Sleep Number Corp - Quarter Report: 2017 July (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 July 1, 2017

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, smaller reporting company, or an emerging growth company. See definition of “large accelerated filer,” “accelerated filer,” “smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.



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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.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 July 1, 2017, 41,066,000 shares of the Registrant’s Common Stock were outstanding.

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PART I: FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited)
	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	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	22
Item 4.	Controls and Procedures	22

PART II: OTHER INFORMATION		23

Item 1.	Legal Proceedings	23
Item 1A.	Risk Factors	23
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	23
Item 3.	Defaults Upon Senior Securities	24
Item 4.	Mine Safety Disclosures	24
Item 5.	Other Information	24
Item 6.	Exhibits	25
SIGNATURES		26

PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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Condensed Consolidated Balance Sheets

(unaudited - in thousands, except per share amounts)



	July 1, 2017		December 31, 2016
Assets
Current assets:
Cash and cash equivalents	$	2,082	$	11,609
Accounts receivable, net of allowance for doubtful accounts of $856 and $884, respectively	24,486		19,705
Inventories	69,856		75,026
Income taxes receivable	3,681		—
Prepaid expenses	10,686		8,705
Other current assets	18,397		23,282
Total current assets	129,188		138,327

Non-current assets:
Property and equipment, net	205,621		208,367
Goodwill and intangible assets, net	78,678		80,817
Deferred income taxes	—		4,667
Other non-current assets	27,243		24,988
Total assets	$	440,730	$	457,166

Liabilities and Shareholders’ Equity
Current liabilities:
Borrowings under revolving credit facility	$	13,950	$	—
Accounts payable	105,593		105,375
Customer prepayments	45,725		26,207
Accrued sales returns	12,602		15,222
Compensation and benefits	29,051		19,455
Taxes and withholding	6,547		23,430
Other current liabilities	39,195		35,628
Total current liabilities	252,663		225,317

Non-current liabilities:
Deferred income taxes	307		—
Other non-current liabilities	73,321		71,529
Total liabilities	326,291		296,846

Shareholders’ equity:
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding	—		—
Common stock, $0.01 par value; 142,500 shares authorized, 41,066 and 43,569 shares issued and outstanding, respectively	411		436
Additional paid-in capital	—		—
Retained earnings	114,028		159,884
Total shareholders’ equity	114,439		160,320
Total liabilities and shareholders’ equity	$	440,730	$	457,166

See accompanying notes to condensed consolidated financial statements.

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SELECT COMFORT CORPORATION

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Condensed Consolidated Statements of Operations

(unaudited - in thousands, except per share amounts)



	Three Months Ended						Six Months Ended
	July 1, 2017			July 2, 2016			July 1, 2017			July 2, 2016
Net sales	$	284,673		$	276,878		$	678,572		$	629,858
Cost of sales	108,054			105,617			255,494			249,523
Gross profit	176,619			171,261			423,078			380,335

Operating expenses:
Sales and marketing	144,498			134,785			313,764			285,453
General and administrative	28,819			27,018			62,588			57,924
Research and development	6,363			7,062			13,959			14,664
Total operating expenses	179,680			168,865			390,311			358,041
Operating (loss) income	(3,061		)	2,396			32,767			22,294
Other expense, net	(282		)	(229		)	(420		)	(326		)
(Loss) income before income taxes	(3,343		)	2,167			32,347			21,968
Income tax (benefit) expense	(2,565		)	751			8,664			7,583
Net (loss) income	$	(778	)	$	1,416		$	23,683		$	14,385

Basic net (loss) income per share:
Net (loss) income per share – basic	$	(0.02	)	$	0.03		$	0.56		$	0.30
Weighted-average shares – basic	41,716			46,394			42,233			47,247
Diluted net (loss) income per share:
Net (loss) income per share – diluted	$	(0.02	)	$	0.03		$	0.55		$	0.30
Weighted-average shares – diluted	41,716			47,044			43,080			47,945

See accompanying notes to condensed consolidated financial statements.

Index

SELECT COMFORT CORPORATION

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Condensed Consolidated Statements of Comprehensive Income

(unaudited - in thousands)



	Three Months Ended					Six Months Ended
	July 1, 2017			July 2, 2016		July 1, 2017		July 2, 2016
Net (loss) income	$	(778	)	$	1,416	$	23,683	$	14,385
Other comprehensive income – unrealized gain on available-for-sale marketable debt securities, net of income tax	—			—		—		14
Comprehensive (loss) income	$	(778	)	$	1,416	$	23,683	$	14,399

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			Total
	Shares		Amount			Additional Paid-in Capital			Retained Earnings			Total
Balance at December 31, 2016	43,569		$	436		$	—		$	159,884		$	160,320
Net income	—		—			—			23,683			23,683
Exercise of common stock options	180		2			2,652			—			2,654
Stock-based compensation	581		6			7,870			—			7,876
Repurchases of common stock	(3,264	)	(33		)	(10,522		)	(69,539		)	(80,094		)
Balance at July 1, 2017	41,066		$	411		$	—		$	114,028		$	114,439

See accompanying notes to condensed consolidated financial statements.

Index

SELECT COMFORT CORPORATION

AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(unaudited - in thousands)



	Six Months Ended
	July 1, 2017			July 2, 2016
Cash flows from operating activities:
Net income	$	23,683		$	14,385
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	31,177			27,960
Stock-based compensation	7,876			7,606
Net loss on disposals and impairments of assets	2			7
Excess tax benefits from stock-based compensation	—			(472		)
Deferred income taxes	4,974			985
Changes in operating assets and liabilities:
Accounts receivable	(4,781		)	5,489
Inventories	5,170			12,904
Income taxes	(14,532		)	15,324
Prepaid expenses and other assets	2,110			(6,838		)
Accounts payable	11,858			(15,282		)
Customer prepayments	19,518			(26,885		)
Accrued compensation and benefits	9,834			9,249
Other taxes and withholding	(6,032		)	1,654
Other accruals and liabilities	(2,050		)	1,034
Net cash provided by operating activities	88,807			47,120

Cash flows from investing activities:
Purchases of property and equipment	(27,132		)	(23,764		)
Proceeds from marketable debt securities	—			15,090
Proceeds from sales of property and equipment	—			67
Decrease in restricted cash	3,150			—
Net cash used in investing activities	(23,982		)	(8,607		)

Cash flows from financing activities:
Repurchases of common stock	(80,094		)	(71,366		)
Net increase in short-term borrowings	3,098			12,574
Proceeds from issuance of common stock	2,654			1,623
Excess tax benefits from stock-based compensation	—			472
Debt issuance costs	(10		)	(409		)
Net cash used in financing activities	(74,352		)	(57,106		)

Net decrease in cash and cash equivalents	(9,527		)	(18,593		)
Cash and cash equivalents, at beginning of period	11,609			20,994
Cash and cash equivalents, at end of period	$	2,082		$	2,401

See accompanying notes to condensed consolidated financial statements.

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SELECT COMFORT CORPORATION

AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. Business and Summary of Significant Accounting Policies

Business & Basis of Presentation

We prepared the condensed consolidated financial statements as of and for the three and six months ended July 1, 2017 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 July 1, 2017 and December 31, 2016, 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 31, 2016 and other recent filings with the SEC.

The preparation of condensed 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 condensed 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 consolidated financial statements in future periods. Our critical accounting policies consist of stock-based compensation, goodwill and indefinite-lived intangible assets, warranty liabilities and revenue recognition.

The condensed 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.

Revenue Recognition

At July 1, 2017 and December 31, 2016, we had deferred revenue totaling $67 million and $61 million, of which $25 million and $21 million are included in other current liabilities, respectively, and $42 million and $40 million are included in other non-current liabilities, respectively, in our consolidated balance sheets. We also have related deferred costs totaling $38 million and $33 million, of which $14 million and $11 million are included in other current assets, respectively, and $24 million and $22 million are included in other non-current assets, respectively, in our consolidated balance sheets. The deferred revenue and costs are recognized over the product’s estimated life of four years.

New Accounting Pronouncements

Adopted

In March 2016, the Financial Accounting Standards Board (FASB) issued new guidance on the accounting for, and disclosure of, stock-based compensation which we adopted effective January 1, 2017. The new guidance is intended to simplify several aspects of the accounting for stock-based compensation arrangements, including the income tax impact, forfeitures and classification on the statement of cash flows. Under the previous guidance, excess tax benefits and deficiencies were recognized in additional paid-in capital in the consolidated balance sheets. Upon adoption of the new guidance, these excess tax benefits or deficiencies are required to be recognized as discrete adjustments to income tax expense in the consolidated statements of operations on a prospective basis. During the three and six months ended July 1, 2017, excess tax benefits of $0.4 million and $1.2 million, respectively, were recognized as a reduction of income tax expense, rather than in additional paid-in capital.

In addition, under the new guidance, excess income tax benefits from stock-based compensation arrangements are classified as an operating activity in the statement of cash flows rather than as a financing activity. This resulted in an increase to operating cash flows of $0.9 million and $2.1 million for the three and six months ended July 1, 2017. We elected to apply the new cash flow classification guidance prospectively. The prior-year statement of cash flows has not been adjusted.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

We have also elected to continue to estimate the number of stock-based awards expected to vest, as permitted by the new guidance, rather than electing to account for forfeitures as they occur.

Not Yet Adopted

In May 2014, the FASB issued a comprehensive new revenue recognition model that requires a company to recognize revenue in a manner that depicts 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 was originally effective for fiscal years beginning after December 15, 2016 and early adoption was not permitted. In July 2015, the FASB deferred the effective date from fiscal years beginning after December 15, 2016 to fiscal years beginning after December 15, 2017 (including interim reporting periods within those fiscal years). Early adoption is permitted to the original effective date of fiscal years beginning after December 15, 2016 (including interim reporting periods within those fiscal years). Companies may use either a full retrospective or a modified retrospective approach to adopt this new guidance. When we adopt this new guidance, we expect to use the modified retrospective approach which will result in an adjustment to opening retained earnings, but would not restate prior periods' financial statements. We are continuing to evaluate the effect on our revenue recognition, disclosure requirements and changes that may be necessary to our internal controls over financial reporting.

In February 2016, the FASB issued new guidance on accounting for leases that generally requires most leases to be recognized on the balance sheet. This new guidance is effective for reporting periods beginning after December 15, 2018, with early adoption permitted. The provisions of this new guidance are to be applied using a modified retrospective approach, with elective reliefs, which requires application of the new guidance for all periods presented. We are evaluating the effect of the new standard on our consolidated financial statements and related disclosures.

2. Fair Value Measurements

At July 1, 2017 and December 31, 2016, we had $2.9 million and $2.3 million, respectively, of debt and equity securities that fund our deferred compensation plan and are classified in other non-current assets. We also had corresponding deferred compensation plan liabilities of $2.9 million and $2.3 million at July 1, 2017 and December 31, 2016, respectively, which are included in other non-current liabilities. 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.

3. Inventories

Inventories consisted of the following (in thousands):



	July 1, 2017		December 31, 2016
Raw materials	$	5,740	$	7,973
Work in progress	95		72
Finished goods	64,021		66,981
	$	69,856	$	75,026

4. Goodwill and Intangible Assets, Net

Goodwill and Indefinite-Lived Intangible Assets

Goodwill was $64.0 million at July 1, 2017 and December 31, 2016. Indefinite-lived trade name/trademarks totaled $1.4 million at July 1, 2017 and December 31, 2016.

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Notes to Condensed Consolidated Financial Statements

(unaudited)

Definite-Lived Intangible Assets

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



	July 1, 2017				December 31, 2016
	Gross Carrying Amount		Accumulated Amortization		Gross Carrying Amount		Accumulated Amortization
Developed technologies	$	18,851	$	5,615	$	18,851	$	4,524
Customer relationships	2,413		2,413		2,413		1,365
Trade names/trademarks	101		101		101		101
	$	21,365	$	8,129	$	21,365	$	5,990

Amortization expense for the three months ended July 1, 2017 and July 2, 2016, was $0.5 million and $0.6 million, respectively. Amortization expense for the six months ended July 1, 2017 and July 2, 2016, was $2.1 million and $1.3 million, respectively.

5. Credit Agreement

In March 2017, we amended our revolving credit facility to increase our net aggregate availability from $150 million to $153.15 million. We maintained the accordion feature which allows us to increase the amount of the credit facility from $153.15 million to $200 million, subject to lenders' approval. There were no other changes to the credit agreement's terms and conditions.

The credit facility is for general corporate purposes and is utilized to meet our seasonal working capital requirements. The credit facility matures in February 2021. The credit agreement provides the lenders with a collateral security interest in substantially all of our assets and those of our subsidiaries and requires us to comply with, among other things, a maximum leverage ratio and a minimum interest coverage ratio. Under the terms of the credit agreement we pay a variable rate of interest and a commitment fee based on our leverage ratio.

As of July 1, 2017, we had $14 million in outstanding borrowings and $3.15 million in outstanding letters of credit. We had additional borrowing capacity of $136 million. As of July 1, 2017, the weighted-average interest rate on borrowings outstanding under the credit facility was 3.3%. We were in compliance with all financial covenants.

6. Repurchase of Common Stock

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



	Three Months Ended				Six Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Amount repurchased under Board-approved share repurchase program	$	25,000	$	20,000	$	75,000	$	70,000
Amount repurchased in connection with the vesting of employee restricted stock grants	300		125		5,094		1,366
Total amount repurchased	$	25,300	$	20,125	$	80,094	$	71,366

As of July 1, 2017, the remaining authorization under our Board-approved share repurchase program was $170 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)

7. Stock-Based Compensation Expense

Total stock-based compensation expense was as follows (in thousands):



	Three Months Ended				Six Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Stock awards	$	3,584	$	3,261	$	6,720	$	6,412
Stock options	588		579		1,156		1,194
Total stock-based compensation expense	4,172		3,840		7,876		7,606
Income tax benefit	1,406		1,325		2,654		2,624
Total stock-based compensation expense, net of tax	$	2,766	$	2,515	$	5,222	$	4,982

In addition to the income tax benefit related to stock-based compensation expense in the table above, excess tax benefits of $0.4 million and $1.2 million were recognized as reductions of income tax expense during the three and six months ended July 1, 2017, respectively. There were no excess tax benefits recognized in income tax expense during the three and six months ended July 2, 2016. See Note 1, New Accounting Pronouncements, for additional discussion of new guidance on the accounting for, and disclosure of, stock-based compensation which we adopted effective January 1, 2017.

8. Profit Sharing and 401(k) Plan

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 pay period, we may make a discretionary contribution equal to a percentage of the employee’s contribution. During the three months ended July 1, 2017 and July 2, 2016, our contributions, net of forfeitures, were $1.2 million and $1.0 million, respectively. During the six months ended July 1, 2017 and July 2, 2016, our contributions, net of forfeitures, were $2.5 million and $2.3 million, respectively.

9. Other Expense, Net

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



	Three Months Ended						Six Months Ended
	July 1, 2017			July 2, 2016			July 1, 2017			July 2, 2016
Interest expense	$	(288	)	$	(251	)	$	(470	)	$	(357	)
Interest income	6			22			50			31
Other expense, net	$	(282	)	$	(229	)	$	(420	)	$	(326	)

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Notes to Condensed Consolidated Financial Statements

(unaudited)

10. Net (Loss) Income per Common Share

The components of basic and diluted net (loss) income per share were as follows (in thousands, except per share amounts):



	Three Months Ended					Six Months Ended
	July 1, 2017			July 2, 2016		July 1, 2017		July 2, 2016
Net (loss) income	$	(778	)	$	1,416	$	23,683	$	14,385

Reconciliation of weighted-average shares outstanding:
Basic weighted-average shares outstanding	41,716			46,394		42,233		47,247
Dilutive effect of stock-based awards	—			650		847		698
Diluted weighted-average shares outstanding	41,716			47,044		43,080		47,945

Net (loss) income per share – basic	$	(0.02	)	$	0.03	$	0.56	$	0.30
Net (loss) income per share – diluted	$	(0.02	)	$	0.03	$	0.55	$	0.30

For the three months ended July 1, 2017, potentially dilutive stock-based awards have been excluded from the calculation of diluted weighted-average shares outstanding, as their inclusion would have had an anti-dilutive effect on our net loss per diluted share. For the six months ended July 1, 2017 and the three and six months ended July 2, 2016, anti-dilutive stock-based awards excluded from the diluted net income per share calculations were immaterial.

11. Commitments and Contingencies

Sales Returns

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



	Six Months Ended
	July 1, 2017			July 2, 2016
Balance at beginning of year	$	15,222		$	20,562
Additions that reduce net sales	32,434			35,419
Deductions from reserves	(35,054		)	(40,226		)
Balance at end of period	$	12,602		$	15,755

Warranty Liabilities

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



	Six Months Ended
	July 1, 2017			July 2, 2016
Balance at beginning of year	$	8,633		$	10,028
Additions charged to costs and expenses for current-year sales	4,243			6,601
Deductions from reserves	(3,665		)	(7,290		)
Changes in liability for pre-existing warranties during the current year, including expirations	(55		)	(1,515		)
Balance at end of period	$	9,156		$	7,824

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Notes to Condensed Consolidated Financial Statements

(unaudited)

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 January 12, 2015, Plaintiffs David and Katina Spade commenced a purported class action lawsuit in New Jersey state court against Select Comfort alleging that Select Comfort violated New Jersey consumer statutes by failing to provide to purchasing consumers certain disclosures required by the New Jersey Furniture Regulations. It is undisputed that plaintiffs suffered no actual damages or in any way relied upon or were impacted by the alleged omissions. Nonetheless, on behalf of a purported class of New Jersey purchasers of Select Comfort beds and bases, plaintiffs seek to recover a $100 statutory fine for each alleged omission, along with attorneys’ fees and costs. Select Comfort removed the case to the United States District Court for the District of New Jersey, which subsequently granted Select Comfort’s motion to dismiss. Plaintiffs appealed to the United States Court of Appeals for the Third Circuit, which has certified two questions of law to the New Jersey Supreme Court relating to whether plaintiffs who have suffered no actual injury may bring claims. The New Jersey Supreme Court has accepted the certified questions and the parties are in the process of preparing and submitting briefs. As the United States District Court for the District of New Jersey determined, we believe that the case is without merit and the order of dismissal should be affirmed.

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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 consolidated 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


•	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;


•	The potential for claims that our products, processes or trademarks infringe the intellectual property rights of others;


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


•	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 main manufacturing facilities;


•	Increasing government regulation;


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


•	The adequacy of our management information systems to meet the evolving needs of our business and existing and evolving regulatory standards applicable to data privacy and security;


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


•	The vulnerability of our management information systems to attacks by hackers or other cyber threats that could compromise the security of our systems or disrupt our business;


•	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.

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

Overview

Company Overview

We are executing a consumer innovation strategy with three significant competitive advantages as we work toward our ambitious vision to become one of the world's most beloved brands by delivering an unparalleled sleep experience. We offer consumers high-quality, individualized sleep solutions and services, which include a complete line of Sleep Number^® beds, bases and bedding accessories. Our competitive advantages are: proprietary sleep innovations, exclusive distribution and lifelong customer relationships.

We are a vertically integrated brand and the developer, manufacturer, marketer, retailer and servicer of a complete line of Sleep Number beds and related technology. We are also the pioneer in biometric sleep tracking and adjustability. Only the Sleep Number bed offers SleepIQ^® technology - proprietary sensor technology that works directly with the bed’s DualAir™ system to track each individual’s sleep. SleepIQ technology communicates how you slept and what adjustments you can make to optimize your sleep and improve your daily life. Our bed assortment is complemented with proprietary FlextFit™ adjustable bases, and Sleep Number pillows, sheets and other bedding products.

Our differentiated products are sold exclusively at more than 540 Sleep Number^® stores located in 49 states, online at SleepNumber.com or via phone. We offer consumers a unique, value-added store and digital experience through our team of over 3,800 individuals who are dedicated to our mission of improving lives by individualizing sleep experiences. This experience, combined with the advantages of our vertical business model and SleepIQ technology, enable a lifelong relationship with our customers. We generate revenue by marketing and selling products directly to new and existing customers.

We expect our business transformation over the past five years to result in improved profitability through the productivity and service advancements associated with our integrated ERP platform, smart bed design, more efficient manufacturing and supply chain network evolution.

We are committed to delivering superior shareholder value through three primary drivers of earnings per share growth: increasing consumer demand, leveraging the business model and deploying capital efficiently. The investments we have made in R&D, technology, digital and our store experience have strengthened our competitive advantages and established our innovation leadership. We have a long-term orientation and are focused on delivering sustainable, profitable growth.

Results of Operations

Quarterly and Year-to-Date Results

Quarterly and year-to-date 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 investments in growth initiatives and infrastructure, timing of store openings/closings and related expenses, changes in net sales resulting from changes in our store base, the timing of new product introductions, 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, 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.

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Highlights

Financial highlights for the period ended July 1, 2017 were as follows:

•

Net sales for the three months ended July 1, 2017 increased 3% to $285 million, compared with $277 million for the same period one year ago. Net sales for the three months ended July 1, 2017 were affected by an approximately $25 million shift in sales from our second quarter to our third quarter (representing approximately 9 percentage points (ppt.) of additional growth over the prior year) as a result of a delay in deliveries and shipments related to an inventory shortage from one of our new suppliers. The issue has been resolved and we don't expect a shortage in the future. We now have the necessary inventory to fulfill our outstanding second-quarter orders and the new supplier's production output has been exceeding our forecasted demand for the third quarter and beyond.


•	The 3% sales increase was driven by 8 ppt. of growth from sales generated by 43 net new stores opened in the past 12 months, partially offset by a 4% comparable sales decline in our Company-Controlled channel.


•	Sales per store (for stores open at least one year), on a trailing twelve-month basis for the period ended July 1, 2017 were $2.3 million, consistent with the prior-year comparable period.


•	In May 2017 we began selling our Sleep Number 360™ i7 and i10 smart beds. The Sleep Number 360 smart bed won 13 awards at CES, including being named the Best of Innovation Honoree in the Home Appliance category. We will continue the changeover of our entire product line to our Sleep Number 360 smart beds in a phased implementation over the next nine months.


•	Operating loss for the quarter totaled $3.1 million, or (1.1%) of net sales, compared with operating income of $2.4 million, or 0.9% of net sales, for the same period one year ago. The decrease in operating income was attributable to the $25 million sales shift.


•	Net loss for the quarter was $0.8 million, or $(0.02) per diluted share, compared with net income of $1.4 million, or $0.03 per diluted share, for the same period one year ago.


•	Cash provided by operating activities totaled $89 million for the six months ended July 1, 2017, compared with $47 million for the same period one year ago. Investing activities for the current-year period included $27 million of property and equipment purchases, compared with $24 million for the same period last year.


•	At July 1, 2017, cash and cash equivalents totaled $2 million and we ended the quarter with $14 million of borrowings under our $153 million revolving credit facility, as planned. We utilize our credit facility to meet our seasonal working capital requirements.


•	In the second quarter of 2017, we repurchased 0.8 million shares of our common stock under our Board-approved share repurchase program at a cost of $25 million (an average of $30.13 per share). As of July 1, 2017, the remaining authorization was $170 million.

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										Six Months Ended
	July 1, 2017					July 2, 2016					July 1, 2017					July 2, 2016
Net sales	$	284.7		100.0	%	$	276.9		100.0	%	$	678.6		100.0	%	$	629.9		100.0	%
Cost of sales	108.1			38.0	%	105.6			38.1	%	255.5			37.7	%	249.5			39.6	%
Gross profit	176.6			62.0	%	171.3			61.9	%	423.1			62.3	%	380.3			60.4	%

Operating expenses:
Sales and marketing	144.5			50.8	%	134.8			48.7	%	313.8			46.2	%	285.5			45.3	%
General and administrative	28.8			10.1	%	27.0			9.8	%	62.6			9.2	%	57.9			9.2	%
Research and development	6.4			2.2	%	7.1			2.6	%	14.0			2.1	%	14.7			2.3	%
Total operating expenses	179.7			63.1	%	168.9			61.0	%	390.3			57.5	%	358.0			56.8	%
Operating (loss) income	(3.1		)	(1.1	%)	2.4			0.9	%	32.8			4.8	%	22.3			3.5	%
Other expense, net	(0.3		)	(0.1	%)	(0.2		)	(0.1	%)	(0.4		)	(0.1	%)	(0.3		)	(0.1	%)
(Loss) income before income taxes	(3.3		)	(1.2	%)	2.2			0.8	%	32.3			4.8	%	22.0			3.5	%
Income tax (benefit) expense	(2.6		)	(0.9	%)	0.8			0.3	%	8.7			1.3	%	7.6			1.2	%
Net (loss) income	$	(0.8	)	(0.3	%)	$	1.4		0.5	%	$	23.7		3.5	%	$	14.4		2.3	%

Net (loss) income per share:
Basic	$	(0.02	)			$	0.03				$	0.56				$	0.30
Diluted	$	(0.02	)			$	0.03				$	0.55				$	0.30

Weighted-average number of common shares:
Basic	41.7					46.4					42.2					47.2
Diluted	41.7					47.0					43.1					47.9

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



	Three Months Ended				Six Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Company-Controlled channel	97.7	%	96.6	%	98.0	%	97.0	%
Wholesale/Other channel	2.3	%	3.4	%	2.0	%	3.0	%
Total	100.0	%	100.0	%	100.0	%	100.0	%

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



	Three Months Ended				Six Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Sales change rates:
Retail comparable-store sales⁽¹⁾	(6	%)	(7	%)	(1	%)	(5	%)
Online and Phone	26	%	(2	%)	22	%	3	%
Company-Controlled comparable sales change	(4	%)	(6	%)	0	%	(5	%)
Net opened/closed stores	8	%	6	%	9	%	5	%
Total Company-Controlled channel	4	%	0	%	9	%	0	%
Wholesale/Other channel	(31	%)	21	%	(27	%)	15	%
Total net sales change	3	%	1	%	8	%	1	%

⁽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						Six Months Ended
	July 1, 2017			July 2, 2016			July 1, 2017		July 2, 2016
Average sales per store⁽¹⁾($ in thousands)	$	2,335		$	2,333
Average sales per square foot⁽¹⁾	$	906		$	937
Stores > $1 million in net sales⁽¹⁾	97		%	98		%
Stores > $2 million in net sales⁽¹⁾	58		%	59		%
Average revenue per mattress unit – Company-Controlled channel⁽²⁾	$	4,306		$	4,206		$	4,155	$	4,074

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

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

The number of retail stores operating was as follows:



	Three Months Ended				Six Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Beginning of period	546		497		540		488
Opened	8		19		24		33
Closed	(5	)	(10	)	(15	)	(15	)
End of period	549		506		549		506

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Comparison of Three Months Ended July 1, 2017 with Three Months Ended July 2, 2016

Net sales

Net sales increased 3% to $285 million for the three months ended July 1, 2017, compared with $277 million for the same period one year ago. Net sales for the three months ended July 1, 2017 were affected by an approximately $25 million shift in sales from our second quarter to our third quarter as a result of delay in deliveries and shipments related to an inventory shortage from one of our new suppliers. The issue has been resolved and we don't expect a shortage in the future. We now have the necessary inventory to fulfill our outstanding second-quarter orders and the new supplier's production output has been exceeding our forecasted demand for the third quarter and beyond. The 3% sales increase was driven by 8 percentage points (ppt.) of growth from sales generated by 43 net new stores opened in the past 12 months, partially offset by a 4% comparable sales decline in our Company-Controlled channel.

The $8 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $21 million increase resulting from net store openings; partially offset by (ii) a $10 million decrease in sales from our Company-Controlled comparable sales; and (iii) a $3 million decrease in Wholesale/Other channel sales. Company-Controlled mattress unit sales increased 2%. Average revenue per mattress unit in our Company-Controlled channel increased by 2% to $4,306.

Gross profit

Gross profit of $177 million increased by $5 million compared with the same period one year ago. The gross profit rate increased to 62.0% of net sales for the three months ended July 1, 2017, compared with 61.9% for the prior-year comparable period. The current-year gross profit rate improvement of 0.1 ppt. was primarily due to lower sales return and exchange costs compared with the same period one year ago and operating efficiencies which more than offset margin pressures from supply chain shipping inefficiencies related to the delayed deliveries in the second quarter. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors, including warranty expenses, product mix changes and performance-based incentive compensation.

Sales and marketing expenses

Sales and marketing expenses for the three months ended July 1, 2017 increased to $144 million, or 50.8% of net sales, compared with $135 million, or 48.7% of net sales, for the same period one year ago. The 2.1 ppt. increase in the sales and marketing expense rate was mainly due to the deleveraging impact resulting from the $25 million net sales shift from our second quarter to our third quarter.

General and administrative expenses

General and administrative (G&A) expenses totaled $29 million for the three months ended July 1, 2017, compared with $27 million in the prior-year period, and increased to 10.1% of net sales, compared with 9.8% of net sales last year. The $1.8 million increase in G&A expenses consisted primarily of the following: (i) $0.9 million increase in infrastructure expenses to support key business initiatives; (ii) $0.5 million of additional depreciation and amortization expense, including incremental depreciation expense from capital expenditures that support the growth of our business; and (iii) a $0.4 million net increase in miscellaneous other expenses. The G&A expense rate increased by 0.3 ppt. in the current-year period compared with the same period one year ago due to the deleveraging impact from the $25 million net sales shift from our second quarter to our third quarter.

Research and development expenses

Research and development (R&D) expenses for the three months ended July 1, 2017 were $6.4 million, or 2.2% of net sales, compared with $7.1 million, or 2.6% of net sales, for the same period one year ago. The $0.7 million decrease in R&D expenses was due to the timing of our investments to support product innovations. For the three months ended July 1, 2017, the investment spending is consistent with our current-year and long-term consumer innovation strategy.

Income tax (benefit) expense

Income tax benefit was $2.6 million for the three months ended July 1, 2017, compared with income tax expense of $0.8 million for the same period one year ago. The tax benefit for the current-year period primarily resulted from: (i) the recognition of additional tax credits; and (ii) stock-based compensation excess tax benefits in accordance with new Financial Accounting Standards Board (FASB) guidance effective for us beginning in 2017. Under previous FASB guidance, excess tax benefits or deficiencies were recognized in additional paid-in capital in our consolidated balance sheet. See Note 1, New Accounting Pronouncements, in the Notes to the Condensed Consolidated Financial Statements for additional details.

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Comparison of Six Months Ended July 1, 2017 with Six Months Ended July 2, 2016

Net sales

Net sales increased 8% to $679 million for the six months ended July 1, 2017, compared with $630 million for the same period one year ago. The sales change was comprised of 9 percentage points (ppt.) of growth from sales generated by 43 net new retail stores opened in the past 12 months, partially offset by a decrease in Wholesale/Other channel sales. Company-Controlled comparable sales were flat year-over-year. Net sales for the six months ended July 1, 2017 were affected by an approximately $25 million shift in sales from our second quarter to our third quarter as a result of a delay in deliveries and shipments related to an inventory shortage from one of our new suppliers. The issue has been resolved and we don't expect a shortage in the future. We now have the necessary inventory to fulfill our outstanding second-quarter orders and the new supplier's production output has been exceeding our forecasted demand for the third quarter and beyond.

The $49 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $53 million increase resulting from net store openings; and (ii) a $1 million increase in sales from our Company-Controlled comparable sales; partially offset by (iii) a $5 million decrease in Wholesale/Other channel sales. Company-Controlled mattress units increased 7% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 2%.

Gross profit

Gross profit of $423 million for the six months ended July 1, 2017 increased by $43 million, or 11%, compared with the same period one year ago. The gross profit rate increased to 62.3% of net sales for the first six months of 2017, compared with 60.4% for the prior-year period. The prior-year gross profit rate was negatively impacted by actions taken to manage operating issues associated with our ERP implementation. The current-year gross profit rate improvement of 1.9 ppt. was primarily due to manufacturing efficiencies and lower sales return and exchange costs compared with the same period one year ago. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors, including warranty expenses, product mix changes and performance-based incentive compensation.

Sales and marketing expenses

Sales and marketing expenses for the six months ended July 1, 2017 increased to $314 million compared with $285 million for the same period one year ago, and increased to 46.2% of net sales compared with 45.3% of net sales last year. The 0.9 ppt. increase in the sales and marketing expense rate was mainly due to the deleveraging impact resulting from the $25 million net sales shift from our second quarter to our third quarter; partially offset by 0.5 ppt. of leverage from media spending, which increased by 4% compared with the prior year, while net sales increased by 8%.

General and administrative expenses

General and administrative (G&A) expenses totaled $63 million for the six months ended July 1, 2017, compared with $58 million in the prior-year period, but the expense rate remained consistent with the prior year at 9.2% of net sales. The $5 million increase in G&A expenses consisted primarily of the following: (i) a $1.0 million increase in employee compensation, including a year-over-year increase in company-wide performance-based incentive compensation, and wage rate increases that were in line with inflation; (ii) $2.1 million of additional depreciation and amortization expense, including incremental depreciation expense from capital expenditures that support the growth of our business; and (iii) a $1.6 million net increase in miscellaneous other expenses. The current year G&A expense rate, while consistent with the prior-year, was negatively impacted by the deleveraging impact from the $25 million net sales shift from our second quarter to our third quarter.

Research and development expenses

Research and development (R&D) expenses for the six months ended July 1, 2017 were $14 million, or 2.1% of net sales, compared with $15 million, or 2.3% of net sales, for the same period one year ago. The $1 million decrease in R&D expenses was due to the timing of our investments to support product innovations. The investment spending year-to-date is consistent with our current-year and long-term consumer innovation strategy.

Income tax expense

Income tax expense was $8.7 million for the six months ended July 1, 2017, compared with $7.6 million for the same period one year ago. The effective tax rate for the six months ended July 1, 2017 was 26.8% compared with 34.5% for the prior-year period. The effective tax rate for the current-year period benefited from: (i) stock-based compensation excess tax benefits in accordance with new Financial Accounting Standards Board (FASB) guidance effective for us beginning in 2017; and (ii) the recognition of additional tax credits. Under previous FASB guidance, excess tax benefits or deficiencies were recognized in additional paid-in capital in our consolidated balance sheet. See Note 1, New Accounting Pronouncements, in the Notes to the Condensed Consolidated Financial Statements for additional details.

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Liquidity and Capital Resources

Managing our liquidity and capital resources is an important part of our commitment to deliver superior shareholder value. Our business model, which can operate with minimal working capital, does not require additional capital from external sources to fund operations or organic growth. Our primary sources of liquidity are cash flows provided by operating activities and cash available under our $153 million revolving credit facility. The 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.

As of July 1, 2017, cash and cash equivalents totaled $2 million compared with $12 million as of December 31, 2016. The $10 million decrease was primarily due to $89 million of cash provided by operating activities, which was more than offset by $27 million of cash used to purchase property and equipment and $80 million of cash used to repurchase our common stock ($75 million under our Board-approved share repurchase program and $5 million in connection with the vesting of employee restricted stock grants).

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



	Six Months Ended
	July 1, 2017			July 2, 2016
Total cash provided by (used in):
Operating activities	$	88.8		$	47.1
Investing activities	(24.0		)	(8.6		)
Financing activities	(74.4		)	(57.1		)
Net decrease in cash and cash equivalents	$	(9.5	)	$	(18.6	)

Cash provided by operating activities for the six months ended July 1, 2017 was $89 million compared with $47 million for the six months ended July 2, 2016. Significant components of the year-over-year change in cash provided by operating activities included: (i) a $9 million increase in net income for the six months ended July 1, 2017, compared with the same period one year ago; (ii) a $46 million fluctuation in customer prepayments resulting from higher than normal customer prepayments at January 2, 2016 (due to ERP implementation issues) and July 1, 2017 (due to an inventory shortage from one of our new suppliers); (iii) a $30 million fluctuation in income taxes based on a $15 million income taxes receivable at January 2, 2016 and a $4 million income taxes receivable at July 1, 2017 (income taxes payable for comparable periods); and (iv) the ERP implementation issues we experienced in our plants and supply chain during the fourth quarter of 2015 that resulted in increased accounts receivables, higher inventories, higher accounts payable and lower other taxes and withholding at the end of 2015.

Net cash used in investing activities was $24 million for the six months ended July 1, 2017, compared with $9 million of net cash used in investing activities for the same period one year ago. Investing activities for the current-year period included $27 million of property and equipment purchases, compared with $24 million for the same period last year. We decreased our investments in marketable debt securities by $15 million during the six months ended July 2, 2016. We did not hold any investments in marketable debt securities as of December 31, 2016 or July 1, 2017.

Net cash used in financing activities was $74 million for the six months ended July 1, 2017, compared with $57 million for the same period one year ago. During the six months ended July 1, 2017, we repurchased $80 million of our stock ($75 million under our Board-approved share repurchase program and $5 million in connection with the vesting of employee restricted stock awards) compared with $71 million ($70 million under our Board-approved share repurchase program and $1 million in connection with the vesting of employee restricted stock awards) during the same period one year ago. Short-term borrowings increased by $3 million during the current-year period, reflecting $14 million of borrowings under our $153 million revolving credit facility as of July 1, 2017, partially offset by a decrease in book overdrafts which are included in the net change in short-term borrowings.

Under our Board-approved share repurchase program, we repurchased 3.1 million shares at a cost of $75 million (an average of $24.57 per share) during the six months ended July 1, 2017. During the six months ended July 2, 2016, we repurchased 3.6 million shares at a cost of $70 million (an average of $19.70 per share). At July 1, 2017, the remaining authorization under our Board-approved share repurchase program was $170 million. There is no expiration date governing the period over which we can repurchase shares.

In March 2017, we amended our revolving credit facility to increase our net aggregate availability from $150 million to $153 million. We maintained the accordion feature which allows us to increase the amount of the credit facility from $153 million to $200 million, subject to lenders' approval. There were no other changes to the credit agreement's terms and conditions.

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We have an agreement with Synchrony Bank to offer qualified customers revolving credit arrangements to finance purchases from us (Synchrony Agreement). The Synchrony Agreement contains certain financial covenants, including a maximum leverage ratio and a minimum interest coverage ratio. As of July 1, 2017, 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.

Non-GAAP Data

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

We define earnings before interest, taxes, depreciation and amortization (Adjusted EBITDA) as net income plus: income tax expense, interest expense, depreciation and amortization, stock-based compensation and asset impairments. 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
	July 1, 2017			July 2, 2016		July 1, 2017		July 2, 2016
Net (loss) income	$	(778	)	$	1,416	$	60,715	$	25,067
Income tax (benefit) expense	(2,565		)	751		25,597		11,691
Interest expense	288			251		924		497
Depreciation and amortization	14,918			14,053		60,170		53,261
Stock-based compensation	4,172			3,840		12,231		12,068
Asset impairments	2			14		47		66
Adjusted EBITDA	$	16,037		$	20,325	$	159,684	$	102,650

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):



	Six Months Ended				Trailing-Twelve Months Ended
	July 1, 2017		July 2, 2016		July 1, 2017		July 2, 2016
Net cash provided by operating activities	$	88,807	$	47,120	$	193,332	$	110,008
Subtract: Purchases of property and equipment	27,132		23,764		61,220		70,412
Free cash flow	$	61,675	$	23,356	$	132,112	$	39,596

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Non-GAAP Data (continued)

Return on Invested Capital (ROIC)

(dollars in thousands)

ROIC is a financial measure we use to determine how efficiently we deploy our capital. It quantifies the return we earn on our invested capital. Management believes ROIC is also a useful metric for investors and financial analysts. We compute ROIC as outlined below. Our definition and calculation of ROIC may not be comparable to similarly titled definitions and calculations used by other companies. The tables below reconcile net operating profit after taxes (NOPAT) and total invested capital, which are non-GAAP financial measures, to the comparable GAAP financial measures:



	Trailing-Twelve Months Ended
	July 1, 2017			July 2, 2016
Net operating profit after taxes (NOPAT)
Operating income	$	87,124		$	37,035
Add: Rent expense⁽¹⁾	70,815			64,232
Add: Interest income	112			219
Less: Depreciation on capitalized operating leases⁽²⁾	(17,956		)	(16,749		)
Less: Income taxes⁽³⁾	(46,095		)	(27,055		)
NOPAT	$	94,000		$	57,682

Average invested capital
Total equity	$	114,439		$	173,807
Less: Cash greater than target⁽⁴⁾	—			—
Add: Long-term debt⁽⁵⁾	—			—
Add: Capitalized operating lease obligations⁽⁶⁾	566,520			513,856
Total invested capital at end of period	$	680,959		$	687,663
Average invested capital⁽⁷⁾	$	690,524		$	724,593
Return on invested capital (ROIC)⁽⁸⁾	13.6		%	8.0		%

___________________

⁽¹⁾ Rent expense is added back to operating income to show the impact of owning versus leasing the related assets.

⁽²⁾ Depreciation is based on the average of the last five fiscal quarters' ending capitalized operating lease obligations (see note 6) for the respective reporting periods with an assumed thirty-year useful life. This is subtracted from operating income to illustrate the impact of owning versus leasing the related assets.

⁽³⁾ Reflects annual effective income tax rates, before discrete adjustments, of 32.9% and 31.9% for 2017 and 2016, respectively.

⁽⁴⁾ Cash greater than target is defined as cash, cash equivalents and marketable debt securities less customer prepayments in excess of $100 million.

⁽⁵⁾ Long-term debt includes existing capital lease obligations, if applicable.

⁽⁶⁾ A multiple of eight times annual rent expense is used as an estimate for capitalizing our operating lease obligations. The methodology utilized aligns with the methodology of a nationally recognized credit rating agency.

⁽⁷⁾ Average invested capital represents the average of the last five fiscal quarters' ending invested capital balances.

⁽⁸⁾ ROIC equals NOPAT divided by average invested capital.

Note - Our ROIC calculation and data are considered non-GAAP financial measures and are not in accordance with, or preferable to, GAAP financial data. However, we are providing this information as we believe it facilitates analysis of the Company's financial performance by investors and financial analysts.

GAAP - generally accepted accounting principles in the U.S.

Index

Off-Balance-Sheet Arrangements and Contractual Obligations

As of July 1, 2017, we were not involved in any unconsolidated special purpose entity transactions. Other than our operating leases and a $3.15 million outstanding letter of credit, we do not have any off-balance-sheet financing.

There has been no material changes in our contractual obligations, other than in the ordinary course of business, since the end of fiscal 2016. See Note 5, 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 31, 2016 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 31, 2016. There were no significant changes in our critical accounting policies since the end of fiscal 2016.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to changes in short-term market interest rates that will impact our net interest expense. If overall interest rates were one percentage point higher than current rates, our net interest expense would not change by a significant amount based on the $14 million of borrowings under our revolving credit facility at July 1, 2017. We do not manage our interest-rate volatility risk through the use of derivative instruments.

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 principal executive officer and principal 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 July 1, 2017, 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

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⁾⁽²⁾	Average Price Paid per Share		Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs⁽¹⁾	Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs⁽³⁾
April 2, 2017 through April 29, 2017	198,182	$	27.82	188,257	$	189,756,000
April 30, 2017 through May 27, 2017	301,412	30.07		301,264	180,697,000
May 28, 2017 through July 1, 2017	341,114	31.44		340,290	170,000,000
Total	840,708	$	30.09	829,811	$	170,000,000


⁽¹⁾	Under our Board-approved $300 million share repurchase program, we repurchased 829,811 shares of our common stock at a cost of $25 million (based on trade dates) during the three months ended July 1, 2017.


⁽²⁾	In connection with the vesting of employee restricted stock grants, we also repurchased 10,897 shares of our common stock at a cost of $0.3 million during the three months ended July 1, 2017.


⁽³⁾	There is no expiration date governing the period over which we can repurchase shares under our Board-approved share repurchase program. 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
10.1	First Amendment, dated June 22, 2017, to Lease Agreement between DCI 1001 Minneapolis Venture, LLC, as Landlord, and Select Comfort Corporation, as Tenant, dated October 21, 2016	Filed herewith
10.2	Amended and Restated Executive Severance Pay Plan dated as of June 12, 2017	Filed herewith
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 July 1, 2017, filed with the SEC on July 28, 2017, formatted in eXtensible Business Reporting Language: (i) Condensed Consolidated Balance Sheets as of July 1, 2017 and December 31, 2016; (ii) Condensed Consolidated Statements of Operations for the three and six months ended July 1, 2017 and July 2, 2016; (iii) Condensed Consolidated Statements of Comprehensive Income for the three and six months ended July 1, 2017 and July 2, 2016; (iv) Condensed Consolidated Statement of Shareholders' Equity for the six months ended July 1, 2017; (v) Condensed Consolidated Statements of Cash Flows for the six months ended July 1, 2017 and July 2, 2016; 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:	July 28, 2017	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)

Index

EXHIBIT INDEX



Exhibit Number	Description	Method of Filing
10.1	First Amendment, dated June 22, 2017, to Lease Agreement between DCI 1001 Minneapolis Venture, LLC, as Landlord, and Select Comfort Corporation, as Tenant, dated October 21, 2016	Filed herewith
10.2	Amended and Restated Executive Severance Pay Plan dated as of June 12, 2017	Filed herewith
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 July 1, 2017, filed with the SEC on July 28, 2017, formatted in eXtensible Business Reporting Language: (i) Condensed Consolidated Balance Sheets as of July 1, 2017 and December 31, 2016; (ii) Condensed Consolidated Statements of Operations for the three and six months ended July 1, 2017 and July 2, 2016; (iii) Condensed Consolidated Statements of Comprehensive Income for the three and six months ended July 1, 2017 and July 2, 2016; (iv) Condensed Consolidated Statement of Shareholders' Equity for the six months ended July 1, 2017; (v) Condensed Consolidated Statements of Cash Flows for the six months ended July 1, 2017 and July 2, 2016; and (vi) Notes to Condensed Consolidated Financial Statements.	Filed herewith