based compensation, and an increase in promotional costs to generate customer traffic and drive sales.


Sales and Marketing Expenses

Sales and marketing expenses in 2010 increased to $269.9 million, or 44.6% of net sales, compared with $259.2 million, or 47.6% of net sales in 2009. The $10.7 million increase was primarily due to an $8.8 million, or 14%, increase in media spending and an increase in variable selling expenses due to the higher sales volume, partially offset by a decrease in expenses resulting from the reduction in our store base. The sales and marketing expense rate declined 3.0 ppt. compared with the same period one year ago due to the leveraging impact of the 11% net sales increase and expense savings from store closures.

General and Administrative Expenses

General and administrative (“G&A”) expenses increased $4.0 million to $53.6 million in 2010, compared with $49.6 million in 2009, but decreased to 8.8% of net sales, compared with 9.1% of net sales in the prior year. The $4.0 million increase was primarily due to higher performance-based incentive compensation resulting from our strong 2010 financial results, partially offset by reduced depreciation expenses and the absence of certain costs incurred during the same period last year, including severance expenses. The G&A expense rate decreased by 0.3 ppt. for 2010 compared with the same period one year ago, primarily due to the leveraging impact of the 11% net sales increase.

Research and Development

Research and development (“R&D”) expenses increased to $2.1 million in 2010 compared with $2.0 million in 2009. R&D expenses for 2010 were 0.4% of net sales, consistent with 2009.

Asset Impairment Charges

During 2010, we recognized impairment charges of $0.3 million primarily related to underperforming stores’ assets. During 2009, we recognized impairment charges of $0.7 million related to assets at stores expected to close prior to their normal lease termination dates, and certain equipment and software.

Terminated Equity Financing Costs

In May 2009, we entered into a securities purchase agreement with a private equity firm. At a special meeting of shareholders held August 27, 2009, our shareholders did not approve the May 2009 securities purchase agreement. During the third quarter of 2009, we expensed $3.3 million of direct, incremental costs incurred in connection with the terminated equity financing.

Other Expense, Net

Other expense, net was $1.9 million for 2010, compared with $6.0 million for the same period one year ago. This decrease was primarily due to (i) reduced current-year interest expense and other debt-related costs as we had no borrowings under our revolving credit facility during 2010, partially offset by (ii) a $1.1 million write-off of unamortized debt costs during the first quarter of 2010. We entered into a new credit agreement on March 26, 2010 and terminated our prior credit agreement.

Income Tax Expense (Benefit)

Income tax expense was $18.9 million for 2010, compared with an income tax benefit of $20.9 million for the same period one year ago. The effective tax rate for 2010 was 37.5% compared with (142.0%) for the same period one year ago. The 2009 income tax benefit and effective tax rate reflected the reversal of a deferred tax valuation allowance based on the resolution of the uncertainty regarding future taxable income during the fourth quarter of 2009. In addition, the 2010 effective tax rate benefited from an increase in the manufacturing deduction, partially offset by an increase in unrecognized tax benefits related to certain federal and state tax matters.


Comparison of 2009 and 2008

Net Sales

Net sales in 2009 decreased 11% to $544.2 million, compared with $608.5 million in 2008. The net sales decrease was due to a 14% year-over-year decline in the number of retail stores we operated, and a decrease in direct, wholesale and E-Commerce channel net sales. Total sales of mattress units decreased 11% compared to the same period one year ago and sales of other products and services decreased by 7%.

The $64.3 million net sales decrease compared with the same period one year ago was comprised of the following: (i) a $30.1 million decrease resulting from the net decline in the number of stores we operated, partially offset by a $2.1 million net increase in net sales from our company-controlled comparable retail stores; (ii) a $20.8 million decrease in direct and E-Commerce Channel sales; and (iii) a $8.9 million decrease in wholesale sales. In addition, 2008 included an additional 53rd week of sales totaling approximately $6.6 million.

Gross Profit

The gross profit rate increased to 61.6% in 2009 compared with 58.9% in 2008. A majority of the gross profit rate increase was due to improved manufacturing efficiencies, lower fuel prices, and actions taken to reduce supply chain and logistics costs which in total added approximately 3.5 ppt. to our gross profit rate for 2009, compared to last year. During the fourth quarter of 2008 and in fiscal 2009, we resized our manufacturing and logistics operations to better align with current customer demand. In addition, a sales mix shift to higher-margin company-controlled channels, higher-margin products and lower warranty expenses improved the gross profit rate by 0.6 ppt., 0.5 ppt. and 0.5 ppt., respectively, compared with the same period one year ago. These improvements were partially offset by an increase in promotional costs to generate customer traffic and drive sales.

Sales and Marketing Expenses

Sales and marketing expenses in 2009 decreased to $259.2 million, or 47.6% of net sales, compared with $332.1 million, or 54.6% of net sales in 2008. The $72.8 million decrease was primarily due to a $30.6 million (or 33%) reduction in media spending and a $20.5 million decrease in other marketing expenses, including financing, promotion and media production expenses compared with the same period one-year ago. The reduction in media and other marketing expenses was mainly due to efforts to enhance the effectiveness and efficiency of our marketing expenditures. The remainder of the expense decrease was due to reduced fixed and variable selling expenses resulting from a 14% year-over-year reduction in our store base, reduced depreciation expense (including the impact of prior-year store asset impairments) and other cost reduction initiatives. The sales and marketing expense rate declined 7.0 ppt. compared to the same period one year ago, with the benefits from the cost reduction initiatives more than offsetting the deleveraging impact of the 11% net sales decline.

General and Administrative Expenses

General and administrative (“G&A”) expenses decreased $8.4 million to $49.6 million or 9.1% of net sales in 2009, compared with $58.0 million or 9.5% of net sales in 2008. The $8.4 million decrease in G&A expenses was primarily due to reduced compensation and benefit costs resulting from workforce reductions, decreased depreciation expense and discretionary spending cuts, partially offset by increased performance-based compensation.

Research and Development

Research and development (“R&D”) expenses decreased to $2.0 million in 2009 compared with $3.4 million in 2008, and decreased as a percentage of net sales to 0.4% from 0.6%.

Asset Impairment Charges

Asset impairment charges decreased to $0.7 million in 2009, compared with $34.6 million in 2008. During 2009, we recognized impairment charges of $0.7 million related to assets at stores expected to close prior to their normal lease termination dates, and certain equipment and software.

During the fourth quarter of fiscal 2008, we elected to abandon our plan to implement an integrated suite of SAP®-based applications and recognized asset impairment charges totaling $27.6 million. Also during 2008, we determined that certain assets at underperforming stores were impaired and recognized impairment charges of $7.0 million.


Terminated Equity Financing Costs

In May 2009, we entered into a securities purchase agreement with a private equity firm. At a special meeting of shareholders held August 27, 2009, our shareholders did not approve the May 2009 securities purchase agreement. During the third quarter of 2009, we expensed $3.3 million of direct, incremental costs incurred in connection with the terminated equity financing.

Other Expense, Net

Other expense, net increased to $6.0 million compared with $3.3 million in 2008. The $2.7 million increase in other expense, net was primarily driven by (i) the current year reduction in capitalized interest expense; (ii) the increased write-off of unamortized debt costs in the current year due to reductions in our revolving credit facility’s borrowing capacity; (iii) an increase in our credit facility fees and expenses; and (iv) increased interest rates compared to the same period one year ago, partially offset by (v) a lower average debt balance for the current year.

Income Tax (Benefit) Expense

Income tax benefit in 2009 was $20.9 million compared with a $2.6 million benefit in 2008. The effective tax rate for 2009 was (142.0%) compared with 3.5% for the same period one year ago. Both 2008 and 2009 were impacted by changes in our deferred tax valuation allowance.
 
Liquidity and Capital Resources

As of January 1, 2011, we had cash and cash equivalents of $81.4 million compared with $17.7 million as of January 2, 2010. The $63.6 million increase in cash and cash equivalents was primarily due to $71.2 million of cash provided by operating activities partially offset by purchases of property and equipment totaling $7.3 million.

The following table summarizes our cash flows for the fiscal years ended January 1, 2011, and January 2, 2010 (in millions). Amounts may not add due to rounding differences.

   
Fiscal Year Ended
 
   
January 1,
2011
   
January 2,
2010
 
Total cash provided by (used in):
           
Operating activities
  $ 71.2     $ 66.6  
Investing activities
    (7.3 )     (2.4 )
Financing activities
    (0.2 )     (59.5 )
Increase in cash and cash equivalents
  $ 63.6     $ 4.7  

Cash provided by operating activities for the fiscal year ended January 1, 2011 was $71.2 million compared with $66.6 million for the fiscal year period ended January 2, 2010. The $4.6 million year-over-year increase in cash from operating activities was comprised of a $15.1 million increase in adjustments to reconcile net income to net cash provided by operating activities (prior year included the reversal of a $26.8 million deferred tax valuation allowance), a $6.5 million decrease in cash from changes in operating assets and liabilities (prior year included a $26.1 million income tax refund), and a $4.0 million decrease in our 2010 net income compared with the same period one year ago (prior year included the reversal of a $26.8 deferred tax valuation allowance). Other changes in operating assets and liabilities included a current year increase in accrued compensation and benefits due to higher incentive compensation resulting from the strong financial performance in 2010, a current year increase in inventories to support the higher sales volume and a current year decrease in prepaid expenses and other assets compared with an increase in the prior year (current year included a refund of a security deposit due to our improved financial position; prior year reflected an increase in prepaid rent and prepaid advertising expenses).

Investing activities for 2010 included $7.3 million of property and equipment purchases, compared with $2.5 million for the same period one year ago. In both periods, our capital expenditures related primarily to new and remodeled retail stores, and investments in information technology. During 2010 we opened seven new retail stores, compared with four new retail stores opened during 2009. Capital expenditures are projected to be approximately $25 million to $30 million in 2011, reflecting a total of 40 to 50 store actions, mainly related to store remodels and relocations, along with an initial investment to upgrade our information systems.


Net cash used in financing activities was $0.2 million during 2010, compared with $59.5 million for the same period one year ago. The $59.3 million year-over-year decrease in cash used in financing activities resulted primarily from an $84.8 million net decrease in short-term borrowings during 2009, partially offset by a $26.5 million increase in proceeds from the issuance of common stock. During fiscal 2009, we completed two separate equity offerings that generated the $26.5 million of net proceeds. Book overdrafts and payments on capital lease obligations are included in the net change in short-term borrowings.

As of January 1, 2011, the remaining authorization under our stock repurchase program was $206.8 million. There is no expiration date governing the period over which we can repurchase shares. We currently have no plans to repurchase our common stock. We continue to focus on strengthening our financial position and increasing our cash balance.

On March 26, 2010, we entered into a new credit agreement (“Credit Agreement”) with Wells Fargo Bank, National Association and terminated our prior credit agreement. The Credit Agreement provides a $20.0 million secured revolving credit facility for working capital and general corporate purposes, including up to $10.0 million available for issuances of letters of credit. Outstanding letters of credit reduce the amounts available under this credit facility. The Credit Agreement expires on July 1, 2012.  We are subject to certain financial covenants under the Credit Agreement, including minimum fixed charge coverage ratios, maximum capital expenditure limits, minimum net worth requirements, and maintenance of an aggregate principal balance of zero under the Credit Agreement for a period of not less than 30 consecutive days in each fiscal year. The Credit Agreement is secured by a first priority security interest in our assets and those of our domestic subsidiaries.

At January 1, 2011, $17.0 million was available under the Credit Agreement, we had no borrowings and we were in compliance with all financial covenants. At January 2, 2010, $35.5 million was available under the prior credit facility, we had no borrowings, and we were in compliance with all financial covenants. As of January 1, 2011, and January 2, 2010, we had outstanding letters of credit of $3.0 million and $4.5 million, respectively.

Cash generated from operations and available under our credit facility is expected to provide sufficient operating liquidity and funding for capital expenditures for the foreseeable future. In addition, our business model, which can operate with minimal working capital, does not require significant additional capital to fund operations or organic growth.

We have an agreement with GE Money Bank to offer qualified customers revolving credit arrangements to finance purchases from us (“GE Agreement”). The GE Agreement contains certain financial covenants, including a maximum leverage ratio and a minimum interest coverage ratio. As of January 1, 2011 we were in compliance with all financial covenants.

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

Off-Balance-Sheet Arrangements and Contractual Obligations

We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships. As of January 1, 2011, we were not involved in any unconsolidated special purpose entity transactions. Other than our operating leases and $3.0 million of outstanding letters of credit, we do not have any off-balance-sheet financing. A summary of our operating lease obligations by fiscal year is included in the “Contractual Obligations” section below. Additional information regarding our operating leases is available in Item 2, Properties, and Note 5, Leases, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.


Contractual Obligations

The following table presents information regarding our contractual obligations by fiscal year (in thousands):

   
Payments Due by Period(1)
 
   
Total
   
< 1 Year
   
1 – 3 Years
   
3 – 5 Years
   
> 5 Years
 
 
                             
Operating leases
  $ 114,533     $ 32,377     $ 47,937     $ 23,039     $ 11,180  
Capital leases
    713       447       266              
Purchase commitments
    4,268       4,100       168              
Total
  $ 119,514     $ 36,924     $ 48,371     $ 23,039     $ 11,180  

(1)
Our unrecognized tax benefits, including interest and penalties, of $1.6 million have not been included in the Contractual Obligations table as we are not able to determine a reasonable estimate of timing of the cash settlement with the respective taxing authorities.

Critical Accounting Policies and Estimates

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

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


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

Description
 
Judgments and Uncertainties
 
Effect if Actual Results
Differ From Assumptions
Asset Impairment Charges
  
  
   
Long-lived assets other than goodwill and other intangible assets, which are separately tested for impairment, are evaluated for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. When evaluating long-lived assets for potential impairment, we first compare the carrying value of the asset to the asset's estimated future cash flows (undiscounted and without interest charges). If the estimated undiscounted cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset's estimated fair value. We generally estimate fair value of long-lived assets, including our retail stores, using the income approach, which we base on estimated future cash flows (discounted and with interest charges). The inputs used to determine fair value relate primarily to future assumptions regarding sales volumes, gross profit rates, store operating expenses and applicable probability weightings regarding future alternative uses. These inputs are categorized as Level 3 inputs under the fair value measurements guidance. The inputs used represent management’s assumptions about what information market participants would use in pricing the assets and are based upon the best information available at the balance sheet date.
 
Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated fair value plus net proceeds expected from disposition of the asset (if any). When we recognize an impairment loss, the carrying amount of the asset is reduced to estimated fair value based on discounted cash flows, quoted market prices or other valuation techniques.
 
Assets to be disposed of are reported at the lower of the carrying amount of the asset or fair value less costs to sell. We review store assets for potential impairment based on historical cash flows, lease termination provisions and expected future store operating results.
 
If we recognize an impairment loss, the adjusted carrying amount of the asset becomes its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset.
 
Our impairment loss calculations contain uncertainties because they require management to make assumptions and to apply judgment to identify events or changes in circumstances indicating the carrying value of assets may not be recoverable, estimate future cash flows, estimate asset fair values, and select a discount rate that reflects the risk inherent in future cash flows.
 
Expected cash flows may not be realized, which could cause long-lived assets to become impaired in future periods and could have a material adverse effect on future results of operations.
 
We have not made any material changes in our impairment loss assessment methodology during the past three fiscal years.
 
As of January 1, 2011, we evaluated 20 under-performing retail stores that had sufficient projected future cash flows to support the carrying value of their long-lived assets and therefore, did not result in additional impairment charges. At January 1, 2011, the carrying amount of the long-lived assets for these stores totaled $0.6 million.
 
We believe that our estimates and assumptions used to calculate long-lived asset impairment charges were reasonable and reflect the current economic environment. Our fair value calculations reflect current consumer spending trends. Our fair value calculations assume the ongoing availability of consumer credit and our ability to provide cost-effective consumer credit options. However, it is reasonably possible that an unexpected decline in consumer spending may expose us to future impairment charges that could be material.
 
Alternatively, if consumer spending increases at a higher rate than we anticipated, impaired stores (which continue to operate) could generate higher than expected future cash flows and operating profits.


Description
  
Judgments and Uncertainties
  
Effect if Actual Results
Differ From Assumptions
Asset Impairment Charges (con’t)
       
Asset impairment charges totaled $0.3 million, $0.7 million and $34.6 million for 2010, 2009 and 2008, respectively. During 2010 total impairment charges included a $0.2 million charge for long-lived assets related to two under-performing retail store locations. As of January 1, 2011, the remaining carrying amount of the long-lived assets at these stores was zero.
 
 
 
 
         
Stock-Based Compensation
  
  
  
  
We have a stock-based compensation plan, which includes non-qualified stock options and nonvested share awards. See Note 1, Business and Summary of Significant Accounting Policies, and Note 7, Shareholders’ Equity, to the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K, for a complete discussion of our stock-based compensation programs.
 
We determine the fair value of our non-qualified stock option awards and the resulting compensation expense at the date of grant using the Black-Scholes-Merton option-pricing model. The most significant inputs into the Black-Scholes-Merton model are exercise price, our estimate of expected stock price volatility and the expected term of the options.
 
We determine the fair value of our performance-based nonvested share awards at the date of grant generally based on the closing market price of our stock.
 
Option-pricing models and generally accepted valuation techniques require management to make assumptions and to apply judgment to determine the fair value of our awards. These assumptions and judgments include estimating the future volatility of our stock price, future employee forfeiture rates and future employee stock option exercise behaviors. Changes in these assumptions can materially affect the fair value estimate or future earnings adjustments.
 
Performance-based nonvested share awards require management to make assumptions regarding the likelihood of achieving performance goals.
 
We do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use to determine stock-based compensation expense. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to changes in stock-based compensation expense that could be material.
 
If actual results are not consistent with the assumptions used, the stock-based compensation expense reported in our financial statements may not be representative of the actual economic cost of the stock-based compensation. Also, if the actual forfeiture rates are not consistent with the assumptions used, it could result in future earnings adjustments.
 
A 10% change in our stock-based compensation expense for the year ended January 1, 2011, would have affected net income by approximately $246,000 in 2010.
 
Self-Insured Liabilities
     
  
We are self-insured for certain losses related to health and workers’ compensation claims. However, we obtain third-party insurance coverage to limit our exposure to these claims.
 
When estimating our self-insured liabilities, we consider a number of factors, including historical claims experience, demographic factors, severity factors and valuations provided by third-party administrators.
 
Periodically, management reviews its assumptions and the valuations provided by third-party administrators to determine the adequacy of our self-insured liabilities.
 
Our self-insured liabilities contain uncertainties because management is required to make assumptions and to apply judgment to estimate the ultimate cost to settle reported claims and claims incurred but not reported as of the balance sheet date.
 
 
 
We have not made any material changes in the accounting methodology used to establish our self-insured liabilities during the past three fiscal years.
 
We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our self-insured liabilities. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.
 
A 10% change in our self-insured liabilities at January 1, 2011, would have affected net income by approximately $273,000 in 2010.


Description
  
Judgments and Uncertainties
  
Effect if Actual Results
Differ From Assumptions
Warranty Liabilities
  
  
  
  
The estimated cost to service warranty claims of customers is included in cost of sales. This estimate is based on historical trends of warranty claims.
 
We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.
 
Our warranty liability contains uncertainties because our warranty obligations cover an extended period of time. A revision of estimated claim rates or the projected cost of materials and freight associated with sending replacement parts to customers could have a material adverse effect on future results of operations.
 
We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our warranty liability. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.
 
A 10% change in our warranty liability at January 1, 2011, would have affected net income by approximately $356,000 in 2010.
 
 
 
 
 
Revenue Recognition
  
  
  
  
Revenue is recognized when the sales price is fixed or determinable, collectability is reasonably assured and title passes. Amounts billed to customers for delivery and set up are included in net sales. Revenue is reported net of estimated sales returns and excludes sales taxes.
 
We accrue for sales returns at the time revenue is recognized and charge actual returns against the liability when they are received. Our general return policy is to allow returns after a 30-night trial period. We estimate future projected returns based on historical return rates.
 
Our estimates of sales returns contain uncertainties as actual returns may vary from expected rates, resulting in adjustments to net sales in future periods. These adjustments could have a material adverse effect on future results of operations.
 
We have not made any material changes in the accounting methodology used to establish our sales returns allowance during the past three fiscal years.
 
We do not believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions we use to calculate our sales returns allowance. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material.
 
A 10% change in our sales returns allowance at January 1, 2011, would have affected net income by approximately $183,000 in 2010.

Recent Accounting Pronouncements

None currently applicable.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

At January 1, 2011, we had no short-term borrowings under our line of credit. We do not currently manage interest rate risk on our debt through the use of derivative instruments.

Any borrowings under our revolving credit facility are currently not subject to material interest rate risk. The credit facility’s interest rate may be reset due to fluctuations in a market-based index, such as the prime rate or LIBOR.


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

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

We have audited the internal control over financial reporting of Select Comfort Corporation and subsidiaries (the “Company”) as of January 1, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting.  Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

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

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

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 1, 2011, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule listed in the Index at Item 15 as of and for the year ended January 1, 2011, of the Company and our report dated February 24, 2011 expressed an unqualified opinion on those financial statements and financial statement schedule.

\s\ DELOITTE & TOUCHE LLP

Minneapolis, Minnesota
February 24, 2011


Report of Independent Registered Public Accounting Firm

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

We have audited the accompanying consolidated balance sheet of Select Comfort Corporation and subsidiaries (the “Company”) as of January 1, 2011, and the related consolidated statements of operations, shareholders’ equity (deficit), and cash flows for the year then ended.  Our audit also included the financial statement schedule for the year ended January 1, 2011, listed in the Index at Item 15.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit.  The consolidated financial statements of the Company for the years ended January 2, 2010 and January 3, 2009, were audited by other auditors whose report, dated February 25, 2010, expressed an unqualified opinion on those statements.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether 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 audit provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Select Comfort Corporation and subsidiaries as of January 1, 2011, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.  Also, in our opinion, such financial statement schedule, when considered in relation to the basic fiscal 2011 consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of January 1, 2011, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 24, 2011 expressed an unqualified opinion on the Company’s internal control over financial reporting.

\s\ DELOITTE & TOUCHE LLP

Minneapolis, Minnesota

February 24, 2011


Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders
Select Comfort Corporation:

We have audited the accompanying consolidated balance sheet of Select Comfort Corporation and subsidiaries as of January 2, 2010, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the fiscal years in the two-year period ended January 2, 2010. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedule II related to valuation and qualifying accounts for each of the fiscal years in the two-year period ended January 2, 2010. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the 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, 2010, and the results of their operations and their cash flows for each of the fiscal years in the two-year period ended January 2, 2010, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

\s\ KPMG LLP

Minneapolis, Minnesota
February 25, 2010


SELECT COMFORT CORPORATION
AND SUBSIDIARIES

Consolidated Balance Sheets
January 1, 2011 and January 2, 2010
(in thousands, except per share amounts)

   
2010
   
2009
 
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 81,361     $ 17,717  
Accounts receivable, net of allowance for doubtful accounts of $302 and $379, respectively
    4,564       5,094  
Inventories
    19,647       15,646  
Income taxes receivable