Filed with the SEC from June 19 to June 25:
Select Comfort (SCSS)
Clinton Group called for replacement of Select Comfort's CEO, Bill McLaughlin, and revision of Select's marketing strategy. The group also expressed disappointment that the Minneapolis bed retailer had declined its request for two board seats. Clinton Group suggested that Select Comfort revise its marketing strategy to refocus on direct marketing, and immediately halt all new store openings and unnecessary capital expenditures until sales improve. Clinton Group holds 3,469,647 shares (7.73% of the total outstanding).
Select Comfort Corporation was founded as a Minnesota-based corporation in 1987 by an entrepreneur who developed and manufactured adjustable firmness mattresses after considering other alternatives such as innerspring and water mattresses. Select Comfort has evolved from a specialty, niche direct marketer, to a nationwide multi-channel business with fiscal 2007 net sales of $799 million.
Our principal business is to develop, manufacture, market and distribute premium quality, adjustable-firmness beds and other sleep-related accessory products. 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 nightâ€™s sleep to the consumer. We have a mission-driven culture focused on serving the needs of our customers. Our mission is to improve peopleâ€™s lives through better sleep. Our goal is to educate our consumers on the importance of a better nightâ€™s sleep and the unique benefits of our 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 â€śSCSS.â€ť When used herein, the terms â€śSelect Comfort,â€ť â€śCompany,â€ť â€śwe,â€ť â€śusâ€ť and â€śourâ€ť refer to Select Comfort Corporation, including consolidated subsidiaries.
Differentiated, Superior Product
The unique benefits of our proprietary Sleep Number bed have been validated through clinical sleep research. Clinical sleep research has shown that people who sleep on a Sleep Number bed generally fall asleep faster and experience deeper sleep with fewer disturbances than those sleeping on a traditional innerspring mattress. The proprietary air-chamber technology of our Sleep Number bed allows adjustable firmness of the mattress at the touch of a button. Our dual chamber technology (two independent air chambers) allows consumers to adjust the firmness on both sides of the bed to meet each personâ€™s individual preference. Our clinical research has shown that our bedâ€™s sleep surface generally provides better sleep quality and greater relief of back pain in comparison with traditional innerspring mattress products.
In 2001, we created the Sleep Number brand. This branding strategy allows our marketing communications to focus on our bedâ€™s distinguishing and proprietary features â€“ adjustable firmness and support for personalized comfort. This is represented by the digital Sleep Number display on the bedâ€™s hand-held remote control, with a brand message hierarchy as follows:
A Sleep Number Â® setting represents an ideal level of mattress comfort, firmness and support; and
You can only find your Sleep Number Â® setting on a Sleep Number Bed by Select Comfort â„˘ .
Controlled Selling Environment
Over 90% of our sales are generated through our company-controlled distribution channels â€“ 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 consumersâ€™ needs. Controlling the selling process enables us to ensure that the unique benefits of our products are effectively communicated to consumers. 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. The modular design of our Sleep Number bed allows a just-in-time, build-to-order production process which requires minimal inventory in our stores and manufacturing plants, resulting in reduced working capital levels. This just-in-time production process also allows our stores to serve primarily as showrooms, without requiring significant product storage capacity.
For 2006, we ranked as the 5 th largest mattress manufacturer according to the June 18, 2007 edition of Furniture/Today , with a 6% market share of industry revenue and 2% market share of industry units. We ranked as the leading U.S. bedding retailer, according to the Top-25 Bedding Retailers report in the August 13, 2007 edition of Furniture/Today . Our vision is to be a leading brand in the bedding industry.
Building Brand Awareness
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 Internet advertising and paid search in our media mix.
We also sell to commercial partners which increases awareness of our brand through media exposure, trial sales and word-of-mouth. These commercial partners include the QVC television shopping channel, the luxury motor home market and Radisson Hotels and Resorts Â® in the U.S., Canada and the Caribbean.
Over the long-term, we expect to operate over 600 company-owned stores in the U.S. with annual square footage growth increasing by 5% to 7% per year. We supplement our company-controlled distribution channels with sales through a limited number of leading home furnishings and specialty bedding retailers.
In 2005, we expanded our distribution network outside the U.S. with a retail partner relationship in Canada. In 2007, the Canadian retail partner relationship grew to 127 doors. During 2007, we formed a strategic alliance with two Australian-based companies to manufacture and distribute Sleep Number beds and accessories in Australia and New Zealand.
Our goal is to continue to lead the industry in innovative sleep products. 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 (â€śR&Dâ€ť) activities. During 2007, we upgraded our entire line of bed models. We believe the new line represents the highest-quality, most technologically advanced beds we have ever produced. Our top-end 7000 and 9000 models were re-launched in June 2007. The new versions of our 3000, 4000 and 5000 models were introduced to all of our stores in July 2007. All of our new models emphasize enhanced comfort-layer materials, and several feature advancements in temperature balancing technology. Our 2008 innovation plans include the launch of two new mattress models which will fill in key price points in our product line-up and provide easier step-up opportunities for our sales professionals.
Leveraging our Infrastructure
Our vertically-integrated business model provides multiple sources for efficiency and leverage. Sustaining such performance over a multi-year period is based on expected scale efficiencies (fixed cost utilization) and cost containment initiatives. We also have an ongoing focus on productivity gains through a variety of programs, including the implementation of a new enterprise resource planning system in the second half of 2008, optimization of our new hub and spoke network, value engineering, marketing and sales initiatives, and a Six Sigma initiative to improve product and service quality.
At the end of 2007, we offered five different Sleep Number bed models through our U.S. company-owned channels, including the Sleep Number 3000, 4000, 5000, 7000 and 9000. Each bed model comes in standard mattress sizes, ranging from twin to king, as well as some specialty mattress sizes. Our bed models vary in features, functionality and price. As you move up the product line, the Sleep Number bed models 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 are optimized when used with our specially designed, proprietary foundation. This durable foundation, 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 $1,000 for the entry-level Sleep Number 3000 queen-size set (mattress and foundation) to $4,000 for the luxurious Sleep Number 9000 queen-size set. Our most popular model is the 5000 queen-size set which sells for approximately $2,000. These prices are subject 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 (â€śUPSâ€ť). For an additional fee, customers can take advantage of our home delivery service, which includes bed assembly and optional mattress removal services.
We also manufacture our Sleep Number beds for distribution through our retail partners. Our retail partner beds have different model numbers or names, but have similar features and benefits, and sell for similar prices.
Each of our Sleep Number beds (not including our Precision Comfort adjustable foundation) comes with a 30 night in-home trial and better nightâ€™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.
In addition to our mattresses and foundations, we offer a line of accessory bedding products, including specialty pillows, mattress pads, comforters, sheets, bed foundations and leg options. The specialty pillows, available in a variety of sizes, materials and firmness levels, are designed to provide personalized comfort and better quality sleep for stomach, back or side sleepers. We also market our Personal Warmth Collectionâ„˘, a group of comforters and blankets designed to be warmer on one half of the bed than the other, accommodating varying warmth preferences among couples.
Other Products and Services
In 2003, we completed the roll-out of our Precision Comfort adjustable foundation to all of our company-owned retail stores. The adjustable foundation enables consumers to raise the head or foot of the bed, and to experience the comfort of massage, using a handheld remote control.
In 2004, we introduced the Sleep Number SofaBed line into a select number of our stores in selected U.S. markets. The Sleep Number SofaBed features a queen-size Sleep Number mattress inside a sofa surround, which is available in a variety of fabrics or leather options.
Unlike traditional bedding manufacturers, which primarily sell through third-party retailers, over 90% of our net sales are through one of three company-controlled distribution channels â€“ 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 consumers. Our direct-to-consumer business model enables us to understand and respond quickly to consumer trends and preferences.
Our retail stores accounted for 75% of our net sales in 2007. Average net sales per company-owned store were $1,318,000 in 2007 versus $626,000 in 2001, with average sales per square foot of $1,024 in 2007 versus $666 in 2001. New stores are expected to average in excess of $1,000,000 in net sales in the first year of operations. In 2007, 73% 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 15% of our net sales in 2007. 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. At the end of 2007, our retail program included 10 retail partners in the U.S. and Canada with a total of 891 doors, up from 353 doors at the end of 2005. Each retail partner serves a unique geographic market, which enables us to increase sales and leverage our media spending to accelerate brand awareness.
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 consumer more information or send a video and brochure. Our total media spending was approximately $110 million in 2007, $105 million in 2006, and $89 million in 2005.
Owners of Sleep Number beds purchased through company-controlled channels are members of our Comfort Club, our customer loyalty program designed primarily to increase referrals and repeat purchases. Each time a referred customer purchases a bed, the referring Comfort Club member receives a $50 coupon for purchase of our products, with increasing benefits for multiple referrals. In 2007, approximately 36,000 new customers bought beds after receiving referrals from our Comfort Club members, and existing owners bought approximately 32,000 additional beds.
Qualified customers are offered revolving credit to finance purchases through a private-label consumer credit facility provided by GE Money Bank. Approximately 44% of our net sales during 2007 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, 2011, 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, and is the owner of the accounts. 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. Consumers that do not qualify for credit under our agreement with GE Money Bank may apply for credit under a secondary program maintained by the company through another provider.
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 foundations. 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 currently shipped from our manufacturing facilities via UPS or through our company-controlled home delivery, assembly and mattress removal service, typically within 48 hours following order receipt. 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 foundations, 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. Beginning in 2005, we initiated work on dual and alternate sourcing, successfully introducing a second source for printed circuit boards and certain foam and fiber components. We will continue working toward dual sourcing on targeted components. However, we believe we can obtain these raw materials and components from other sources of supply in the ordinary course of business, if necessary.
Our proprietary air chambers are produced to our specifications by a sole source Eastern European supplier, which has been our sole source of supply of air chambers since 1994. Our agreement with this supplier runs through September 2011 and is thereafter subject to automatic annual renewal unless either party gives 365 daysâ€™ notice of its intention not to renew the agreement. We expect to continue this supplier relationship for the foreseeable future.
Our proprietary blow-molded foundations are produced to our specifications by a single domestic supplier under an agreement that expires in December 2010. 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 supplierâ€™s ability to maintain uninterrupted supply of materials and components.
Home Delivery Service
Select Comfortâ€™s home delivery, assembly and mattress removal service has contributed to improving the overall customer experience. Our home delivery technicians are Sleep Number bed owners who can articulate the benefits of the bed, reinforcing the sales process and ensuring satisfied customers. Approximately 60% of beds sold through our company-owned retail stores in 2007 were delivered by our full-service home delivery team.
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 new Hub and Spoke network organized around 13 regional hubs. Twelve of 13 hubs were operational as of December 2007.
We maintain an in-house customer service department staffed by customer service representatives who receive extensive training in sleep technology and all aspects of our products and operations. Our customer service representatives field customer calls and also interact with each of our retail stores to address customer questions and concerns. Our customer service team is part of our total quality process, facilitating early identification of emerging trends or issues. They coordinate with engineering and manufacturing 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 help enhance our products. Since the introduction of our first bed, we have continued to improve and expand our product line, including new bed models, a quieter Firmness Control System, remote controls with digital settings, more luxurious fabrics and covers, new generations of foams and foundation systems. Our research and development expenses were $5.7 million in 2007, $4.7 million in 2006, and $2.2 million in 2005.
We use information technology systems to operate, analyze and manage our business, to reduce operating costs and to enhance our customersâ€™ 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, retail partner support 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 and E-Commerce Web site have recently been relocated to our new state-of-the-art corporate headquarters with redundant environmental systems. We maintain a disaster recovery plan that is tested annually.
During the second half of fiscal 2008, we plan on implementing an integrated suite of SAPÂ®-based applications, including enterprise resources planning, retail store, customer relationship management, human capital management, strategic enterprise management, business intelligence and enterprise portal systems to replace most of our current systems. We believe this SAP Â® -based IT architecture, along with best-practices-based processes and greater utilization of off-the-shelf, highly integrated packaged solutions with minimal customization and enhancement, will provide greater flexibility and functionality for our growing and evolving business model and be less expensive to maintain over the long-term.
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, and features related to sofa sleepers with air mattresses, as well as other technology. We have 24 issued U.S. patents, expiring at various dates between March 2009 and June 2022, and five U.S. patent applications pending. We also hold 31 foreign patents and 9 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.
â€ś Select Comfort â€ť and â€ś Sleep Number â€ť are trademarks registered with the U.S. Patent and Trademark Office. We have a number of other registered trademarks including our â€ś Select Comfort â€ť logo with the double arrow design, â€ś Select Comfort Creator of the Sleep Number Bed ,â€ť â€ś Whatâ€™s Your Sleep Number? ,â€ť â€ś Precision Comfort, â€ť â€ś The Sleep Number Bed by Select Comfort â€ť (logo), â€ś The Sleep Number Store by Select Comfort â€ť (logo), â€ś Comfort Club â€ť and â€ś Sleep Better on Air â€ť and â€ś LuxLayer .â€ť U.S. applications are pending for a number of other marks. Several of these trademarks have been registered, or are the subject of pending applications, in various foreign countries. Each federally 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 our right to use these marks.
Industry and Competition
The U.S. bedding manufacturing industry is a mature and stable industry. According to the 2006 Annual Report by the International Sleep Products Association (ISPA), industry wholesale shipments of mattresses and foundations were estimated to be $6.8 billion in 2006, a 5% increase compared to $6.5 billion in 2005. We estimate that traditional innerspring mattresses represent approximately 77% of total U.S. bedding sales. Furniture/Today, a furniture industry trade publication, has ranked Select Comfort as the largest U.S. bedding retailer for seven consecutive years, most recently in its August 13, 2007 issue.
According to the 2006 Annual Report by ISPA, since 1984 the industry has consistently demonstrated growth on a dollar basis, with a 0.3% decline in 2001 being the only exception. Over the 5-year, 10-year and 20-year periods ended 2006, the value of U.S. wholesale bedding shipments increased at compound annual growth rates of 8.1%, 7.3% and 6.5%, 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 highly fragmented and 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 bedding market. Simmons and Sealy, as well as a number of smaller manufacturers, have offered air-bed products in recent years. Tempur-Pedic International, Inc., and a number of other mattress manufacturers, offer foam mattress products.
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.
A portion of our net sales consists of refurbished products that are assembled in part from components returned to us from customers. These refurbished products must be properly labeled and marketed as refurbished products under applicable laws. Our sales of refurbished products are limited to approximately 24 states, as other states do not allow the sale of refurbished bedding products.
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, potentially reducing our manufacturing capacity. These regulations also result in higher product development costs as new products must undergo rigorous flammability testing.
Our direct marketing and E-Commerce operations are or may become subject to various adopted or proposed federal and state â€śdo not callâ€ť and â€śdo not mailâ€ť 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 limit our ability to maintain or use consumer or customer information in our business.
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 as 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.
We believe we are in compliance in all material respects with each of these governmental regulations.
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 2007, there were no material capital expenditures for environmental control facilities and no such material expenditures are anticipated.
No single customer accounts for 10% or more of our net sales, and the loss of any one customer would not have a material impact on our business.
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.
Our investment to open a new store is approximately $250,000, including inventory. We target new stores to be cash flow positive within 12 months with a payback of the initial cash investment in less than 24 months. Our stores break even on a four-wall cash flow basis with approximately $600,000 of annual net sales. Our four-wall cash flow is calculated as gross profit generated from store sales less store expenses, without deduction of depreciation expenses or indirect marketing expenses.
The component nature of our products allows our stores to serve as product showrooms for our Sleep Number beds. This aspect of our business model allows us to maintain low inventory levels which enables us to operate with minimal working capital. We have historically generated sufficient cash flows to self-fund our growth through an accelerated cash-conversion cycle. In addition, our $100 million bank revolving line of credit is available for additional working capital needs or investment opportunities. However, we may elect to seek additional sources of capital to fund growth initiatives, or if a prolonged or more severe economic downturn impacts our ability to meet our financial covenants.
At December 29, 2007, we employed 3,247 persons, including 1,691 retail sales and support employees, 214 direct marketing and customer service employees, 1,007 manufacturing and logistics employees, and 335 management and administrative employees. Approximately 190 of our employees were employed on a part-time basis at December 29, 2007. Except for managerial employees and professional support staff, all of our employees are paid on an hourly basis plus commissions for sales associates. None of our employees are represented by a labor union or covered by a collective bargaining agreement. We believe that our relations with our employees are good.
Thomas J. Albani has served as a member of our Board of Directors since February 1994. Mr. Albani served as President and Chief Executive Officer of Electrolux Corporation, a manufacturer of premium floor care machines, from June 1991 to May 1998. From September 1984 to April 1989, he was employed by Allegheny International Inc., a home appliance manufacturing company, in a number of positions, most recently as Executive Vice President and Chief Operating Officer.
David T. Kollat has served as a member of our Board of Directors since February 1994. Dr. Kollat has served as President and Chairman of 22 Inc., a research and consulting company for retailers and consumer goods manufacturers, since 1987. From 1976 until 1987, he served in various capacities for The Limited, a women's apparel retailer, including Executive Vice President of Marketing and President of Victoria ' s Secret Catalogue. Dr. Kollat also serves as a director of Big Lots, Inc., The Limited, Inc. and Wolverine World Wide, Inc.
William R. McLaughlin joined our company in March 2000 as President and Chief Executive Officer and as a member of our Board of Directors. In May 2004, Mr. McLaughlin was also named Chairman of our Board of Directors. 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.
Christopher P. Kirchen has served as a member of our Board of Directors since December 1991. Mr. Kirchen is currently Managing General Partner of BEV Capital, a venture capital firm that he co-founded in March 1997. From 1986 to December 2002, he was a General Partner of Consumer Venture Partners, a venture capital firm and a former investor in our company. Mr. Kirchen also serves as a director of several privately held companies.
Brenda J. Lauderback was appointed to our Board of Directors in February 2004. Ms. Lauderback served as President of the Retail and Wholesale Group for the Nine West Group, Inc., a designer and marketer of women's footwear and accessories, from May 1995 until January 1998. Ms. Lauderback also serves as a director of Big Lots, Inc., Irwin Financial Corporation, Wolverine World Wide, Inc. and Dennyâ€™s Corporation.
Michael A. Peel has served as a member of our Board of Directors since February 2003. Mr. Peel has served as Senior Vice President, Human Resources and Corporate Services of General Mills, Inc., a manufacturer and marketer of packaged consumer foods, since 1991. From 1977 to 1991, Mr. Peel served in various capacities for PepsiCo, Inc., including as Senior Vice President, Human Resources for PepsiCo Worldwide Foods from 1987 to 1991.
Jean-Michel Valette has served as a member of our Board of Directors since October 1994. Mr. Valette is an independent adviser to branded consumer companies. In April 2005, Mr. Valette was named the Chairman (non-executive) of Robert Mondavi Winery and from October 2004 to April 2005 he served as President and Managing Director of Robert Mondavi Winery. Since January 2004 he has served as Chairman of the Board of Directors of Peetâ€™s Coffee and Tea, Inc. From August 1998 to May 2000, Mr. Valette served as President and Chief Executive Officer of Franciscan Estates, Inc., a Napa Valley winery. He was a Managing Director of Hambrecht & Quist LLC, an investment banking firm, from October 1994 to August 1998 and served as a Senior Analyst at Hambrecht & Quist LLC from November 1992 to October 1994. Mr. Valette also serves as a director of The Boston Beer Company.
Christine M. Day was appointed to our Board of Directors in November 2004. From July 2004 until February 2007, Ms. Day served as President of Asia Pacific Group, Starbucks Coffee International. Prior to holding this position, she served as Senior Vice President, Starbucks Coffee International. From 1987 to 2003, Ms. Day served in various other capacities for Starbucks, including Senior Vice President, North American Finance and Administration; Senior Vice President, North American Strategic Business Systems; and Vice President of Sales and Operations for Starbucks foodservice and licensed concepts division.
Stephen L. Gulis, Jr., was appointed to our Board of Directors in July 2005. Since April 1996, Mr. Gulis has been the Executive Vice President, CFO and Treasurer of Wolverine World Wide, Inc. (WWW). From 1988 to 1996, Mr. Gulis served in various capacities with WWW, including CFO, Vice President of Finance, and Vice President Finance and Administration of the Hush Puppies Company. Prior to joining WWW, he served six years on the audit staff of Deloitte & Touche. Mr. Gulis also serves as a director for Independent Bank Corporation.
Ervin R. Shames has served as a member of our Board of Directors since April 1996. From April 1996 to April 1999, Mr. Shames served as Chairman of our Board of Directors. In May 2004, Mr. Shames also assumed the role of Lead Director under our Corporate Governance Principles. Since January 1995, Mr. Shames has served as an independent management consultant to consumer goods and services companies, advising on management and marketing strategy. Since 1996, he has been a Lecturer at the University of Virginia's Darden Graduate School of Business. From December 1993 to January 1995, he served as the Chief Executive Officer of Borden, Inc. and was President and Chief Operating Officer of Borden, Inc. from July 1993 until December 1993. From June 1990 to June 1992, he was the Chief Executive Officer of Stride Rite Corporation and from June 1992 to July 1993 he was Stride Rite's Chairman and Chief Executive Officer. From 1967 to 1989, Mr. Shames was employed by General Foods/Altria Companies in varying capacities including the presidencies of General Foods International, General Foods USA and Kraft USA. Mr. Shames serves as a director of Online Resources Corporation, Choice Hotels International, Inc. and several privately held companies.
Base Salary . Base salaries for our executive officers are reviewed annually, shortly after the end of each fiscal year. In order to enable the company to attract and retain executive officers who will enable us to build a significantly larger enterprise, the Committee seeks to benchmark base salaries at the median of the general industry survey data, as adjusted by regression analysis to account for company size.
In addition to the broad industry market data and comparisons with the peer group noted above, the Committee considers other factors in arriving at or adjusting each executive officerâ€™s base salary, including: (1) each executive officerâ€™s scope of responsibilities; (2) each executive officerâ€™s qualifications, skills and experience; (3) internal pay equity among senior executives; and (4) individual job performance, including both impact on current financial results and contributions to building longer-term competitive advantage and shareholder value. Annual increases in base salary are primarily driven by the Committeeâ€™s evaluation of individual performance.
Annual Cash Incentive Compensation . We provide annual cash incentive compensation for executive officers and other employees under our Executive and Key Employee Incentive Plan (the â€śAnnual Incentive Planâ€ť). The Annual Incentive Plan is designed to drive company-wide performance for the relevant fiscal year at or above our stated long-term growth and profitability objectives. Consistent with the companyâ€™s performance-based compensation philosophy, the Board seeks to set its company-wide financial performance objectives so as to achieve above-median performance relative to the companyâ€™s peer group. The Committee then seeks to set annual cash incentive targets so that achievement of above-median performance will enable the executives to achieve above-median total cash compensation.
At the beginning of each fiscal year, the Committee determines the three principal elements of the Annual Incentive Plan for the coming fiscal year: (1) the performance goals; (2) the target bonus levels, expressed as a percentage of base salary; and (3) the split between company-wide performance goals and individual performance goals (if any). Actual bonus payments are increased above the target bonus levels for results that exceed the performance goals and are decreased below the target bonus levels, and may be reduced to zero, for results that do not fully meet the goals, with the amount of the increase or decrease based on a sliding scale determined by the Committee.
â€˘ Performance Goals . The Committee determines both the type and the amount of the performance goals for each year. The Annual Incentive Plan limits the types of performance goals to quarterly or annual sales growth or volume, net operating profit before tax, cash flows, earnings per share, return on capital employed, and/or return on assets.
In the several years immediately prior to the establishment of the Annual Incentive Plan in 2001, the company had experienced stagnating growth and operating losses. As a result, since the inception of the Annual Incentive Plan, the Committee has selected company-wide annual net operating profit as the primary performance goal based on its belief that this performance measure provides a balanced focus on both revenue growth and improved profitability. For 2005 and 2006, the Committee also added company-wide unit sales growth as a secondary performance goal. For 2007, the Committee has again established company-wide net operating profit as the primary performance goal and has established an extraordinary revenue growth target as a secondary performance goal (provided that a minimum level of net operating profit as a percentage of net sales is maintained).
As noted above, the amount of the performance goals, i.e., the amount of net operating profit required to be achieved for bonuses at the target level, is designed to reflect above-median performance relative to the companyâ€™s peer group. The Committee believes that the performance goals have generally met this standard as the targets have been exceeded in three of the last five fiscal years, and have not been met in two of the last five fiscal years, while the company has significantly outperformed its industry and delivered cumulative average growth rates in net sales and earnings per share of 24% and 45%, respectively, over the last five fiscal years.
In 2005, the company achieved both competitively superior net operating profit growth of 38%, and also achieved its secondary unit sales growth target, resulting in payments at 133% of the target bonus levels described above. In 2006, the company fell short of its profit growth objective (while still achieving growth in earnings per share on a like-for-like accounting basis of 23%), and did not achieve its unit growth objective, resulting in bonus payments at 83% of the target bonus levels.
In 2006, the Committee exercised its discretion and adjusted the performance target to account for two items that were not contemplated when the annual performance targets were first established at the beginning of the year. The Committee reduced the targeted net operating profit level by approximately $1.9 million to offset a correction in warranty accruals recognized in our 2006 consolidated results of operations to include freight costs which had not been included in prior periods and by approximately $0.4 million to offset incremental expenses arising from the special five-year stock option grant to the companyâ€™s Chairman and CEO discussed in greater detail below. The Committee did not adjust the performance target for approximately $6.0 million in asset impairment charges taken during the third and fourth quarter of 2006 related to the write-off of systems development work due to the decision to pursue an SAP-based information technology architecture and the difference between the fair value and net book value of certain impaired store assets, which resulted in the reduction of bonus payments from approximately 98% of targeted levels to 83% of targeted levels.
For 2007, the Committee has established net operating profit of $90.1 million, which represents growth of 20% versus 2006 (as adjusted for the two items noted in the preceding paragraph that reduced the 2006 target), as the performance benchmark for payment of bonuses at target levels, which the Committee believes would reflect above-median pay for above-median performance. Actual results above the net operating profit goal would result in a 3.5% increase in the bonus payment for each 1% increase in net operating profit. Actual results below the net operating profit goal would result in a 2.5% decrease in bonus payment for each 1% decrease in net operating profit. The steeper slope for above-target performance reflects the Committeeâ€™s objective of payment of above-median compensation for above-median performance. If the 2007 net operating profit is at or below $75.1 million, which would represent no growth versus 2006, no incentive compensation would be payable under the Annual Incentive Plan.
The 2007 Annual Incentive Plan design also provides for an additional 15% increase in the bonus payout if net sales meet or exceed the companyâ€™s stretch objective of $1 billion (which would represent 24% top-line growth versus 2006) and net operating profit is at least 10% of net sales (versus 9% of net sales for 2006). The Committee believes that this is an effective means of aligning the entire organization behind achievement of an important strategic milestone.
â€˘ Target Bonus Levels . The target bonus level for the CEO has been set at 75% of base salary for each year since 2002. The target bonus level for each of the other named executive officers has been set at 55% of base salary for each year since 2003. These target bonus levels were initially benchmarked against high growth companies of the same size and larger and these target bonus levels are reviewed annually against these benchmarks. As noted above, these target bonus levels, when combined with the performance goals established by the Committee are designed to deliver above-median total cash compensation for above-median performance relative to the companyâ€™s peer group.
â€˘ Split between Company-Wide Goals and Individual Goals . The Annual Incentive Plan specifies that, for senior executive officers, at least 75% of any award must be based on objective company-wide performance goals and not more than 25% of any award may be based on objective individual performance goals. Since the inception of the Annual Incentive Plan, the Committee has based awards payable to senior executives entirely on objective company-wide performance goals. The Committee believes that this approach has properly focused the senior management team on delivery of common, company-wide objectives aligned with the interests of our shareholders. The Committee has elected to recognize and reward strong individual performance through merit increases in base salary and through enhanced equity awards, rather than through establishment of individual goals under the Annual Incentive Plan.
In order to enable compensation paid under our Annual Incentive Plan to qualify for an exemption from limits on deductibility of compensation in excess of $1 million under Internal Revenue Code section 162(m) and related regulations, we have chosen to submit the material terms of the performance goals under the Annual Incentive Plan to our shareholders for approval every five years. Our shareholders initially approved the material terms of these performance goals in 2001 and approved them again in 2006.
Long-Term Equity-Based Incentive Compensation . We make long-term incentive compensation available to our executive officers, as well as to many of our other employees, in the form of stock options, restricted stock awards and performance stock awards. Through the grant of these equity incentives, we seek to align the long-term interests of our executives and other employees with the long-term interests of our shareholders by creating a strong and direct linkage between compensation and shareholder return. We further seek to enable executives and other key employees to achieve significant ownership in our company, thereby improving our ability to retain executives and other key employees. As we offer no pension or defined benefit retirement plan, long-term equity-based incentive grants are an important element in enabling our employees at all levels to build savings for retirement.
Executive officers and other employees are eligible for equity-based grants upon joining the company and thereafter on an annual basis. The annual long-term equity-based awards are typically granted in late February or early March of each year, following the completion of our annual audit and release of our earnings for the prior fiscal year, and coinciding with our annual performance review process and our first quarter Board meeting.
Historically, stock option grants have been the primary form of equity-based incentives granted to our executives and other key employees. In 2003, we began to grant restricted stock awards to certain executives and other key employees for retention and recognition purposes and to further align the interests of these employees with those of our shareholders. In 2005, we began to grant performance stock awards to executive officers, vice presidents and director-level employees, with the mix of annual awards for these employees targeted at 75% in the form of stock options and 25% in the form of performance stock awards. Key employees below the director level receive equity compensation grants exclusively in the form of restricted stock. With the adoption of stock option expensing in 2006, we believe the increased use of restricted stock and performance stock provides an effective means of delivering variable, performance-based equity compensation to our employees.
Restricted stock awards represent full share grants that become fully vested and owned by the employee free of restrictions only at the end of four years from the date of grant, provided the employee continues in service with the company.
Performance stock awards are essentially similar to restricted stock awards, with the number of shares that may ultimately vest to the employee determined on the basis of the companyâ€™s performance against net operating profit targets in the year of grant. The number of shares may be increased by up to 50% or decreased by up to 75% for above or below-plan performance in the year of grant. The table below sets forth the award multipliers for each level of performance against our net operating profit goals. The performance bands set forth below have been tightened from the performance bands used in 2005 and 2006, during which no adjustments resulted for performance between 90% and 110% of the net operating profit target.
MANAGEMENT DISCUSSION FROM LATEST 10K
Select Comfort is the leading developer, manufacturer and marketer of premium-quality, adjustable-firmness beds. 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 nightâ€™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 leading home furnishings retailers, specialty bedding retailers, the QVC shopping channel and to several end users such as Radisson Hotels and ResortsÂ®.
Vision and Strategy
Our vision is to be a leading brand in the bedding industry, while improving peopleâ€™s lives through better sleep.
We are executing against a defined growth strategy which focuses on the following key components:
Building brand awareness and increasing store traffic through effective marketing programs;
Prudently managing our business in the current economic environment through disciplined controls over costs and cash;
Expanding distribution, primarily through our company-owned stores, with a long-term goal of operating over 600 company-owned stores in the U.S.;
Accelerating product innovation to lead the industry in innovative sleep products; and
Leveraging our infrastructure in order to facilitate long-term profitable growth.
Results of Operations
Fiscal 2007 Summary
Financial highlights for the fiscal year ended December 29, 2007 were as follows:
Net income totaled $27.6 million, or $0.57 per diluted share, compared with $47.2 million or $0.85 per diluted share in 2006.
Net sales decreased 1% to $799.2 million, compared with $806.0 million for the prior year, primarily due to an 11% comparable-store sales decline in our company-owned retail stores, partially offset by 36 net new company-owned retail stores opened in the past 12 months.
Our 2007 gross profit rate of 60.9% was consistent with the prior year. Increased manufacturing costs to comply with the new fire retardant product regulations and increased material costs for our new bed line, were offset by continued efficiency gains in manufacturing and logistics.
Sales and marketing expenses increased to 46.6% of net sales in 2007, compared with 42.4% of net sales for the prior year. The rate increase was driven by the deleveraging impact of an 11% comparable-store sales decrease.
General and administrative expenses declined $1.0 million compared with the prior year and remained consistent as a percentage of net sales.
Cash provided by operating activities in 2007 totaled $44.0 million, compared with $59.4 million for the prior year.
During 2007, we repurchased $131.9 million or 7.6 million shares of common stock (based on trade dates) compared with $79.7 million or 3.9 million shares in 2006.
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.
Comparison of 2007 and 2006
Net sales in 2007 decreased 1% to $799.2 million, compared with $806.0 million in 2006. The sales decrease was due to an 11% comparable-store sales decline in our company-owned retail stores and a decrease in direct channel sales, partially offset by sales from 36 net new company-owned retail stores opened in the past 12 months and sales growth in our E-Commerce and wholesale distribution channels. Total sales of mattress units decreased 1% compared to 2006, and the average selling price per bed (mattress sales only divided by mattress units) in our company-controlled channels was essentially flat at $1,694, while sales of other product and services increased by 2%.
The $6.8 million net sales decrease compared with 2006 was comprised of the following: (i) a $12.2 million decrease in direct marketing sales and (ii) an $11.6 million net decrease in sales from our company-owned retail stores, comprised of a $66.3 million decrease from comparable-stores and a $54.7 million increase from new stores, net of stores closed, partially offset by, (iii) a $9.0 million increase in E-Commerce sales and (iv) an $8.0 million increase in wholesale sales.
The gross profit rate of 60.9% in 2007 was consistent with the prior year. The gross profit rate benefited from improvements in sourcing, manufacturing productivity and our ongoing implementation of a hub-and-spoke logistics network which reduced our cost of sales. The gross profit rate also benefited from a reduction in warranty costs per unit.
These items were offset by increased costs to comply with the new open flame fire retardancy standards which became effective for all products manufactured after July 1, 2007 and increased production costs associated with our new line of beds. In addition, the gross profit rate was negatively impacted by a sales mix shift to lower margin products which reduced the gross profit rate by approximately 0.4 percentage points (â€śpptâ€ť).
Sales and Marketing Expenses
Sales and marketing expenses in 2007 increased to $372.5 million, or 46.6% of net sales, compared with $341.6 million, or 42.4% of net sales in 2006. The $30.9 million expense increase was primarily due to operating costs associated with 36 net new stores opened in the past 12 months, an increased use of promotional financing offers and increased media spending. The 4.2 ppt sales and marketing expense rate increase was primarily due to the deleveraging impact of an 11% comparable-store sales decline and the $30.9 million expense increase compared with the prior year. Total media spending increased 4% compared with 2006 and was 0.7 ppt higher on a rate basis.
General and Administrative Expenses
General and administrative (â€śG&Aâ€ť) expenses decreased $1.0 million to $64.4 million in 2007, compared with $65.4 million in 2006, and remained consistent with the prior year on a rate basis. G&A expenses were favorably impacted by a $3.7 million reduction in incentive-based compensation costs compared to the prior year, partially offset by an increase in other expenses of $2.7 million, including increased information technology expenses and occupancy costs.
Research and Development
Research and development (â€śR&Dâ€ť) expenses increased to $5.7 million in 2007 compared with $4.7 million in 2006, and increased as a percentage of net sales to 0.7% from 0.6%. The dollar and percentage of net sales increases in R&D expenses were the result of continued investment in new product innovation and increased development costs to comply with the new open flame fire retardancy standards.
Asset Impairment Charges
Asset impairment charges decreased to $0.4 million in 2007, compared with $6.0 million in 2006. The 2007 asset impairment charges primarily related to assets at underperforming stores. The 2006 asset impairment charges included $5.4 million for abandoned software in connection with our decision to implement a new SAPÂ® enterprise resource planning system, and $0.6 million related to assets at underperforming stores.
Other (Expense) Income, Net
Other expense was flat in 2007, compared with $3.0 million of other income in 2006. The $3.0 million decrease was driven by lower average cash and investment balances compared with 2006 which resulted in reduced interest income, increased interest expense from borrowings under our revolving line of credit to fund 2007 common stock repurchases and $0.3 million of net realized losses on the sales of marketable debt securities.
Income Tax Expense
Income tax expense decreased to $15.8 million in 2007, compared with $28.6 million in 2006. The effective tax rate was 36.5% and 37.8% in 2007 and 2006, respectively. The lower effective tax rate in 2007 was primarily due to research and development income tax credits recognized in 2007 based on federal tax law changes, and increased tax benefit related to manufacturing deductions.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Comparison of Three Months Ended September 29, 2007 with Three Months Ended September 30, 2006
Net sales increased 3% to $213.1 million for the three months ended September 29, 2007 compared with $207.7 million for the same period one year ago. The sales increase was driven by sales from 46 net new company-owned retail stores opened in the past 12 months and sales growth in our e-commerce channel, partially offset by a 6% comparable-store sales decline in our company-owned retail stores, and a sales decrease in our direct channel. Sales of mattress units increased 1% overall compared to the same period one year ago, and the average selling price per bed (mattress sales only divided by mattress units) in our company-controlled channels increased 1% to $1,726, while sales of other products and services increased by 8%.
The $5.4 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $5.0 million increase in sales from our retail stores, comprised of a $14.9 million increase from new stores, net of stores closed and a $9.9 million decrease from comparable-stores and (ii) a $3.3 million increase in e-commerce sales, partially offset by, (iii) a $2.8 million decrease in direct marketing sales and (iv) a $0.1 million decrease in wholesale sales.
The gross profit rate decreased to 61.6% of net sales for the three months ended September 29, 2007 as compared with 62.0% for the same period one year ago. A sales mix shift to lower margin products reduced the gross profit rate by approximately 0.4 percentage points (ppt). In addition, the third quarter of fiscal 2007 gross profit percentage included the full burden of costs for compliance with the new open flame fire retardancy standards and increased production costs associated with our new line of beds. These incremental costs were partially offset by improvements in sourcing, manufacturing productivity and our ongoing implementation of a hub-and-spoke logistics network. Finally, increased use of promotional financing offers (which increased sales and marketing expenses) in lieu of product discounts, benefited the third quarter gross profit rate by 0.2 ppt.
Sales and marketing expenses
Sales and marketing expenses for the three months ended September 29, 2007 increased 9% to $95.7 million, or 44.9% of net sales, compared with $87.7 million, or 42.2% of net sales, for the same period one year ago. The $8.0 million increase was primarily due to a higher number of stores and an increased use of promotional financing offers. The 2.7 ppt sales and marketing expense rate increase was principally due to the deleveraging impact of a 6% comparable store sales decline and the $8.0 million expense increase compared with the same period one year ago. Total media spending decreased 3% compared with the same period one year ago and was 0.7 ppt lower on a rate basis.
General and administrative expenses
General and administrative (G&A) expenses decreased 8% to $14.9 million for the three months ended September 29, 2007 compared with $16.1 million for the same period one year ago and decreased 0.8 ppt on a rate basis. The $1.3 million decrease in G&A expenses was comprised of a $1.9 million reduction in incentive-based compensation costs, partially offset by a $0.4 million increase in occupancy costs and a $0.2 million increase in other G&A expenses.
Research and development expenses
Research and development (R&D) expenses increased to $1.3 million for the third quarter of fiscal 2007 compared with $1.1 million for the same period one year ago, and increased as a percentage of net sales to 0.6% from 0.5% for the comparable prior-year period. The increase in R&D expenses was the result of continued investment in new product innovation.
Asset impairment charges
Asset impairment charges decreased to $0.2 million for the three months ended September 29, 2007, compared with $1.8 million for the same period one year ago. The fiscal 2007 third quarter asset impairment charges related to assets at two underperforming stores. The fiscal 2006 third quarter asset impairment charges included $1.2 million for abandoned software and $0.5 million related to assets at underperforming stores.
Interest (expense) income, net
Net interest expense was $0.3 million for the three months ended September 29, 2007 compared to net interest income of $0.6 million for the same period one year ago. The change was primarily due to interest expense from borrowings under our revolving line of credit to fund fiscal 2007 common stock repurchases and lower average cash and investment balances compared with the same period one year ago.
Income tax expense
Income tax expense decreased to $7.0 million for the three months ended September 29, 2007 compared with $8.6 million for the same period one year ago. The effective tax rate was 37.0% for the third quarter of fiscal 2007 and 38.1% for the same period one year ago. The third quarter of fiscal 2007 tax rate included $0.2 million of discrete tax adjustments related to the resolution of certain federal and state income tax matters.
Thank you, operator. Good afternoon, and welcome to Select Comfort Corporationâ€™s first quarter 2008 Earnings Call. Thank you all for joining us. I am Mark Kimball, Senior Vice President and General Counsel. With me on the call are Bill McLaughlin, our President and Chief Executive Officer; and Jim Raabe, our Senior Vice President and Chief Financial Officer.
In a moment, Iâ€™ll turn the call over to Bill. Following our prepared remarks, we will open the call to your questions.
Please be advised that this telephone conference is being recorded and will be available by telephone replay. It will also be archived on our website. Please refer to the details set forth in our press release to access the replay on our website. The primary purpose of this call is to discuss the results of the fiscal period just ended. However, our commentary and responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings release and discussed in some detail in our Annual Report on Form 10-K and other periodic filings with the SEC. The companyâ€™s actual future results may vary materially.
Before I turn the call over to Bill, we have prepared a few slides to support our discussion today. To access these slides, please go to the Investor Relations section of our website at selectcomfort.com. We will reference the slide as appropriate during our prepared remarks.
I will now turn the call over to Bill for his comments.
Thanks, Mark, and welcome to everyone on the call. During our last earnings call, I stated that the first half of 2008 would be a challenge and to date this certainly has been true. As announced earlier today, Select Comfort experienced a 22% decline in sales for the quarter. The decline was the result of a combination of external and internal factors affecting our business.
There are two points Jim and I want to share with you today. First, although this certainly was a difficult quarter, we do not believe it represents what we can expect the balance of the year. Second, we want to share the action and actions that we will take that we believe will return the company to profitability in the second half of the year.
Like retailers across the country, weâ€™ve been affected by the downturn in consumer confidence and discretionary spending, which accelerated late in the fourth quarter of 2007 and into the first quarter of this year. While we have no unique insight into forecasting macroeconomic trends, we are not anticipating any marketplace improvement in 2008. That said, we are committed to returning our business to profitable growth, focusing on what we can control to realize the full potential of our great product.
For those of you who have accessed the slides, weâ€™ve provided, the first slide summarizes our results for the period. Revenue was $48 million less than year ago. Pre-tax profit was down $28 million, and importantly, free cash flow was a positive $4 million.
The second slide speaks to why. In addition to macro trends, our revenue in the quarter was affected by a few important, non-reoccurring factors that we are not expected to be an issue during the balance of the year. For example, wholesale revenue was $7 million less in the first quarter than the prior year. This was due in part to the timing of a QVC program and also due in part to prior year retail partner sales in advance of the conversion to fire retardant models.
Sales in the quarter were also negatively affected by a decision to balance spending with sales performance, lowering marketing support until the new brand campaign, which launched late in the quarter.
First quarter profit also does not reflect the margins that we anticipate going forward. Gross margin was 58% in the first quarter. It was impacted by a particularly soft product mix early in the period as we featured entry price point value and before we launched our new mid-priced product. Gross margin also was challenged by underutilized staffing of production lines until late in the quarter. Similarly, SG&A was de-leveraged for much of the quarter, and restructuring severance expense of 1.5 million impacted the quarter.
That said, over the past months, we began implementing programs to position the company for profitability in the second half. We targeted achieving lower overhead costs in line with prior years when sales were lower. With more clarity on commodity outlook for the year, we targeted actions to position us to achieve a gross margin of 60% or better by year end. To stabilize and eventually return to top line growth, we recommitted to our planned product innovation schedule, to increase marketing investments, and to continue investment in our selling leadership and customer experience. And to preserve cash and to focus our smaller work team on immediate priorities, we postponed and delayed a range of work and capital expenditures including delaying the SAP launch, reducing the number of new stores and remodels, and cutting investments in international expansion.
We also are working closely with our banks. Given the challenging market conditions, we believe it is prudent to maintain proactive communication with our banking partners. We remain in compliance with our loan covenants at this time. And we believe the actions we are taking to preserve cash and manage the business will help ensure we stay well within the $100 million amount of our credit line. Specifically, to reduce expense and protect margin, we took a number of important actions in the quarter that we expect to contribute an incremental $30 million in margin in 2008 and more than $45 million annually.
As represented on slide five, these included reducing headquarter staff by 17%, which we completed in March, re-sizing our selling teams to reflect the anticipated sales level also completed in March. We reduced plant shifts in March, again to reflect anticipated sales levels with contingency plans and flexibility to scale up as needed. And we set tactical pricing actions and reductions in promotional discounts for the second half of the year. These cost and margin improvement actions will allow us to invest in increased media. We now planned to spend at 2007 levels for the rest of the year.
Let me offer a brief perspective on our marketing opportunity, which is summarized on slide six. As a company that has a very special product with a unique point of difference, we believe we have a meaningful competitive advantage, yet, our top of mind brand and store awareness are still low. This presents substantial opportunity for our business and our marketing.
In order to consider our brand, consumers must first know who we are, how our product uniquely can help them, and where to find us. For the first time ever we are approaching this task as a multi-channel retailer, aligning our messaging and spend to the opportunity across our stores, call center and web.
Our new marketing programs aim to both drive broad awareness as well as to advance consideration to learn more about Sleep Number beds. This includes the addition of awareness building, broad reach media on top of a strong foundation of cost efficient, longer length, direct response advertising, which offers depth of information and trackability.
We also have sharpened our message to expand our appeal. Our past marketing built awareness of dual adjustability. Research indicated a Sleep Number was sometimes misunderstood to represent a fixed point in time determined at the store and never readjusted. Research revealed an opportunity to build on the unique product feature of individual adjustability day in and day out and over time. This significantly increases the relevance of the Sleep Number bedsâ€™ benefit to a broader audience.
Our new brand marketing campaign leverages a proprietary selling line in Sleep Number itâ€™s the bed that counts. Based on extensive focus groups, consumers responded positively to the dual meaning of this idea. Furthermore, research shows that in order to believe that they will sleep better, consumers must first be persuaded that a bed is truly comfortable. Our new work strongly communicates that the most comfortable sleep is the one you control yourself. Our new campaign also leverages a timely consumer insight that the tougher your day the more you deserve a Sleep Number night.
Most importantly, early end market results show measurable improvement in overall trends and particularly, in local markets receiving incremental media support. We believe we have found an enduring long-term idea in Sleep Number, itâ€™s the bed that counts. This new brand marketing campaign has reenergized our sales force, and upcoming executions will continue to build the breadth and appeal of this idea with scenarios that highlight the benefit of personalized comfort.
Beyond marketing and the other first quarter initiatives that we have discussed, we continue to review all areas of our business to ensure weâ€™re taking the right steps to improve performance in cost and growth.
Much like our turnaround in 2001, the milestones that we will monitor include first, cost and margin improvement; second, we look for volume trends stabilization particularly in our company-controlled channels; third is cash, we made significant gains in quarter one on working capital and our focus will be to maintain and possibly build on these gains; and fourth is people. With our restructuring behind us, we are now working with our teams to ensure proper focus and understanding of priorities and expectations.
We have a great team that is committed to moving forward and celebrating our future wins.
In summary, I have shared with you our perspective on the first quarter and what we are working on for the balance of the year. Management and the Board know what must be done to improve our business performance, and we are well down the path of execution, and there are early signs of improvement. Second quarter will continue to be difficult as itâ€™s our seasonal low period, and we will only experience partial benefit at some of our cost and pricing actions. Our focus is on executing a few things well and getting the greatest benefit out of each program. We are looking to stabilize volume and restore profitability in the second half.
With that, Iâ€™ll turn it over to Jim who will provide additional financial information about the quarter and our outlook.
Thanks Bill. As indicated, sales for the first quarter totaled $168.2 million. All channels experienced the impact of consumer spending slowdown and our reduced media investment.
Slide 7 provides an overview of channel sales. Retail sales declined $33 million on a same-store sales decline of 25% net of 34 new store openings. We also completed three store remodels utilizing our new stores design. We continue to see sales performance in these stores as significantly better than our existing design. E-commerce and direct marketing sales declined by 27%. These channels were impacted more significantly by media investment level and should respond well to comparably higher media spend over the balance of the year.
As it relates to wholesale, sales were negatively impacted due to the shift of a large QVC show from the first to the second quarter and from a 48% decline in retail partner channel sales due primarily to the introduction of fire retardant product in the first quarter of last year. The QVC show that was shifted to the end of March successfully kicked off the start of the second quarter.
Over the balance of the year, we expect 17 more store openings, 12 store closings, and 17 more store remodels. In addition to slowing the pace of new store openings, we continue to monitor our existing store base to determine if additional actions are necessary. Store growth will remain essentially flat over the balance of the year having a declining impact on sales. Same-store growth should be favorably impacted by slowing new store growth and additional store remodels. We expect to end 2008 with approximately 485 stores, 58 with our new store design.
Our next slide shows operating profits declined from $16.8 million in profit a year ago to an $11 million loss this year. The most significant contributors were the $48 million sales shortfall and a decline in gross margin rate to 57.6%, 4.4 percentage points lower than a year ago. The decline in gross margins in the first quarter was a direct result of higher commodity cost and the de-leveraging of fixed manufacturing costs on lower sales, which were partially offset by price increases. A mix shift to lower margin models during January and February also contributed to the margin decline, which began to reverse with the improved mix that accompanied the introduction of our new Sleep Number 6000 bed model in March.
Selling, marketing and G&A expenses all declined on a year-over-year basis, but increased as a percentage of sales on lower sales volumes. The primary contributors to lower expenses was our decision to delay media investments until our new campaign was up and running along with our aggressive management of cost structure, including reductions in head count, deferrals in filling open positions, and the reduction of variable costs including sales commissions, financing costs, and percentage ramp.
Overall selling expenses were essentially flat despite an increase of 34 stores compared to a year ago. Despite slowing sales on a net loss, we reported positive operating cash flow of 14.6 million for the quarter, which is highlighted on slide nine.
We made significant progress toward returning inventory balances to historic levels with additional opportunities to increase inventory turns in upcoming quarters. We also reduced accounts receivable. These two factors contributed $18 million to our cash position. Needless to say, our cash conversion cycle remained strong in the first quarter at negative 30 days. These improvements reflect the cash advantage of our business along with the controls we have put in place to manage working capital in the face of slowing sales. We expect to generate positive operating cash flow for the full year.
We incurred $10 million of capital expenditures in the first quarter. We have elected to slow our CapEx investment over the balance of the year to preserve cash, reducing planned store openings from 30 to 24 stores, and remodel from 50 to 20 stores. We also have deferred our SAP implementation until February of 2009. The SAP implementation remained on track, but the adjusted timing will allow us to reduce monthly expenditures and provide for an overall lower investment as we reduce the number of higher cost consulting resources that were in place to meet an accelerated time line. CapEx is now planned at approximately $27 million for the year.
Now a few comments on the remainder of 2008. We continue to anticipate a challenging sales environment. In addition, we expect a sequential decline in sales as we enter the second quarter, our seasonal low point. During the second quarter, we are returning our media spend to 2007 levels as we invest in our new brand marketing campaign, offset only partially by cost initiatives that will not fully take effect until Q3. Therefore we anticipate a loss for the second quarter before returning to profitability in the second half.
Sales and profits should improve in the third and fourth quarters on seasonally higher sales beginning with mattress seasonality in Q3 and increased mall traffic in Q4. By that time, we also expect to begin to benefit from a lower cost structure and improved sales as our various initiatives gain traction. For those of you familiar with our company, first and third quarter sales and profits are historically similar; a variety of actions should make 2008 different.
Slide 10 provides an overview. First, our cost restructuring efforts were taken near the end of the first quarter. In addition to reduced head count in our corporate and sales organization, severance cost will be eliminated and financing costs, which are priced off of interest rates will also be lower. The combined impact of these reductions is between 4 and $5 million per quarter.
Second, we expect gross margins will improve by up to 200 basis points during the balance of the year. While we expect increasing inflationary pressures from oil and currency exchange, rightsizing our planned and home delivery options, selective pricing action, none which impact our most popular bed sizes and models, along with a reduction in promotional activities should offset these pressures. And we expect the improved mix weâ€™ve experienced with the introduction of our Sleep Number 6000 model to continue and be further enhanced with the introduction of another bed model in the second half.
Finally, as compared to the first quarter, we expect third and fourth quarter sales to increase without improvement in macro trend. The reasons for sequential sales growth were outlined by Bill earlier, primarily returning media spend to normal levels beginning in Q2 as the year-over-year spend was 23% lower during the first quarter. Another reason is normalized wholesale sales primarily QVC shows that were shifted out of Q1 in the current year. We have not factored in additional lift from the new brand marketing campaign.
Combined, we believe these actions will contribute $10 million or more of improvement in operating profit in the third quarter as compared to the first quarter. Results for 2008 also will benefit from the 53rd week in the fourth quarter.
Iâ€™d now like to turn the call back over to Bill before we move on to questions.
Thanks Jim. And Iâ€™d like to conclude our prepared remarks with the following two points. The first point is that the strategic opportunity for our products and company remain unchanged. Specifically those include the consumersâ€™ need for personal comfort and sleep continues to increase. Our product remains unique and appreciated by our customers. Our business model selling directly to customers is advantaged in customersâ€™ experience and business potential. And finally, our team and their passion for our product and customers is unparalleled in the industry.
And second, we are working through a broad macroeconomic trough. We have taken actions we believe will help us improve our performance in the second half and we are now focused on execution, confident that we can return to profitability.