Sleep Number Corp - Quarter Report: 2014 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE

ACT OF 1934

For the Quarterly Period Ended September 27, 2014

Commission File Number: 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

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

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

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



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

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

As of September 27, 2014, 53,289,000 shares of the Registrant’s Common Stock were outstanding.

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INDEX



		Page

PART I: FINANCIAL INFORMATION

Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets	2
	Condensed Consolidated Statements of Operations	3
	Condensed Consolidated Statements of Comprehensive Income	4
	Condensed Consolidated Statement of Shareholders’ Equity	5
	Condensed Consolidated Statements of Cash Flows	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24

PART II: OTHER INFORMATION		24
Item 1.	Legal Proceedings	24
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	Mine Safety Disclosures	25
Item 5.	Other Information	25
Item 6.	Exhibits	26
SIGNATURES		27

PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)



	(unaudited) September 27, 2014		December 28, 2013
Assets
Current assets:
Cash and cash equivalents	$	78,426	$	58,223
Marketable debt securities – current	55,317		52,159
Accounts receivable, net of allowance for doubtful accounts of $641 and $425, respectively	29,154		14,979
Inventories	48,704		40,152
Prepaid expenses	9,250		9,216
Deferred income taxes	6,939		6,936
Other current assets	10,254		7,874
Total current assets	238,044		189,539

Non-current assets:
Marketable debt securities – non-current	43,376		34,632
Property and equipment, net	159,475		129,542
Goodwill and intangible assets, net	16,194		16,823
Deferred income taxes	9,249		4,943
Other assets	8,513		6,286
Total assets	$	474,851	$	381,765

Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	85,597	$	73,391
Customer prepayments	29,239		15,392
Accrued sales returns	14,406		9,433
Compensation and benefits	29,023		15,242
Taxes and withholding	26,540		12,517
Other current liabilities	15,579		11,207
Total current liabilities	200,384		137,182

Non-current liabilities:
Warranty liabilities	2,253		1,567
Other long-term liabilities	23,182		17,796
Total liabilities	225,819		156,545

Shareholders’ equity:
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding	—		—
Common stock, $0.01 par value; 142,500 shares authorized, 53,289 and 54,901 shares issued and outstanding, respectively	533		549
Additional paid-in capital	—		5,382
Retained earnings	248,491		219,276
Accumulated other comprehensive income	8		13
Total shareholders’ equity	249,032		225,220
Total liabilities and shareholders’ equity	$	474,851	$	381,765

See accompanying notes to condensed consolidated financial statements.

Index

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Condensed Consolidated Statements of Operations

(unaudited - in thousands, except per share amounts)



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Net sales	$	323,366	$	263,689	$	834,541	$	729,317
Cost of sales	124,782		97,269		322,177		268,083
Gross profit	198,584		166,420		512,364		461,234

Operating expenses:
Sales and marketing	137,863		118,307		369,597		326,477
General and administrative	23,022		15,055		63,183		46,249
Research and development	2,353		2,359		5,725		7,475
Total operating expenses	163,238		135,721		438,505		380,201
Operating income	35,346		30,699		73,859		81,033
Other income, net	96		74		276		243
Income before income taxes	35,442		30,773		74,135		81,276
Income tax expense	11,888		10,514		25,108		27,620
Net income	$	23,554	$	20,259	$	49,027	$	53,656

Basic net income per share:
Net income per share – basic	$	0.44	$	0.37	$	0.91	$	0.98
Weighted-average shares – basic	53,271		54,854		53,677		54,992
Diluted net income per share:
Net income per share – diluted	$	0.44	$	0.36	$	0.90	$	0.96
Weighted-average shares – diluted	53,971		55,748		54,358		55,990

See accompanying notes to condensed consolidated financial statements.

Index

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Condensed Consolidated Statements of Comprehensive Income

(unaudited - in thousands)



	Three Months Ended					Nine Months Ended
	September 27, 2014			September 28, 2013		September 27, 2014			September 28, 2013
Net income	$	23,554		$	20,259	$	49,027		$	53,656
Other comprehensive (loss) income – unrealized (loss) gain on available-for-sale marketable debt securities, net of income tax	(35		)	47		(5		)	2
Comprehensive income	$	23,519		$	20,306	$	49,022		$	53,658

See accompanying notes to condensed consolidated financial statements.

Index

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Condensed Consolidated Statement of Shareholders’ Equity

(unaudited - in thousands)



	Common Stock					Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Total
	Shares		Amount			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Total
Balance at December 28, 2013	54,901		$	549		$	5,382		$	219,276		$	13		$	225,220
Net income	—		—			—			49,027			—			49,027
Other comprehensive loss:
Unrealized loss on available-for-sale marketable debt securities, net of tax	—		—			—			—			(5		)	(5		)
Exercise of common stock options	124		1			1,630			—			—			1,631
Tax effect from stock-based compensation	—		—			345			—			—			345
Stock-based compensation	(87	)	(1		)	4,295			—			—			4,294
Repurchases of common stock	(1,649	)	(16		)	(11,652		)	(19,812		)	—			(31,480		)
Balance at September 27, 2014	53,289		$	533		$	—		$	248,491		$	8		$	249,032

See accompanying notes to condensed consolidated financial statements.

Index

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Condensed Consolidated Statements of Cash Flows

(unaudited - in thousands)



	Nine Months Ended
	September 27, 2014			September 28, 2013
Cash flows from operating activities:
Net income	$	49,027		$	53,656
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	29,579			22,199
Stock-based compensation	4,294			3,058
Net loss (gain) on disposals and impairments of assets	115			(10		)
Excess tax benefits from stock-based compensation	(754		)	(3,088		)
Deferred income taxes	(4,306		)	4,288
Changes in operating assets and liabilities, net of effect of acquisition:
Accounts receivable	(14,195		)	1,717
Inventories	(8,552		)	(5,069		)
Income taxes	9,883			7,114
Prepaid expenses and other assets	(4,146		)	(5,144		)
Accounts payable	27,359			11,029
Customer prepayments	13,847			97
Accrued compensation and benefits	17,318			(5,607		)
Other taxes and withholding	4,484			1,504
Warranty liabilities	953			(1,218		)
Other accruals and liabilities	10,929			5,556
Net cash provided by operating activities	135,835			90,082

Cash flows from investing activities:
Purchases of property and equipment	(58,377		)	(57,820		)
Investments in marketable debt securities	(58,403		)	(26,041		)
Proceeds from maturities of marketable debt securities	38,237			31,973
Increase in restricted cash	(500		)	—
Proceeds from sales of property and equipment	5			117
Acquisition of business	—			(15,500		)
Investment in non-marketable equity securities	—			(3,000		)
Net cash used in investing activities	(79,038		)	(70,271		)

Cash flows from financing activities:
Repurchases of common stock	(31,480		)	(32,054		)
Net decrease in short-term borrowings	(7,499		)	(4,567		)
Proceeds from issuance of common stock	1,631			7,108
Excess tax benefits from stock-based compensation	754			3,088
Net cash used in financing activities	(36,594		)	(26,425		)

Net increase (decrease) in cash and cash equivalents	20,203			(6,614		)
Cash and cash equivalents, at beginning of period	58,223			87,915
Cash and cash equivalents, at end of period	$	78,426		$	81,301

See accompanying notes to condensed consolidated financial statements.

Index

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Notes to Condensed Consolidated Financial Statements

(unaudited)

1. Basis of Presentation

We prepared the condensed consolidated financial statements as of and for the three and nine months ended September 27, 2014 of Select Comfort Corporation and 100%-owned subsidiaries (“Select Comfort” or the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and they reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly our financial position as of September 27, 2014, and December 28, 2013, and the consolidated results of operations and cash flows for the periods presented. Our historical and quarterly consolidated results of operations may not be indicative of the results that may be achieved for the full year or any future period.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with our most recent audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013 and other recent filings with the SEC.

The preparation of consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of sales, expenses and income taxes during the reporting period. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in these estimates will be reflected in the financial statements in future periods. Our critical accounting policies consist of stock-based compensation, asset impairment charges, goodwill and indefinite-lived intangible assets, warranty liabilities and revenue recognition.

The consolidated financial statements include the accounts of Select Comfort Corporation and our 100%-owned subsidiaries. All significant intra-entity balances and transactions have been eliminated in consolidation.

New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board issued a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services. This new guidance is effective for annual reporting periods beginning after December 15, 2016 and early adoption is not permitted. Accordingly, we will adopt this new guidance beginning in fiscal 2017. Companies may use either a full retrospective or a modified retrospective approach to adopt this new guidance and management is currently evaluating which transition approach to use. Management does not expect this new guidance to materially impact our consolidated results of operations, financial position or cash flows.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

2. Fair Value Measurements

The following tables set forth, by level within the fair value hierarchy, our financial assets that were accounted for at fair value on a recurring basis according to the valuation techniques we used to determine their fair value (in thousands):



	September 27, 2014
	Level 1		Level 2		Level 3		Total
Marketable debt securities – current
U.S. Treasury securities	$	17,516	$	—	$	—	$	17,516
Corporate bonds	—		17,736		—		17,736
U.S. Agency bonds	—		9,544		—		9,544
Municipal bonds	—		5,526		—		5,526
Commercial paper	—		4,995		—		4,995
	17,516		37,801		—		55,317
Marketable debt securities – non-current
U.S. Treasury securities	14,996		—		—		14,996
Corporate bonds	—		15,242		—		15,242
U.S. Agency bonds	—		10,019		—		10,019
Municipal bonds	—		3,119		—		3,119
	14,996		28,380		—		43,376
	$	32,512	$	66,181	$	—	$	98,693



	December 28, 2013
	Level 1		Level 2		Level 3		Total
Marketable debt securities – current
U.S. Treasury securities	$	15,011	$	—	$	—	$	15,011
Corporate bonds	—		20,300		—		20,300
U.S. Agency bonds	—		12,025		—		12,025
Municipal bonds	—		4,823		—		4,823
	15,011		37,148		—		52,159
Marketable debt securities – non-current
U.S. Treasury securities	8,978		—		—		8,978
Corporate bonds	—		15,484		—		15,484
U.S. Agency bonds	—		7,498		—		7,498
Municipal bonds	—		2,672		—		2,672
	8,978		25,654		—		34,632
	$	23,989	$	62,802	$	—	$	86,791

We did not have any transfers between Level 1 and Level 2 fair value measurements during the periods presented.

At September 27, 2014 and December 28, 2013, we had $0.9 million and $1.1 million, respectively, of debt and equity securities that funded our deferred compensation plan and are classified in other assets in our condensed consolidated balance sheets. We also had corresponding deferred compensation plan liabilities of $0.9 million and $1.1 million at September 27, 2014 and December 28, 2013, respectively, which are included in other long-term liabilities in our condensed consolidated balance sheets. The majority of the debt and equity securities are Level 1 as they trade with sufficient frequency and volume to enable us to obtain pricing information on an ongoing basis. Unrealized gains/(losses) on the debt and equity securities offset those associated with the corresponding deferred compensation plan liabilities.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

3. Investments

Marketable Debt Securities

Investments in marketable debt securities were comprised of the following (in thousands):



	September 27, 2014
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Treasury securities	$	32,494	$	21	$	(3	)	$	32,512
Corporate bonds	32,996		4		(22		)	32,978
U.S. Agency bonds	19,568		8		(13		)	19,563
Municipal bonds	8,625		20		—			8,645
Commercial paper	4,996		—		(1		)	4,995
	$	98,679	$	53	$	(39	)	$	98,693



	December 28, 2013
	Amortized Cost		Unrealized Gains		Unrealized Losses			Fair Value
U.S. Treasury securities	$	23,975	$	15	$	(1	)	$	23,989
Corporate bonds	35,804		3		(23		)	35,784
U.S. Agency bonds	19,517		10		(4		)	19,523
Municipal bonds	7,474		23		(2		)	7,495
	$	86,770	$	51	$	(30	)	$	86,791

Maturities of marketable debt securities were as follows (in thousands):



	September 27, 2014				December 28, 2013
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Marketable debt securities – current (due in less than one year)	$	55,290	$	55,317	$	52,122	$	52,159
Marketable debt securities – non-current (due in one to two years)	43,389		43,376		34,648		34,632
	$	98,679	$	98,693	$	86,770	$	86,791

During the three months ended September 27, 2014 and September 28, 2013, $14.6 million and $8.5 million, respectively, of marketable debt securities matured and were redeemed at face value. During the nine months ended September 27, 2014 and September 28, 2013, $38.1 million and $31.8 million, respectively, of marketable debt securities matured and were redeemed at face value. During the nine months ended September 27, 2014, there were no other-than-temporary declines in market value.

Other Investments

During 2013, we made a minority equity investment in one of our strategic product-development partners. The carrying value of this investment at September 27, 2014 and December 28, 2013 using the cost method is $4.5 million and is included in other assets on our condensed consolidated balance sheets.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

4. Inventories

Inventories consisted of the following (in thousands):



	September 27, 2014		December 28, 2013
Raw materials	$	10,013	$	7,118
Work in progress	340		505
Finished goods	38,351		32,529
	$	48,704	$	40,152

5. Goodwill and Intangible Assets

Goodwill and Indefinite-Lived Intangible Assets

The following is a roll forward of goodwill and indefinite-lived trade name/trademarks (in thousands):



	Nine Months Ended				Nine Months Ended
	September 27, 2014				September 28, 2013
	Goodwill		Indefinite-Lived Trade Name/ Trademarks		Goodwill		Indefinite-Lived Trade Name/ Trademarks
Beginning balance	$	8,963	$	1,396	$	2,850	$	—
Comfortaire purchase⁽¹⁾	—		—		6,113		1,396
Ending balance	$	8,963	$	1,396	$	8,963	$	1,396

⁽¹⁾ Comfortaire purchase includes goodwill and indefinite-lived trade name/trademarks resulting from the acquisition of Comfortaire Corporation in the first quarter of fiscal 2013.

Definite-Lived Intangible Assets

The following table provides the gross carrying amount and related accumulated amortization of our definite-lived intangible assets (in thousands):



	September 27, 2014				December 28, 2013
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
Developed technologies	$	5,231	$	1,220	$	5,231	$	850
Customer relationships	2,413		589		2,413		330
Trade names/trademarks	101		101		101		101
	$	7,745	$	1,910	$	7,745	$	1,281

Amortization expense for definite-lived intangible assets was $0.2 million and $0.6 million, for the three and nine months ended September 27, 2014, respectively, and $0.2 million and $0.6 million, for the three and nine months ended September 28, 2013, respectively.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

6. Credit Agreement

Our $20.0 million Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association, as amended, is an unsecured revolving credit facility that matures on August 31, 2016. The Credit Agreement contains an accordion feature that allows us to increase the amount of the line from $20.0 million to up to $50.0 million in total availability, subject to lender approval.

Any borrowings under the Credit Agreement will, at our request, be classified as either LIBOR Loans or Adjusted Base Rate (“ABR”) Loans (both as defined in the Credit Agreement). The rate of interest payable by us in respect of loans outstanding under the revolving credit facility is: (i) with respect to LIBOR Loans, the Adjusted LIBO Rate (as defined in the Credit Agreement) for the interest period then in effect, plus 1.25%; or (ii) with respect to ABR Loans, the ABR (as defined in the Credit Agreement) then in effect for the Daily One-Month LIBO Rate (as defined in the Credit Agreement), plus 1.50%, or the prime rate. We are subject to certain financial covenants under the Credit Agreement, including minimum tangible net worth, a requirement to maintain a minimum amount of cash, cash equivalents and marketable debt securities, and to maintain at the administrative agent cash, cash equivalents and marketable debt securities equal to the amount the lenders are committed to lend under the Credit Agreement.

At both September 27, 2014, and December 28, 2013, $20.0 million was available under the Credit Agreement, we had no borrowings and we were in compliance with all financial covenants. We had no outstanding letters of credit as of September 27, 2014 or December 28, 2013.

7. Repurchase of Common Stock

Repurchases of our common stock were as follows (in thousands):



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Amount repurchased under Board-approved share repurchase program	$	10,010	$	10,008	$	30,032	$	30,027
Amount repurchased in connection with the vesting of employee restricted stock grants	—		15		1,448		2,027
Total amount repurchased	$	10,010	$	10,023	$	31,480	$	32,054

Effective as of September 27, 2014, our Board of Directors ("Board") increased our total remaining share repurchase authorization to $250.0 million. There is no expiration date governing the period over which we can repurchase shares. Any repurchased shares are constructively retired and returned to an unissued status.

The cost of stock repurchases is first charged to additional paid-in-capital. Once additional paid-in capital is reduced to zero, any additional amounts are charged to retained earnings.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

8. Stock-Based Compensation

We compensate officers, directors and key employees with stock-based compensation under two stock plans approved by our shareholders in 2004 and 2010 and administered under the supervision of our Board. Compensation expense, net of estimated forfeitures, is recognized ratably over the vesting period.

Stock-based compensation expense consisted of the following (in thousands):



	Three Months Ended						Nine Months Ended
	September 27, 2014			September 28, 2013			September 27, 2014			September 28, 2013
Options	$	574		$	740		$	1,503		$	2,018
Restricted shares	1,685			326			2,791			1,040
Total stock-based compensation expense⁽¹⁾	2,259			1,066			4,294			3,058
Income tax benefit	(768		)	(366		)	(1,464		)	(1,049		)
Total stock-based compensation expense, net of tax	$	1,491		$	700		$	2,830		$	2,009

⁽¹⁾ The nine months ended September 27, 2014 includes a $1.2 million benefit related to a change in estimated forfeitures due to employee turnover during the three months ended March 29, 2014.

9. Employee Benefits

Under our profit sharing and 401(k) plan, eligible employees may defer up to 50% of their compensation on a pre-tax basis, subject to Internal Revenue Service limitations. Each calendar quarter, we may make a discretionary contribution equal to a percentage of the employee’s contribution. During the three months ended September 27, 2014 and September 28, 2013 our contributions, net of forfeitures, were $0.9 million and $0.8 million, respectively. During the nine months ended September 27, 2014 and September 28, 2013 our contributions, net of forfeitures, were $2.7 million and $2.3 million, respectively.

10. Other Income, Net

Other income, net, consisted of the following (in thousands):



	Three Months Ended						Nine Months Ended
	September 27, 2014			September 28, 2013			September 27, 2014			September 28, 2013
Interest income	$	106		$	88		$	306		$	284
Interest expense	(10		)	(14		)	(30		)	(41		)
Other income, net	$	96		$	74		$	276		$	243

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Notes to Condensed Consolidated Financial Statements

(unaudited)

11. Net Income per Common Share

The following computations reconcile net income per share – basic with net income per share – diluted (in thousands, except per share amounts):



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Net income	$	23,554	$	20,259	$	49,027	$	53,656

Reconciliation of weighted-average shares outstanding:
Basic weighted-average shares outstanding	53,271		54,854		53,677		54,992
Effect of dilutive securities:
Options	383		531		368		589
Restricted shares	317		363		313		409
Diluted weighted-average shares outstanding	53,971		55,748		54,358		55,990

Net income per share – basic	$	0.44	$	0.37	$	0.91	$	0.98
Net income per share – diluted	$	0.44	$	0.36	$	0.90	$	0.96

Additional potentially dilutive stock options totaling 0.7 million and 0.6 million for the three months ended September 27, 2014 and September 28, 2013, respectively, and 0.9 million and 1.3 million for the nine months ended September 27, 2014 and September 28, 2013, respectively, have been excluded from our diluted net income per share calculations because these securities’ exercise prices were anti-dilutive (e.g., greater than the average market price of our common stock).

12. Commitments and Contingencies

Sales Returns

The accrued sales returns estimate is based on historical return rates, which are reasonably consistent from period to period, and is adjusted for any current trends as appropriate. If actual returns vary from expected rates, sales in future periods are adjusted.

The activity in the sales returns liability account was as follows (in thousands):



	Nine Months Ended
	September 27, 2014			September 28, 2013
Balance at beginning of year	$	9,433		$	5,330
Additions that reduce net sales	55,047			33,260
Deductions from reserves	(50,074		)	(28,816		)
Acquired sales return reserve⁽¹⁾	—			98
Balance at end of period	$	14,406		$	9,872

⁽¹⁾ Acquired sales return reserve resulted from the acquisition of Comfortaire Corporation in the first quarter of fiscal 2013.

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

Warranty Liabilities

We provide a 25-year limited warranty on our beds. The customer participates over the last 23 years of the warranty period by paying a portion of the retail value of replacement parts. The estimated warranty costs, which are expensed at the time of sale and included in cost of sales, are based on historical trends and warranty claims rates incurred by us and are adjusted for any current trends as appropriate. Actual warranty claim costs could differ from these estimates. We regularly assess and adjust the estimate of accrued warranty claims by updating claims rates for actual trends and projected claim costs.

The activity in the accrued warranty liabilities account was as follows (in thousands):



	Nine Months Ended
	September 27, 2014			September 28, 2013
Balance at beginning of year	$	4,153		$	4,858
Additions charged to costs and expenses for current-year sales	6,119			3,206
Deductions from reserves	(5,434		)	(4,428		)
Changes in liability for pre-existing warranties during the current year, including expirations	268			3
Acquired warranty reserve⁽¹⁾	—			532
Balance at end of period	$	5,106		$	4,171

⁽¹⁾ Acquired warranty reserve resulted from the acquisition of Comfortaire Corporation in the first quarter of fiscal 2013.

Legal Proceedings

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

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

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ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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 seven sections:


•	Risk Factors


•	Overview


•	Results of Operations


•	Liquidity and Capital Resources


•	Non-GAAP Data Reconciliations


•	Off-Balance-Sheet Arrangements and Contractual Obligations


•	Critical Accounting Policies

Risk Factors

The following discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and the Notes thereto included herein. This quarterly report on Form 10-Q contains certain forward-looking statements that relate to future plans, events, financial results or performance. You can identify forward-looking statements by those that are not historical in nature, particularly those that use terminology such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” “believe,” “estimate,” “plan,” “project,” “predict,” “intend,” “potential,” “continue” or the negative of these or similar terms. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections.

These risks and uncertainties include, among others:


•	Current and future general and industry economic trends and consumer confidence;


•	The effectiveness of our marketing messages;


•	The efficiency of our advertising and promotional efforts;


•	Our ability to execute our Company-Controlled distribution strategy;


•	Our ability to achieve and maintain acceptable levels of product and service quality, and acceptable product return and warranty claims rates;


•	Our ability to continue to improve and expand our product line, and consumer acceptance of our products, product quality, innovation and brand image;


•	Industry competition, the emergence of additional competitive products, and the adequacy of our intellectual property rights to protect our products and brand from competitive or infringing activities;


•	Availability of attractive and cost-effective consumer credit options;


•	Pending and unforeseen litigation and the potential for adverse publicity associated with litigation;


•	Our “just-in-time” manufacturing processes with minimal levels of inventory, which may leave us vulnerable to shortages in supply;


•	Our dependence on significant suppliers and our ability to maintain relationships with key suppliers, including several sole-source suppliers;


•	Rising commodity costs and other inflationary pressures;


•	Risks inherent in global sourcing activities;


•	Risks of disruption in the operation of either of our two primary manufacturing facilities;


•	Increasing government regulation;


•	The adequacy of our management information systems to meet the evolving needs of our business and to protect sensitive data from potential cyber threats;


•	The costs and potential disruptions to our business related to upgrading our management information systems;


•	Our ability to attract, retain and motivate qualified management, executive and other key employees, including qualified retail sales professionals and managers; and


•	Uncertainties arising from global events, such as terrorist attacks or a pandemic outbreak, or the threat of such events.

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

We have no obligation to publicly update or revise any of the forward-looking statements contained in this quarterly report on Form 10-Q.

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Overview

Business Overview

We are leading the industry in delivering unparalleled sleep experiences by offering consumers high-quality and individualized sleep solutions and services, which include a complete line of Sleep Number® beds and bedding. We are the exclusive designer, manufacturer, marketer, retailer and servicer of the revolutionary Sleep Number bed. We offer further individualization through our new sleep tracking technology, SleepIQ^TM, and a solutions-focused line of Sleep Number pillows, sheets, FlexFit^TM adjustable bases, and other bedding products, including the innovative DualTemp^TM temperature-balancing layer.

We generate revenue by selling products through two distribution channels. Our vertical, direct to consumer business model is our primary source of revenue with exclusive distribution through our Company-Controlled channel, which includes Retail, E-Commerce and Direct Marketing. In addition, we operate a small wholesale business in the United States and Australia.

Mission, Vision and Goals

Our mission is to improve lives by Individualizing Sleep Experiences.

Our vision is to become one of the world’s most beloved brands by delivering an Unparalleled Sleep Experience. We expect our customer-focused strategies and goals will build our competitive advantages and deliver sustainable, profitable growth.

Our long-term goals are:


•	Everyone will know Sleep Number®


•	Innovative Sleep Number products will deliver meaningful benefits;


•	Customers will easily find and interact with Sleep Number;


•	Customers will enthusiastically recommend Sleep Number; and


•	We will leverage our business model to fund innovation and growth.

Results of Operations

Quarterly and Annual Results

Quarterly and annual operating results may fluctuate significantly as a result of a variety of factors, including increases or decreases in sales, the timing, amount and effectiveness of advertising expenditures, changes in sales return rates or warranty experience, timing of store openings/closings and related expenses, changes in net sales resulting from changes in our store base, the timing of promotional offerings, competitive factors, changes in commodity costs, any disruptions in supplies or third-party service providers, seasonality of retail and bedding industry sales, timing and volume of QVC shows, consumer confidence and general economic conditions. Therefore, our historical results of operations may not be indicative of the results that may be achieved for any future period.

Highlights

Financial highlights for the periods ended September 27, 2014 were as follows:


•	Net sales for the quarter increased 23% to $323.4 million, compared with $263.7 million for the same period one year ago. Company-Controlled comparable sales increased 16% and sales from 37 net new stores opened in the past 12 months added 8% growth in the quarter.


•	On a trailing twelve-month basis, sales per store (for stores open at least one year) increased 5% to $2.2 million, compared with the prior-year trailing twelve-month period.


•	Operating income for the quarter increased 15% to $35.3 million, or 10.9% of net sales, compared with $30.7 million, or 11.6% of net sales, for the same period one year ago. The increase in operating income was primarily due to the additional operating income generated by the 23% increase in net sales.


•	Net income for the quarter increased 16% to $23.6 million, or $0.44 per diluted share, compared with net income of $20.3 million, or $0.36 per diluted share, for the same period one year ago.


•	Cash provided by operating activities totaled $135.8 million for the nine months ended September 27, 2014, compared with $90.1 million for the same period one year ago.


•	At September 27, 2014, cash, cash equivalents and marketable debt securities totaled $177.1 million and we had no borrowings under our revolving credit facility.

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•	In the third quarter of 2014, we repurchased 474,222 shares of our common stock under our Board-approved share repurchase program at a cost of $10.0 million (an average of $21.11 per share).


•	Effective as of September 27, 2014, our Board increased our total remaining share repurchase authorization to $250 million. We intend to increase share repurchase activity by as much as 50 percent beginning in the fourth quarter of 2014.

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



	Three Months Ended								Nine Months Ended
	September 27, 2014				September 28, 2013				September 27, 2014				September 28, 2013
Net sales	$	323.4	100.0	%	$	263.7	100.0	%	$	834.5	100.0	%	$	729.3	100.0	%
Cost of sales	124.8		38.6	%	97.3		36.9	%	322.2		38.6	%	268.1		36.8	%
Gross profit	198.6		61.4	%	166.4		63.1	%	512.4		61.4	%	461.2		63.2	%

Operating expenses:
Sales and marketing	137.9		42.6	%	118.3		44.9	%	369.6		44.3	%	326.5		44.8	%
General and administrative	23.0		7.1	%	15.1		5.7	%	63.2		7.6	%	46.2		6.3	%
Research and development	2.4		0.7	%	2.4		0.9	%	5.7		0.7	%	7.5		1.0	%
Total operating expenses	163.2		50.5	%	135.7		51.5	%	438.5		52.5	%	380.2		52.1	%
Operating income	35.3		10.9	%	30.7		11.6	%	73.9		8.9	%	81.0		11.1	%
Operating income – as adjusted ⁽¹⁾	35.3		10.9	%	30.6		11.6	%	73.9		8.9	%	80.5		11.0	%
Other income, net	0.1		0.0	%	0.1		0.0	%	0.3		0.0	%	0.2		0.0	%
Income before income taxes	35.4		11.0	%	30.8		11.7	%	74.1		8.9	%	81.3		11.1	%
Income tax expense	11.9		3.7	%	10.5		4.0	%	25.1		3.0	%	27.6		3.8	%
Net income	$	23.6	7.3	%	$	20.3	7.7	%	$	49.0	5.9	%	$	53.7	7.4	%
Net income – as adjusted ⁽¹⁾	$	23.6	7.3	%	$	20.2	7.6	%	$	49.0	5.9	%	$	53.3	7.3	%

Net income per share:
Basic	$	0.44			$	0.37			$	0.91			$	0.98
Diluted	$	0.44			$	0.36			$	0.90			$	0.96
Diluted – as adjusted ⁽¹⁾	$	0.44			$	0.36			$	0.90			$	0.95

Weighted-average number of common shares:
Basic	53.3				54.9				53.7				55.0
Diluted	54.0				55.7				54.4				56.0


⁽¹⁾	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 22 for a reconciliation of these non-GAAP measures to the appropriate GAAP measures


(2)	3.

GAAP – generally accepted accounting principles

The percentage of our total net sales, by dollar volume, from each of our channels was as follows:



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Company-Controlled channel	98.0	%	96.8	%	96.9	%	95.9	%
Wholesale/Other channel	2.0	%	3.2	%	3.1	%	4.1	%
Total	100.0	%	100.0	%	100.0	%	100.0	%

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



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Sales change rates:
Retail comparable-store sales⁽¹⁾	16	%	(1	%)	9	%	(5	%)
E-Commerce and Direct	18	%	(6	%)	5	%	(8	%)
Company-Controlled comparable sales change	16	%	(1	%)	9	%	(5	%)
Net store openings/closings	8	%	7	%	7	%	6	%
Total Company-Controlled channel	24	%	6	%	16	%	1	%
Wholesale/Other channel	(23	%)	55	%	(14	%)	31	%
Total net sales change	23	%	7	%	14	%	2	%

⁽¹⁾ Stores are included in the comparable-store calculations in the 13th full month of operations. Stores that have been remodeled or repositioned within the same shopping center remain in the comparable-store base.

Other sales metrics were as follows:



	Three Months Ended						Nine Months Ended
	September 27, 2014			September 28, 2013			September 27, 2014		September 28, 2013
Average sales per store⁽¹⁾ ($ in thousands)	$	2,216		$	2,102
Average sales per square foot⁽¹⁾	$	1,007		$	1,131
Stores > $1 million in net sales⁽¹⁾	98		%	97		%
Stores > $2 million in net sales⁽¹⁾	50		%	47		%
Average revenue per mattress unit⁽²⁾	$	3,733		$	3,304		$	3,600	$	3,207

⁽¹⁾ Trailing twelve months for stores included in our comparable-store calculations.

⁽²⁾ Represents Company-Controlled channel total net sales divided by Company-Controlled channel mattress units.

The number of retail stores operating was as follows:



	Three Months Ended				Nine Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Beginning of period	451		413		440		410
Opened	13		16		46		43
Closed	(4	)	(6	)	(26	)	(30	)
End of period	460		423		460		423

Comparison of Three Months Ended September 27, 2014 with Three Months Ended September 28, 2013

Net sales

Net sales increased 23% to $323.4 million for the three months ended September 27, 2014, compared with $263.7 million for the same period one year ago. Demand for our latest product innovations drove traffic to our stores and contributed to the sales increase. Company-Controlled comparable sales increased 16% and sales from 37 net new stores opened in the past 12 months added 8% growth in the quarter.

The $59.7 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $35.6 million increase in sales from our Company-Controlled comparable retail stores; (ii) a $23.1 million sales increase resulting from net store openings; and (iii) a $2.9 million increase in E-Commerce and Direct sales, partially offset by (iv) a $1.9 million decrease in Wholesale/Other channel sales. Company-Controlled mattress unit sales increased 10% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 13% to $3,733, driven by sales of new product innovations, including our new FlexFit adjustable bases, and our retail store experience.

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Gross profit

Gross profit of $198.6 million increased by $32.2 million, or 19%, compared with the same period one year ago. The gross profit rate decreased to 61.4% of net sales for the three months ended September 27, 2014, compared with 63.1% for the prior-year period. The 1.7 ppt. decrease in the gross profit rate was primarily due to: (i) a higher sales mix of lower-margin rate products, principally our FlexFit adjustable bases; and (ii) supply chain inefficiencies related to the strong demand for our new products. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors, including supply chain efficiencies, raw materials price fluctuations, warranty expenses and performance-based incentive compensation.

Sales and marketing expenses

The sales and marketing expense rate for the three months ended September 27, 2014 decreased to 42.6% of net sales, compared with 44.9% of net sales for the same period one year ago. The 2.3 ppt. decrease in the sales and marketing expense rate in the current period was mainly due to leveraging our media spending, which increased by 9% compared with the prior-year period, while net sales increased 23%.

General and administrative expenses

General and administrative (“G&A”) expenses increased $8.0 million to $23.0 million for the three months ended September 27, 2014, compared with $15.1 million in the same period one year ago, and increased to 7.1% of net sales, compared with 5.7% of net sales last year. The $8.0 million increase in G&A expenses was primarily due to: (i) a $5.8 million increase in employee compensation (including company-wide performance-based incentive compensation which was not earned in the prior-year); (ii) $0.9 million of additional depreciation expense resulting from the increase in capital expenditures to support the growth of the business, including our new digital website which was launched in the second quarter of 2014; and (iii) a $1.3 million increase in miscellaneous other expenses. The G&A expense rate increased by 1.4 ppt. in the current period compared with the same period one year ago due to the increase in expenses discussed above, partially offset by the leveraging impact of the 23% net sales increase.

Research and development expenses

Research and development expenses for the three months ended September 27, 2014 were $2.4 million, or 0.7% of net sales, compared with $2.4 million, or 0.9% of net sales, for the same period one year ago.

Other income, net

Other income, net was $0.1 million for the three months ended September 27, 2014, consistent with the comparable period one year ago.

Income tax expense

Income tax expense was $11.9 million for the three months ended September 27, 2014 compared with $10.5 million for the same period one year ago. The effective tax rate for the three months ended September 27, 2014 was 33.5%, compared with the prior-year period rate of 34.2%.

Comparison of Nine Months Ended September 27, 2014 with Nine Months Ended September 28, 2013

Net sales

Net sales increased 14% to $834.5 million for the nine months ended September 27, 2014, compared with $729.3 million for the same period one year ago. The net sales increase was primarily driven by sales from 37 net new stores opened in the past 12 months and a 9% comparable sales increase in our Company-Controlled channel.

The $105.2 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $54.3 million sales increase resulting from net new store openings; (ii) a $52.9 million increase in sales from our Company-Controlled comparable retail stores; and (iii) a $2.3 million increase in E-Commerce and Direct sales, partially offset by (iv) a $4.3 million decrease in Wholesale/Other channel sales. Company-Controlled mattress unit sales increased 3% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 12% to $3,600, driven by sales of new product innovations, including our new FlexFit adjustable bases, and our retail store experience.

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Gross profit

Gross profit of $512.4 million increased by $51.1 million, or 11%, compared with the same period one year ago.The gross profit rate decreased to 61.4% of net sales for the nine months ended September 27, 2014, compared with 63.2% for the prior-year period. The 1.8 ppt. decrease in the gross profit rate was primarily due to: (i) a higher sales mix of lower-margin rate products, principally our FlexFit adjustable bases; and (ii) increased sales return and exchange costs resulting from the second quarter 2013 change in our 30-night trial policy to 100 nights. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors, including supply chain efficiencies, raw materials price fluctuations, warranty expenses and performance-based incentive compensation.

Sales and marketing expenses

The sales and marketing expense rate for the nine months ended September 27, 2014 decreased to 44.3% of net sales, compared with 44.8% of net sales, for the same period one year ago. The sales and marketing expense rate declined 0.5 ppt. compared with the same period one year ago due to the leveraging impact of the 14% net sales increase.

General and administrative expenses

General and administrative (“G&A”) expenses increased $16.9 million to $63.2 million for the nine months ended September 27, 2014, compared with $46.2 million in the prior year, and increased to 7.6% of net sales, compared with 6.3% of net sales one year ago. The $16.9 million increase in G&A expenses was primarily due to: (i) an $11.5 million increase in employee compensation (including company-wide performance-based incentive compensation which was not earned in the prior-year); (ii) $1.9 million of additional depreciation expense resulting from the increase in capital expenditures to support the growth of the business, including our new digital website which was launched in the second quarter of 2014; and (iii) a $3.5 million net increase in miscellaneous other expenses. The G&A expense rate increased by 1.3 ppt. in the current period compared with the same period one year ago due to the increase in expenses discussed above, partially offset by the leveraging impact of the 14% net sales increase.

Research and development expenses

Research and development ("R&D") expenses for the nine months ended September 27, 2014 were $5.7 million, or 0.7% of net sales, compared with $7.5 million, or 1.0% of net sales, for the same period one year ago.

Other income, net

Other income, net was $0.3 million for the nine months ended September 27, 2014, consistent with the comparable period one year ago.

Income tax expense

Income tax expense was $25.1 million for the nine months ended September 27, 2014, compared with $27.6 million for the same period one year ago. The effective tax rate for the nine months ended September 27, 2014 was 33.9% compared with 34.0% for the prior-year period.

Liquidity and Capital Resources

As of September 27, 2014, cash, cash equivalents and marketable debt securities totaled $177.1 million compared with $145.0 million as of December 28, 2013. The $32.1 million increase was primarily due to $135.8 million of cash provided by operating activities, partially offset by $58.4 million of cash used to purchase property and equipment, $31.5 million of cash used to repurchase our common stock ($30.0 million under our Board-approved share repurchase program and $1.4 million in connection with the vesting of employee restricted stock grants), and a $7.5 million decrease in short-term borrowings. The $98.7 million of marketable debt securities held as of September 27, 2014 are all highly liquid and include U.S. government and agency securities, corporate debt securities, municipal bonds and commercial paper.

The following table summarizes our cash flows (dollars in millions). Amounts may not add due to rounding differences:



	Nine Months Ended
	September 27, 2014			September 28, 2013
Total cash provided by (used in):
Operating activities	$	135.8		$	90.1
Investing activities	(79.0		)	(70.3		)
Financing activities	(36.6		)	(26.4		)
Net increase (decrease) in cash and cash equivalents	$	20.2		$	(6.6	)

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Cash provided by operating activities for the nine months ended September 27, 2014 was $135.8 million compared with $90.1 million for the nine months ended September 28, 2013. The $45.8 million year-over-year increase in cash from operating activities was comprised of a $47.9 million increase in cash from changes in operating assets and liabilities and a $2.5 million increase in adjustments to reconcile net income to net cash provided by operating activities, partially offset by a $4.6 million decrease in net income for the nine months ended September 27, 2014 compared with the same period one year ago. The change in operating assets and liabilities includes $5 million of deferred revenue and $3 million of deferred expenses associated with our SleepIQ product, which will be recognized in our statement of operations over the product's useful life (currently estimated at five years).

Net cash used in investing activities was $79.0 million for the nine months ended September 27, 2014, compared with $70.3 million for the same period one year ago. Investing activities for the current-year period included $58.4 million of property and equipment purchases, including $20.0 million related to upgrading our management information systems, compared with $57.8 million for the same period one year ago. On a net basis, we increased our investments in marketable debt securities by $20.2 million during the nine months ended September 27, 2014 compared with a net reduction of $5.9 million during the comparable period one year ago.

Net cash used in financing activities was $36.6 million for the nine months ended September 27, 2014, compared with $26.4 million for the same period one year ago. During the nine months ended September 27, 2014, we repurchased $31.5 million of our stock ($30.0 million under our Board-approved share repurchase program and $1.4 million in connection with the vesting of employee restricted stock grants) compared with $32.1 million ($30.0 million under our Board-approved share repurchase program and $2.0 million in connection with the vesting of employee restricted stock grants) during the same period one year ago. Changes in book overdrafts are included in the net change in short-term borrowings. Financing activities for both periods reflect the vesting of employee restricted stock awards and exercise of employee stock options along with the associated excess tax benefits.

Under the Board-approved share repurchase program, we repurchased 1,572,708 shares at a cost of $30.0 million (an average of $19.10 per share) during the nine months ended September 27, 2014. During the nine months ended September 28, 2013, we repurchased 1,347,579 shares at a cost of $30.0 million (an average of $22.28 per share). Effective as of September 27, 2014, our Board increased the total remaining share repurchase authorization to $250 million. There is no expiration date governing the period over which we can repurchase shares. We intend to increase share repurchase activity by as much as 50 percent beginning in the fourth quarter of 2014.

Our $20.0 million Credit Agreement (the “Credit Agreement”) with Wells Fargo Bank, National Association, as amended, is an unsecured revolving credit facility that matures August 31, 2016. The Credit Agreement contains an accordion feature that allows us to increase the amount of the line from $20.0 million to up to $50.0 million in total availability, subject to lender approval. As of September 27, 2014 we were in compliance with all financial covenants.

Our business model, which can operate with minimal working capital, does not require additional capital from external sources to fund operations or organic growth. The $177.1 million of cash, cash equivalents and marketable debt securities, cash generated from ongoing operations, and cash available under our revolving credit facility are expected to be adequate to maintain operations and fund anticipated expansion and strategic initiatives for the foreseeable future.

We have an agreement with Synchrony Bank (formerly GE Capital Retail Bank) to offer qualified customers revolving credit arrangements to finance purchases from us (“Synchrony Agreement”). The Synchrony Agreement contains certain financial covenants, including a minimum tangible net worth requirement and a minimum working capital requirement. As of September 27, 2014 we were in compliance with all financial covenants.

Under the terms of the Synchrony Agreement, Synchrony 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.

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Non-GAAP Data Reconciliations

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

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



	Three Months Ended
	September 27, 2014		September 28, 2013
	As Reported		As Reported		CEO Transition Benefit⁽¹⁾			As Adjusted
Operating income	$	35,346	$	30,699	$	(143	)	$	30,556
Other income, net	96		74		—			74

Income before income taxes	35,442		30,773		(143		)	30,630
Income tax expense⁽²⁾	11,888		10,514		(49		)	10,465
Net income	$	23,554	$	20,259	$	(94	)	$	20,165

Net income per share –
Basic	$	0.44	$	0.37	$	0.00		$	0.37
Diluted	$	0.44	$	0.36	$	0.00		$	0.36

Basic Shares	53,271		54,854		54,854			54,854
Diluted Shares	53,971		55,748		55,748			55,748



	Nine Months Ended
	September 27, 2014		September 28, 2013
	As Reported		As Reported		CEO Transition Benefit⁽¹⁾			As Adjusted
Operating income	$	73,859	$	81,033	$	(534	)	$	80,499
Other income, net	276		243		—			243

Income before income taxes	74,135		81,276		(534		)	80,742
Income tax expense⁽²⁾	25,108		27,620		(183		)	27,437
Net income	$	49,027	$	53,656	$	(351	)	$	53,305

Net income per share –
Basic	$	0.91	$	0.98	$	(0.01	)	$	0.97
Diluted	$	0.90	$	0.96	$	(0.01	)	$	0.95

Basic Shares	53,677		54,992		54,992			54,992
Diluted Shares	54,358		55,990		55,990			55,990

⁽¹⁾ In February 2012, we announced that William R. McLaughlin, then President and Chief Executive Officer would retire from the Company effective June 1, 2012. In recognition of Mr. McLaughlin’s contributions, the Compensation Committee approved the modification of Mr. McLaughlin’s currently unvested stock awards, including performance-based stock awards. The performance-based stock awards are subject to applicable performance adjustments through 2014 based on actual performance versus performance targets. For the three and nine months ended September 28, 2013, we recorded non-cash compensation benefits of $0.1 million ($0.1 million net of tax) and $0.5 million ($0.4 million, net of income tax), respectively, resulting from performance-based stock award adjustments.

⁽²⁾ Reflects effective income tax rate, before discrete adjustments, of 34.3% for 2013.

GAAP - generally accepted accounting principles

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

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

Our Adjusted EBITDA calculations are as follows (dollars in thousands):



	Three Months Ended				Trailing-Twelve Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Net income	$	23,554	$	20,259	$	55,452	$	66,151
Income tax expense	11,888		10,514		28,418		34,629
Interest expense	10		14		40		53
Depreciation and amortization	10,125		7,774		37,095		26,932
Stock-based compensation	2,259		1,067		5,467		3,796
Asset impairments	28		48		153		126
Adjusted EBITDA	$	47,864	$	39,676	$	126,625	$	131,687

Free Cash Flow

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

The following table summarizes our free cash flow calculations (dollars in thousands):



	Nine Months Ended				Trailing-Twelve Months Ended
	September 27, 2014		September 28, 2013		September 27, 2014		September 28, 2013
Net cash provided by operating activities	$	135,835	$	90,082	$	133,858	$	93,072
Subtract: Purchases of property and equipment	58,377		57,820		77,368		72,597
Free cash flow	$	77,458	$	32,262	$	56,490	$	20,475

Off-Balance-Sheet Arrangements and Contractual Obligations

As of September 27, 2014, we were not involved in any unconsolidated special purpose entity transactions. Other than our operating leases, we do not have any off-balance-sheet financing. There were no outstanding letters of credit at September 27, 2014.

There has been no material change in our contractual obligations since the end of fiscal 2013. See Note 6, Credit Agreement, of the Notes to our Condensed Consolidated Financial Statements for information regarding our credit agreement. See our Annual Report on Form 10-K for the fiscal year ended December 28, 2013 for additional information regarding our other contractual obligations.

Critical Accounting Policies

We discuss our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 28, 2013. There were no significant changes in our critical accounting policies since the end of fiscal 2013.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Changes in the overall level of interest rates affect interest income generated from our short-term and long-term investments in marketable debt securities. If overall interest rates were one percentage point lower than current rates, our annual interest income would not change by a significant amount based on our investments in marketable debt securities as of September 27, 2014 and the current low interest-rate environment. We do not manage our investment interest-rate volatility risk through the use of derivative instruments.

As of September 27, 2014, we had no borrowings under our revolving credit facility.

ITEM 4. CONTROLS AND PROCEDURES

Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e), that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

Changes in Internal Controls

There were no changes in our internal control over financial reporting during the fiscal quarter ended September 27, 2014, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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ITEM 1A. RISK FACTORS

Our business, financial condition and operating results are subject to a number of risks and uncertainties, including both those that are specific to our business and others that affect all businesses operating in a global environment. Investors should carefully consider the information in this report under the heading, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and also the information under the heading, “Risk Factors” in our most recent Annual Report on Form 10-K. The risk factors discussed in the Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q do not identify all risks that we face because our business operations could also be affected by additional risk factors that are not presently known to us or that we currently consider to be immaterial to our operations.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



(a) – (b)	Not applicable.
(c)	Issuer Purchases of Equity Securities



Fiscal Period	Total Number of Shares Purchased⁽¹⁾	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⁽²⁾
June 29, 2014 through July 26, 2014	148,371	$	20.35	148,371	$	113,661,000
July 27, 2014 though August 23, 2014	150,588	21.10		150,588	110,484,000
August 24, 2014 through September 27, 2014	175,263	21.76		175,263	250,000,000
Total	474,222	$	21.11	474,222	$	250,000,000


⁽¹⁾	Under the then-current Board-approved share repurchase program, we repurchased 474,222 shares of our common stock at a cost of $10.0 million (based on trade dates) during the three months ended September 27, 2014.


⁽²⁾	Effective as of September 27, 2014, our Board increased the total remaining share repurchase authorization to $250.0 million. There is no expiration date governing the period over which we can repurchase shares. Any repurchased shares are constructively retired and returned to an unissued status.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

Not applicable.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

Not applicable.

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ITEM 6. EXHIBITS



Exhibit Number	Description	Method of Filing

31.1	Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Filed herewith

31.2	Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Filed herewith

32.1	Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350	Furnished herewith

32.2	Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350	Furnished herewith

101	The following financial information from the Company's Quarterly Report on Form 10-Q for the period ended September 27, 2014, filed with the SEC on October 29, 2014, formatted in eXtensible Business Reporting Language: (i) Condensed Consolidated Balance Sheets as of September 27, 2014 and December 28, 2013; (ii) Condensed Consolidated Statements of Operations for the three and nine months ended September 27, 2014 and September 28, 2013; (iii) Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 27, 2014 and September 28, 2013; (iv) Condensed Consolidated Statement of Shareholders' Equity for the nine months ended September 27, 2014; (v) Condensed Consolidated Statements of Cash Flows for the nine months ended September 27, 2014 and September 28, 2013; and (vi) Notes to Condensed Consolidated Financial Statements.	Filed herewith

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		SELECT COMFORT CORPORATION
		(Registrant)

Dated:	October 29, 2014	By:	/s/ Shelly R. Ibach
			Shelly R. Ibach
			Chief Executive Officer
			(principal executive officer)

		By:	/s/ Robert J. Poirier
			Robert J. Poirier
			Chief Accounting Officer
			(principal accounting officer)

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EXHIBIT INDEX



Exhibit Number	Description	Method of Filing

31.1	Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Filed herewith

31.2	Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	Filed herewith

32.1	Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350	Furnished herewith

32.2	Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350	Furnished herewith

101	The following financial information from the Company's Quarterly Report on Form 10-Q for the period ended September 27, 2014, filed with the SEC on October 29, 2014, formatted in eXtensible Business Reporting Language: (i) Condensed Consolidated Balance Sheets as of September 27, 2014 and December 28, 2013; (ii) Condensed Consolidated Statements of Operations for the three and nine months ended September 27, 2014 and September 28, 2013; (iii) Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 27, 2014 and September 28, 2013; (iv) Condensed Consolidated Statement of Shareholders' Equity for the nine months ended September 27, 2014; (v) Condensed Consolidated Statements of Cash Flows for the nine months ended September 27, 2014 and September 28, 2013; and (vi) Notes to Condensed Consolidated Financial Statements.	Filed herewith