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EX-31.2 - EXHIBIT 31.2 - Sleep Number Corpex312_2015xq3.htm
EX-10.4 - EXHIBIT 10.4 - Sleep Number Corpex104_2015xq3.htm
EX-10.1 - EXHIBIT 10.1 - Sleep Number Corpex101_2015xq3.htm
EX-10.3 - EXHIBIT 10.3 - Sleep Number Corpex103_2015xq3.htm
EX-32.2 - EXHIBIT 32.2 - Sleep Number Corpex322_2015xq3.htm
EX-10.2 - EXHIBIT 10.2 - Sleep Number Corpex102_2015xq3.htm
EX-32.1 - EXHIBIT 32.1 - Sleep Number Corpex321_2015xq3.htm
EX-10.5 - EXHIBIT 10.5 - Sleep Number Corpex105_2015xq3.htm
EX-31.1 - EXHIBIT 31.1 - Sleep Number Corpex311_2015xq3.htm
 
 
 
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 October 3, 2015

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 October 3, 2015, 50,646,000 shares of the Registrant’s Common Stock were outstanding.
 
 



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
INDEX

 
Page
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
 
 
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.




ii


PART I: FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(unaudited - in thousands, except per share amounts)

October 3,
2015

January 3,
2015
Assets
 

 
Current assets:
 

 
Cash and cash equivalents
$
72,678


$
51,995

Marketable debt securities – current
33,243


69,609

Accounts receivable, net of allowance for doubtful accounts of $750 and $739, respectively
26,286


19,693

Inventories
77,753


53,535

Prepaid expenses
14,815


17,792

Deferred income taxes
8,561


8,786

Other current assets
12,865


11,185

Total current assets
246,201


232,595






Non-current assets:
 


 
Marketable debt securities – non-current
8,581


44,441

Property and equipment, net
197,886


165,453

Goodwill and intangible assets, net
85,093


15,986

Deferred income taxes
10,219


3,433

Other assets
17,913


12,279

Total assets
$
565,893


$
474,187






Liabilities and Shareholders’ Equity
 


 
Current liabilities:
 


 
Accounts payable
$
115,330


$
84,197

Customer prepayments
25,387


28,726

Accrued sales returns
19,313

 
15,262

Compensation and benefits
32,960


33,066

Taxes and withholding
25,236


10,207

Other current liabilities
25,100


15,594

Total current liabilities
243,326


187,052






Non-current liabilities:
 


 
Warranty liabilities
5,143


2,722

Other long-term liabilities
45,501


27,506

Total liabilities
293,970


217,280






Shareholders’ equity:
 


 
Undesignated preferred stock; 5,000 shares authorized, no shares issued and outstanding



Common stock, $0.01 par value; 142,500 shares authorized, 50,646 and 52,798 shares issued and outstanding, respectively
506


528

Additional paid-in capital



Retained earnings
271,410


256,413

Accumulated other comprehensive income (loss)
7


(34
)
Total shareholders’ equity
271,923


256,907

Total liabilities and shareholders’ equity
$
565,893


$
474,187



See accompanying notes to condensed consolidated financial statements.

2


SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(unaudited - in thousands, except per share amounts)

 
Three Months Ended
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Net sales
$
373,919

 
$
323,366

 
$
999,017

 
$
834,541

Cost of sales
140,283

 
124,782

 
379,009

 
322,177

Gross profit
233,636

 
198,584

 
620,008

 
512,364

 
 
 
 

 
 

 
 

Operating expenses:
 

 
 
 
 
 
 
Sales and marketing
156,899

 
137,863

 
424,029

 
369,597

General and administrative
27,817

 
23,022

 
79,951

 
63,183

Research and development
3,521

 
2,353

 
10,275

 
5,725

Total operating expenses
188,237

 
163,238

 
514,255

 
438,505

Operating income
45,399

 
35,346

 
105,753

 
73,859

Other income, net
78

 
96

 
364

 
276

Income before income taxes
45,477

 
35,442

 
106,117

 
74,135

Income tax expense
13,623

 
11,888

 
34,426

 
25,108

Net income
$
31,854

 
$
23,554

 
$
71,691

 
$
49,027

 
 
 
 
 
 
 
 
Basic net income per share:
 

 
 

 
 
 
 
Net income per share – basic
$
0.63

 
$
0.44

 
$
1.39

 
$
0.91

Weighted-average shares – basic
50,945

 
53,271

 
51,654

 
53,677

Diluted net income per share:
 

 
 

 
 
 
 
Net income per share – diluted
$
0.62

 
$
0.44

 
$
1.36

 
$
0.90

Weighted-average shares – diluted
51,701

 
53,971

 
52,524

 
54,358


 























See accompanying notes to condensed consolidated financial statements.

3


SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Comprehensive Income
(unaudited - in thousands)

 
Three Months Ended
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Net income
$
31,854

 
$
23,554

 
$
71,691

 
$
49,027

Other comprehensive (loss) income – unrealized (loss) gain on available-for-sale marketable debt securities, net of income tax
(11
)
 
(35
)
 
41

 
(5
)
Comprehensive income
$
31,843

 
$
23,519

 
$
71,732

 
$
49,022






































 






See accompanying notes to condensed consolidated financial statements.

4


SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statement of Shareholders’ Equity
(unaudited - in thousands)

 
Common Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income/(Loss)
 
Total
 
Shares
 
Amount
 
 
 
 
Balance at January 3, 2015
52,798

 
$
528

 
$

 
$
256,413

 
$
(34
)
 
$
256,907

Net income

 

 

 
71,691

 

 
71,691

Other comprehensive income:
 

 
 

 
 

 
 

 
 

 
 
Unrealized gain on available-for-sale marketable debt securities, net of tax

 

 

 

 
41

 
41

Exercise of common stock options
212

 
2

 
2,656

 

 

 
2,658

Tax effect from stock-based compensation

 

 
1,974

 

 

 
1,974

Stock-based compensation
(6
)
 

 
8,952

 

 

 
8,952

Repurchases of common stock
(2,358
)
 
(24
)
 
(13,582
)
 
(56,694
)
 

 
(70,300
)
Balance at October 3, 2015
50,646

 
$
506

 
$

 
$
271,410

 
$
7

 
$
271,923

 





































See accompanying notes to condensed consolidated financial statements.

5


SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(unaudited - in thousands)
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
Cash flows from operating activities:
 
 
 
Net income
$
71,691

 
$
49,027

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 

Depreciation and amortization
33,694

 
29,579

Stock-based compensation
8,952

 
4,294

Net loss on disposals and impairments of assets
202

 
115

Excess tax benefits from stock-based compensation
(1,991
)
 
(754
)
Deferred income taxes
(5,633
)
 
(4,306
)
Gain on non-marketable equity securities
(6,891
)
 

Changes in operating assets and liabilities, net of effect of acquisition:
 
 
 

Accounts receivable
(6,543
)
 
(14,195
)
Inventories
(24,120
)
 
(8,552
)
Income taxes
13,433

 
9,883

Prepaid expenses and other assets
4,756

 
(4,146
)
Accounts payable
24,623

 
27,359

Customer prepayments
(3,351
)
 
13,847

Accrued compensation and benefits
(97
)
 
17,318

Other taxes and withholding
3,569

 
4,484

Warranty liabilities
3,945

 
953

Other accruals and liabilities
15,348

 
10,929

Net cash provided by operating activities
131,587

 
135,835

 
 
 
 
Cash flows from investing activities:
 
 
 
Proceeds from marketable debt securities
101,087

 
38,237

Acquisition of business
(70,018
)
 

Purchases of property and equipment
(61,435
)
 
(58,377
)
Investments in marketable debt securities
(29,299
)
 
(58,403
)
Proceeds from non-marketable equity securities
12,891

 

Proceeds from sales of property and equipment
41

 
5

Increase in restricted cash

 
(500
)
Net cash used in investing activities
(46,733
)
 
(79,038
)
 
 
 
 
Cash flows from financing activities:
 

 
 

Repurchases of common stock
(70,300
)
 
(31,480
)
Proceeds from issuance of common stock
2,658

 
1,631

Net increase (decrease) in short-term borrowings
2,119

 
(7,499
)
Excess tax benefits from stock-based compensation
1,991

 
754

Debt issuance costs
(639
)
 

Net cash used in financing activities
(64,171
)
 
(36,594
)
 
 
 
 
Net increase in cash and cash equivalents
20,683

 
20,203

Cash and cash equivalents, at beginning of period
51,995

 
58,223

Cash and cash equivalents, at end of period
$
72,678

 
$
78,426








See accompanying notes to condensed consolidated financial statements.

6


SELECT COMFORT CORPORATION
AND SUBSIDIARIES
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 October 3, 2015 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 October 3, 2015, and January 3, 2015, 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 January 3, 2015 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 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.

New Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (FASB) 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 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. We are evaluating the effect of the new standard on our consolidated financial statements and related disclosures, and have not yet selected a transition method.

In 2015, the FASB issued new guidance related to business combinations. The new guidance requires that adjustments made to provisional amounts recognized in a business combination be recorded in the period such adjustments are determined, rather than retrospectively adjusting previously reported amounts. The new guidance is effective for fiscal years, and interim reporting periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. We are evaluating the impact, if any, of adopting this new accounting guidance on our consolidated financial statements and related disclosures. We will adopt the new guidance in the first quarter of 2016.


7



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



2. Acquisition of BAM Labs, Inc.

In September 2015, we completed the acquisition of BAM Labs, Inc. (BAM Labs), the leading provider of biometric sensor and sleep monitoring for data-driven health and wellness. The addition of BAM Labs strengthens Sleep Number’s leadership in sleep innovation, adjustability and individualization. The acquisition broadens and deepens electrical, biomedical, software and backend capabilities - API (application program interface) and bio-signal analysis. Our ownership and control of biometric data advances smart, connected products that empower our customers to ‘know better sleep.’

We previously held a $6.0 million minority equity investment in BAM Labs based on the cost method (see Note 4, Investments, for further details). In connection with the acquisition, our equity investment was remeasured to a fair value of $12.9 million. We acquired the remaining capital stock of BAM Labs for $57.1 million for a total enterprise value of $70.0 million. The acquisition of BAM Labs did not have a significant impact on our consolidated results of operations, operating cash flows or financial position.

The following table summarizes the preliminary fair value of the net assets acquired as of October 3, 2015 (in thousands):
 
 
Accounts receivable
$
104

Inventories
98

Prepaid expenses
98

Property and equipment
91

Deferred income taxes
954

Goodwill
56,201

Intangible assets
13,619

Total assets acquired
71,165

Accounts payable
267

Compensation and benefits
322

Other liabilities
558

Total liabilities acquired
1,147

Net assets acquired
$
70,018


Purchased intangible assets of $13.6 million consisted of developed technologies with an estimated useful life of eight years. The definite-lived intangible assets will be deductible for income tax purposes over 15 years on a straight-line basis. The goodwill will not be deductible for income tax purposes. Purchase accounting is considered preliminary, subject to revision, mainly with respect to certain working capital accounts, income taxes and goodwill, as final information was not available as of October 3, 2015.




8



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



3. 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):
 
 
October 3, 2015
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Marketable debt securities – current
 
 
 
 
 
 
 
 
Corporate bonds
 
$

 
$
12,597

 
$

 
$
12,597

Commercial paper
 

 
9,993

 

 
9,993

Municipal bonds
 

 
8,140

 

 
8,140

U.S. Agency bonds
 

 
2,513

 

 
2,513

 
 

 
33,243

 

 
33,243

Marketable debt securities – non-current
 
 
 
 
 
 
 
 
Corporate bonds
 

 
5,013

 

 
5,013

U.S. Agency bonds
 

 
2,498

 

 
2,498

Municipal bonds
 

 
1,070

 

 
1,070

 
 

 
8,581

 

 
8,581

 
 
$

 
$
41,824

 
$

 
$
41,824


 
 
January 3, 2015
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Marketable debt securities – current
 
 
 
 
 
 
 
 
U.S. Treasury securities
 
$
17,506

 
$

 
$

 
$
17,506

Corporate bonds
 

 
20,139

 

 
20,139

U.S. Agency bonds
 

 
12,525

 

 
12,525

Commercial paper
 

 
12,486

 

 
12,486

Municipal bonds
 

 
6,953

 

 
6,953

 
 
17,506

 
52,103

 

 
69,609

Marketable debt securities – non-current
 
 
 
 
 
 
 
 
U.S. Treasury securities
 
14,990

 

 

 
14,990

Corporate bonds
 

 
15,236

 

 
15,236

U.S. Agency bonds
 

 
10,014

 

 
10,014

Municipal bonds
 

 
4,201

 

 
4,201

 
 
14,990

 
29,451

 

 
44,441

 
 
$
32,496

 
$
81,554

 
$

 
$
114,050


At October 3, 2015 and January 3, 2015, we had $1.5 million and $1.0 million, respectively, of debt and equity securities that fund 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 $1.5 million and $1.0 million at October 3, 2015 and January 3, 2015, 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.


9



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



4. Investments

Marketable Debt Securities

Investments in marketable debt securities were comprised of the following (in thousands):
 
October 3, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate bonds
$
17,612

 
$
4

 
$
(6
)
 
$
17,610

U.S. Agency bonds
4,998

 
13

 

 
5,011

Commercial paper
9,993

 

 

 
9,993

Municipal bonds
9,209

 
2

 
(1
)
 
9,210

 
$
41,812

 
$
19

 
$
(7
)
 
$
41,824

 
January 3, 2015
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Fair
Value
Corporate bonds
$
35,409

 
$
2

 
$
(36
)
 
$
35,375

U.S. Treasury securities
32,507

 
12

 
(23
)
 
32,496

U.S. Agency bonds
22,545

 
4

 
(10
)
 
22,539

Commercial paper
12,487

 

 
(1
)
 
12,486

Municipal bonds
11,157

 
2

 
(5
)
 
11,154

 
$
114,105

 
$
20

 
$
(75
)
 
$
114,050

 

Maturities of marketable debt securities were as follows (in thousands):
 
October 3, 2015
 
January 3, 2015
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
Marketable debt securities – current (due in less than one year)
$
33,231

 
$
33,243

 
$
69,607

 
$
69,609

Marketable debt securities – non-current (due in one to two years)
8,581

 
8,581

 
44,498

 
44,441

 
$
41,812

 
$
41,824

 
$
114,105

 
$
114,050


During the three months ended October 3, 2015 and September 27, 2014, we received proceeds of $59.2 million and $14.6 million, respectively, from marketable debt securities. During the nine months ended October 3, 2015 and September 27, 2014, we received proceeds of $101.0 million and $38.1 million, respectively, from marketable debt securities.
 
Other Investments

We previously held a minority equity investment in one of our strategic product-development partners, BAM Labs. In September 2015, we completed the acquisition of the remaining outstanding capital stock of BAM Labs. The carrying value of our equity investment in BAM Labs prior to the acquisition was $6.0 million based on the cost method. In connection with the acquisition, our equity investment was remeasured to a fair value of $12.9 million, resulting in a $3.0 million gain net of: (i) $3.4 million of acquisition related expenses; and (ii) $0.5 million of incremental BAM Labs research and development expenses. The remeasured fair value of our equity investment was based on the fair value of BAM Labs at the acquisition date. The net gain of $3.5 million is included in general and administrative expenses and the incremental BAM Labs expenses of $0.5 million are included in research and development expenses on our condensed consolidated statements of operations for the three and nine months ended October 3, 2015. See Note 2, Acquisition of BAM Labs, Inc., for details regarding this acquisition.


10



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



5. Inventories

Inventories consisted of the following (in thousands):
 
October 3,
2015
 
January 3,
2015
Raw materials
$
13,558

 
$
10,220

Work in progress
830

 
411

Finished goods
63,365

 
42,904

 
$
77,753

 
$
53,535


6. 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
 
 
October 3, 2015
 
September 27, 2014
 
 
Goodwill
 
Indefinite-Lived
Trade Name/
Trademarks
 
Goodwill
 
Indefinite-Lived
Trade Name/
Trademarks
 
 
Beginning balance
$
8,963

 
$
1,396

 
$
8,963

 
$
1,396

 
BAM Labs acquisition
56,201

 

 

 

 
Ending balance
$
65,164

 
$
1,396

 
$
8,963

 
$
1,396


Definite-Lived Intangible Assets

The following table provides the gross carrying amount and related accumulated amortization of our definite-lived intangible assets (in thousands):
 
October 3, 2015
 
January 3, 2015
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Gross Carrying
Amount
 
Accumulated
Amortization
Developed technologies(1)
$
18,850

 
$
1,796

 
$
5,231

 
$
1,342

Customer relationships
2,413

 
934

 
2,413

 
675

Trade names/trademarks
101

 
101

 
101

 
101

 
$
21,364

 
$
2,831

 
$
7,745

 
$
2,118

        
(1) In September 2015, in connection with the acquisition of BAM Labs, Inc., we acquired $13.6 million of definite-lived intangible assets consisting of developed technologies.

Amortization expense for definite-lived intangible assets was $0.3 million and $0.7 million for the three and nine months ended October 3, 2015, respectively, and $0.2 million and $0.6 million for the three and nine months ended September 27, 2014, respectively. Annual amortization for definite-lived intangible assets is expected to be approximately $2.5 million for each of the next five years.

See Note 2, Acquisition of BAM Labs, Inc., for additional details.


11



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



7. Credit Agreement
  
In September 2015, we entered into a new revolving credit facility (Credit Agreement) with a syndicate of banks (Lenders). The Credit Agreement provides a revolving credit facility for general corporate purposes with net aggregate availability of $100 million. The Credit Agreement contains an accordion feature that allows us to increase the amount of the credit facility from $100 million up to $150 million in total availability, subject to Lenders' approval. The Credit Agreement matures in September 2020. The Credit Agreement replaced our $20 million credit facility that was set to expire in August 2016.

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 October 3, 2015, we had no outstanding borrowings or letters of credit and we were in compliance with all financial covenants.

8. Repurchase of Common Stock
   
Repurchases of our common stock were as follows (in thousands): 
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Amount repurchased under Board-approved share repurchase program
 
$
18,530

 
$
10,010

 
$
68,557

 
$
30,032

Amount repurchased in connection with the vesting of employee restricted stock grants
 
140

 

 
1,743

 
1,448

Total amount repurchased
 
$
18,670

 
$
10,010

 
$
70,300

 
$
31,480

  
As of October 3, 2015, the remaining share repurchase authorization under our Board-approved share repurchase plan was $166 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 share 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.

9. Stock-Based Compensation

Stock-based compensation expense consisted of the following (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Options
 
$
668

 
$
574

 
$
1,984

 
$
1,503

Restricted shares
 
2,456

 
1,685

 
6,968

 
2,791

Total stock-based compensation expense(1)
 
3,124

 
2,259

 
8,952

 
4,294

Income tax benefit
 
904

 
768

 
2,909

 
1,464

Total stock-based compensation expense, net of tax
 
$
2,220

 
$
1,491

 
$
6,043

 
$
2,830

 
(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.
 
10. 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 October 3, 2015 and September 27, 2014, our contributions, net of forfeitures, were $1.3 million and $0.9 million, respectively. During the nine months ended October 3, 2015 and September 27, 2014, our contributions, net of forfeitures, were $3.3 million and $2.7 million, respectively.

12



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



11. Other Income, Net

Other income, net, consisted of the following (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Interest income
$
122

 
$
106

 
$
428

 
$
306

Interest expense
(44
)
 
(10
)
 
(64
)
 
(30
)
Other income, net
$
78

 
$
96

 
$
364

 
$
276


12. Net Income per Common Share

The components of basic and diluted net income per share were as follows (in thousands, except per share amounts):
 
Three Months Ended
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Net income
$
31,854

 
$
23,554

 
$
71,691

 
$
49,027

 
 
 
 
 
 
 
 
Reconciliation of weighted-average shares outstanding:
 
 

 
 
 
 
Basic weighted-average shares outstanding
50,945

 
53,271

 
51,654

 
53,677

Dilutive effect of stock-based awards
756

 
700

 
870

 
681

Diluted weighted-average shares outstanding
51,701

 
53,971

 
52,524

 
54,358

 
 
 
 
 
 
 
 
Net income per share – basic
$
0.63

 
$
0.44

 
$
1.39

 
$
0.91

Net income per share – diluted
$
0.62

 
$
0.44

 
$
1.36

 
$
0.90

Anti-dilutive stock-based awards excluded from the calculations of diluted net income per share calculations were immaterial for the periods presented.

13. Commitments and Contingencies

Sales Returns
   
The activity in the sales returns liability account was as follows (in thousands):
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
Balance at beginning of year
$
15,262

 
$
9,433

Additions that reduce net sales
67,944

 
55,047

Deductions from reserves
(63,893
)
 
(50,074
)
Balance at end of period
$
19,313

 
$
14,406


13



SELECT COMFORT CORPORATION
AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(unaudited)



Warranty Liabilities
   
The activity in the accrued warranty liabilities account was as follows (in thousands): 
 
Nine Months Ended
 
October 3,
2015
 
September 27,
2014
Balance at beginning of year
$
5,824

 
$
4,153

Additions charged to costs and expenses for current-year sales
7,514

 
6,119

Deductions from reserves
(4,995
)
 
(5,434
)
Changes in liability for pre-existing warranties during the current year, including expirations
1,426

 
268

Balance at end of period
$
9,769

 
$
5,106


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.


14


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
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.

15


Overview

Business Overview

We offer consumers high-quality, innovative and individualized sleep solutions and services, which include a complete line of SLEEP NUMBER® beds and bedding accessories. Our vertically integrated business model has three significant competitive advantages: proprietary sleep innovations, ongoing customer relationships and exclusive distribution.

We are the exclusive designer, manufacturer, marketer, retailer and servicer of a complete line of Sleep Number® beds. Only the Sleep Number bed offers SleepIQ® technology - proprietary sensor technology that works directly with the bed’s DualAir™ system to track and monitor 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. Sleep Number also offers a full line of exclusive sleep products, including FlexFit™ adjustable bases and Sleep Number® pillows, sheets and other bedding products.
 
We are committed to delivering superior shareholder value through three primary EPS drivers: increasing demand, leveraging our business model and deploying our capital efficiently. We are the sleep innovation leader and drive growth through effective brand marketing and a differentiated retail experience.

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 plan to achieve this through our consumer-driven innovation strategy with technology as our differentiator.

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 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.

Highlights

Financial highlights for the period ended October 3, 2015 were as follows:

Net sales for the quarter increased 16% to $374 million, compared with $323 million for the same period one year ago. The sales increase was driven by an 11% comparable sales increase in our Company-Controlled channel and 4 percentage points of growth from sales generated by 15 net new stores opened in the past 12 months.
Sales per store (for stores open at least one year), on a trailing twelve-month basis, increased 16% to $2.6 million, compared with $2.2 million for the prior-year trailing twelve-month period.
Operating income for the quarter increased 28% to $45 million, or 12.1% of net sales, compared with $35 million, or 10.9% of net sales, for the same period one year ago. The increase in operating income was primarily generated by the 16% increase in net sales and the 110 basis point improvement in the gross profit rate.
Net income for the quarter increased 35% to $32 million, or $0.62 per diluted share, compared with net income of $24 million, or $0.44 per diluted share, for the same period one year ago.
We achieved a return on invested capital (ROIC) of 17.2% during the trailing-twelve month period ended October 3, 2015, well above our 10% cost of capital.
Cash provided by operating activities totaled $132 million for the nine months ended October 3, 2015, compared with $136 million for the same period one year ago.
At October 3, 2015, cash, cash equivalents and marketable debt securities, less customer prepayments, totaled $89 million and there were no borrowings under our revolving credit facility.
During the quarter we increased our inventories and accelerated customer shipments to Q3 from Q4 in preparation for the October 2015 launch of our new enterprise resource planning (ERP) system.

16


In the third quarter of 2015, we repurchased 717,382 shares of our common stock under our Board-approved share repurchase program at a cost of $18.5 million (an average of $25.83 per share). As of October 3, 2015, the remaining authorization under our Board-approved share repurchase program was $166 million.
In September 2015, we completed the acquisition of BAM Labs, Inc. (BAM Labs), the leading provider of biometric sensor and sleep monitoring for data-driven health and wellness. In connection with the acquisition, our previously held equity investment was remeasured to a fair value of $12.9 million, resulting in a $3.0 million gain net of: (i) $3.4 million of acquisition related expenses; and (ii) $0.5 million of incremental BAM Labs research and development expenses. See Note 2, Acquisition of BAM Labs, Inc., and Note 4, Investments, of the Notes to Condensed Consolidated Financial Statements for additional details.

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
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Net sales
 
$
373.9

 
100.0
%
 
$
323.4

 
100.0
%
 
$
999.0

 
100.0
%
 
$
834.5

 
100.0
%
Cost of sales
 
140.3

 
37.5
%
 
124.8

 
38.6
%
 
379.0

 
37.9
%
 
322.2

 
38.6
%
Gross profit
 
233.6

 
62.5
%
 
198.6

 
61.4
%
 
620.0

 
62.1
%
 
512.4

 
61.4
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Sales and marketing
 
156.9

 
42.0
%
 
137.9

 
42.6
%
 
424.0

 
42.4
%
 
369.6

 
44.3
%
General and administrative
 
27.8

 
7.4
%
 
23.0

 
7.1
%
 
80.0

 
8.0
%
 
63.2

 
7.6
%
Research and development
 
3.5

 
0.9
%
 
2.4

 
0.7
%
 
10.3

 
1.0
%
 
5.7

 
0.7
%
Total operating expenses
 
188.2

 
50.3
%
 
163.2

 
50.5
%
 
514.3

 
51.5
%
 
438.5

 
52.5
%
Operating income
 
45.4

 
12.1
%
 
35.3

 
10.9
%
 
105.8

 
10.6
%
 
73.9

 
8.9
%
Other income, net
 
0.1

 
0.0
%
 
0.1

 
0.0
%
 
0.4

 
0.0
%
 
0.3

 
0.0
%
Income before income taxes
 
45.5

 
12.2
%
 
35.4

 
11.0
%
 
106.1

 
10.6
%
 
74.1

 
8.9
%
Income tax expense
 
13.6

 
3.6
%
 
11.9

 
3.7
%
 
34.4

 
3.4
%
 
25.1

 
3.0
%
Net income
 
$
31.9

 
8.5
%
 
$
23.6

 
7.3
%
 
$
71.7

 
7.2
%
 
$
49.0

 
5.9
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income per share:
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Basic
 
$
0.63

 
 

 
$
0.44

 
 
 
$
1.39

 
 
 
$
0.91

 
 

Diluted
 
$
0.62

 
 

 
$
0.44

 
 
 
$
1.36

 
 
 
$
0.90

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average number of common shares:
 
 

 
 
 
 
 
 
 
 
 
 
 
 

Basic
 
50.9

 
 

 
53.3

 
 
 
51.7

 
 
 
53.7

 
 

Diluted
 
51.7

 
 

 
54.0

 
 
 
52.5

 
 
 
54.4

 
 


The percentage of our total net sales, by dollar volume, from each of our channels was as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Company-Controlled channel
 
97.4
%
 
98.0
%
 
97.4
%
 
96.9
%
Wholesale/Other channel
 
2.6
%
 
2.0
%
 
2.6
%
 
3.1
%
Total
 
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%


17


The components of total net sales growth, including comparable net sales changes, were as follows: 
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Sales change rates:
 
 
 
 
 
 

 
 

Retail comparable-store sales(1)
 
12
%
 
16
%
 
15
%
 
9
%
E-Commerce and Direct
 
3
%
 
18
%
 
11
%
 
5
%
Company-Controlled comparable sales change
 
11
%
 
16
%
 
15
%
 
9
%
Net store openings/closings
 
4
%
 
8
%
 
5
%
 
7
%
Total Company-Controlled channel
 
15
%
 
24
%
 
20
%
 
16
%
Wholesale/Other channel
 
51
%
 
(23
%)
 
2
%
 
(14
%)
Total net sales change
 
16
%
 
23
%
 
20
%
 
14
%
 
(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
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Average sales per store ($ in thousands)(1) (3)
 
$
2,559

 
$
2,216

 
 
 
 
Average sales per square foot(1) (3)
 
$
1,063

 
$
1,007

 
 
 
 
Stores > $1 million in net sales(1) (3)
 
100
%
 
98
%
 
 
 
 
Stores > $2 million in net sales(1) (3)
 
69
%
 
50
%
 
 
 
 
Average revenue per mattress unit – Company-Controlled channel(2)
 
$
3,992

 
$
3,733

 
$
3,991

 
$
3,600

 
(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.
(3) Fiscal 2014 included 53 weeks, as compared to 52 weeks in fiscal 2015 and 2013. The additional week in 2014 was in the fiscal fourth quarter. Company-Controlled comparable sales metrics have been adjusted to remove the estimated impact of the additional week on those metrics.

The number of retail stores operating was as follows:
 
 
Three Months Ended
 
Nine Months Ended
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Beginning of period
 
467

 
451

 
463

 
440

Opened
 
11

 
13

 
24

 
46

Closed
 
(3
)
 
(4
)
 
(12
)
 
(26
)
End of period
 
475

 
460

 
475

 
460


Comparison of Three Months Ended October 3, 2015 with Three Months Ended September 27, 2014

Net sales
Net sales increased 16% to $374 million for the three months ended October 3, 2015, compared with $323 million for the same period one year ago. Demand for our product innovations, effective marketing and our differentiated retail experience all contributed to the strong sales increase. The sales increase was driven by an 11% comparable sales increase in our Company-Controlled channel and 4 percentage points of growth from sales generated by 15 net new stores opened in the past 12 months.
 
The $51 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $34 million increase in sales from our Company-Controlled comparable retail stores; (ii) a $13 million increase resulting from net store openings; (iii) a $3 million increase in Wholesale/Other channel sales; and (iv) a $1 million increase in E-Commerce and Direct sales. Company-Controlled mattress unit sales increased 7% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 7% to $3,992 driven by sales of product innovations, including our new FlexFit™ adjustable bases.


18


Gross profit
Gross profit of $234 million increased by $35 million, or 18%, compared with the same period one year ago. The gross profit rate was 62.5% of net sales for the three months ended October 3, 2015, compared with 61.4% for the prior-year period. The 110 basis point increase in the gross profit rate was primarily due to: (i) reductions in promotional discounts; (ii) volume benefits; (iii) favorable product mix changes resulting from advancements in our selling process and product innovations over the last 12 months; and (iv) manufacturing efficiencies. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors, including raw material price fluctuations, return and exchange costs, warranty expenses and performance-based incentive compensation.

Sales and marketing expenses
Sales and marketing expenses for the three months ended October 3, 2015 increased to $157 million, or 42.0% of net sales, compared with $138 million, or 42.6% of net sales, for the same period one year ago. The 60 basis point decrease in the sales and marketing expense rate in the current period was mainly due to the leveraging impact of the 16% net sales increase, partially offset by increased media costs, including costs to support the launch of our new SleepIQ Kids™ bed and the expansion into our tenth aggressive growth market.

General and administrative expenses
General and administrative (G&A) expenses increased $5 million to $28 million for the three months ended October 3, 2015, compared with $23 million in the same period one year ago, and increased to 7.4% of net sales, compared with 7.1% of net sales last year. The increase in G&A expenses was due to: (i) $7.0 million of data conversion and training expenses incurred to support the October 2015 launch of our new ERP system; and (ii) a $1.3 million increase in miscellaneous other expenses; partially offset by (iii) a $3.5 million gain (net of acquisition related expenses) related to our previously held minority equity investment in BAM Labs. We completed the acquisition of BAM Labs in September 2015. See Note 2, Acquisition of BAM Labs, Inc., and Note 4, Investments, of the Notes to Condensed Consolidated Financial Statements for additional details. The G&A expense rate increased by 30 basis points in the current period compared with the same period one year ago due to the items discussed above, partially offset by the leveraging impact of the 16% net sales increase.

Research and development expenses
Research and development expenses for the three months ended October 3, 2015 were $3.5 million, or 0.9% of net sales, compared with $2.4 million, or 0.7% of net sales, for the same period one year ago. The $1.2 million increase in R&D expenses was due to increased investments to support product innovations, including $0.5 million of expenses related to BAM Labs operations (post acquisition). The $1.2 million increase is consistent with our long-term consumer innovation strategy.

Income tax expense
Income tax expense was $14 million for the three months ended October 3, 2015, compared with $12 million for the same period one year ago. The effective tax rate for the three months ended October 3, 2015 was 30.0% compared with 33.5% for the prior-year period. The decrease in the effective tax rate primarily resulted from the tax planning benefits associated with the BAM Labs acquisition gain.

Comparison of Nine Months Ended October 3, 2015 with Nine Months Ended September 27, 2014

Net sales
Net sales in 2015 increased 20% to $999 million, compared with $835 million for the same period one year ago. Demand for our product innovations, effective marketing and our differentiated retail experience all contributed to the strong sales increase. The sales increase was driven by a 15% comparable sales increase in our Company-Controlled channel and 5 percentage points of growth from sales generated by 15 net new retail stores opened in the past 12 months.
 
The $164 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $111 million increase from our Company-Controlled comparable retail stores; (ii) a $47 million increase resulting from net store openings; and (iii) a $6 million increase in E-Commerce and Direct sales. Company-Controlled mattress units increased 9% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 11%.

Gross profit
Gross profit of $620 million increased by $108 million, or 21%, compared with the same period one year ago. The gross profit rate increased to 62.1% of net sales for the first nine months of 2015, compared with 61.4% for the prior-year period. The 70 basis point increase in the gross profit rate was primarily due to: (i) reductions in promotional discounts; (ii) volume benefits; (iii) favorable product mix changes resulting from advancements in our selling process and product innovations over the last 12 months; and (iv) manufacturing efficiencies. In addition, our gross profit rate can fluctuate from quarter to quarter due to a variety of other factors,

19


including raw material price fluctuations, return and exchange costs, warranty expenses and performance-based incentive compensation.

Sales and marketing expenses
Sales and marketing expenses in 2015 increased to $424 million compared with $370 million for the same period one year ago, but decreased to 42.4% of net sales compared with 44.3% of net sales last year. The 190 basis point decrease in the sales and marketing expense rate in the current period was mainly due to the leveraging impact of the 20% net sales increase, which more than offset higher marketing, selling and occupancy costs as we continue to invest in our exclusive distribution strategy.
 
General and administrative expenses
General and administrative (G&A) expenses increased to $80 million in 2015, compared with $63 million in the prior year and increased to 8.0% of net sales, compared with 7.6% of net sales one year ago. The increase in G&A expenses was comprised of the following: (i) $9.0 million of data conversion and training expenses incurred to support the October 2015 launch of our new ERP system; (ii) a $6.6 million increase in employee compensation, including increased stock-based compensation (the nine months ended September 27, 2014 included a $1.2 million benefit related to a change in estimated forfeitures due to employee turnover during the three months ended March 29, 2014) and incremental compensation costs to enhance our IT infrastructure; (iii) $2.0 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 (iv) a $2.7 million increase in miscellaneous other expenses; partially offset by (v) a $3.5 million gain (net of acquisition related expenses) related to our previously held equity investment in BAM Labs. We completed the acquisition of BAM Labs in September 2015. See Note 2, Acquisition of BAM Labs, Inc., and Note 4, Investments, of the Notes to Condensed Consolidated Financial Statements for additional details. The G&A expense rate increased by 40 basis points in the current period compared with the same period one year ago due to the items discussed above, partially offset by the leveraging impact of the 20% net sales increase.

Research and development expenses
Research and development expenses for the nine months ended October 3, 2015 were $10.3 million, or 1.0% of net sales, compared with $5.7 million, or 0.7% of net sales, for the same period one year ago. The $4.6 million increase in R&D expenses was due to increased investments to support product innovations, including $0.5 million of expenses related to BAM Labs operations (post acquisition). The $4.6 million increase is consistent with our long-term consumer innovation strategy.

Income tax expense
Income tax expense was $34 million for the nine months ended October 3, 2015, compared with $25 million for the same period one year ago. The effective tax rate for the nine months ended October 3, 2015 was 32.4% compared with 33.9% for the prior-year period. The decrease in the effective tax rate primarily resulted from the tax planning benefits associated with the BAM Labs acquisition gain.

Liquidity and Capital Resources

As of October 3, 2015, cash, cash equivalents and marketable debt securities totaled $115 million compared with $166 million as of January 3, 2015. The $52 million decrease was primarily due to $132 million of cash provided by operating activities, which was more than offset by $61 million of cash used to purchase property and equipment, $70 million of cash used to repurchase our common stock ($68.6 million under our Board-approved share repurchase program and $1.7 million in connection with the vesting of employee restricted stock grants) and $57 million to acquire the remaining capital stock of BAM Labs. Our $42 million of marketable debt securities held as of October 3, 2015 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
 
 
October 3,
2015
 
September 27,
2014
Total cash provided by (used in):
 
 
 
 
Operating activities
 
$
131.6

 
$
135.8

Investing activities
 
(46.7
)
 
(79.0
)
Financing activities
 
(64.2
)
 
(36.6
)
Net increase in cash and cash equivalents
 
$
20.7

 
$
20.2

 
Cash provided by operating activities for the nine months ended October 3, 2015 was $132 million compared with $136 million for the nine months ended September 27, 2014. Significant components of the year-over-year change in cash provided by operating

20


activities included: (i) a $23 million increase in net income for the nine month ended October 3, 2015 compared with the same period one year ago, including a $3 million net pre-tax gain associated with our acquisition of BAM Labs; (ii) a $17 million fluctuation in accrued compensation and benefits which primarily resulted from year-over-year changes in company-wide performance-based incentive compensation that was earned in 2014 and paid in the first quarter of 2015, but was not earned in 2013; and (iii) we increased our inventories and accelerated customer shipments in preparation for the October 2015 launch of our new ERP system. This resulted in higher inventory levels, increased accounts receivable, increased accounts payable and decreased customer prepayments.
 
Net cash used in investing activities was $47 million for the nine months ended October 3, 2015, compared with $79 million for the same period one year ago. Investing activities for the current-year period included $61 million of property and equipment purchases, compared with $58 million for the same period one year ago. On a net basis, we decreased our investments in marketable debt securities by $72 million during the nine months ended October 3, 2015, compared with a net increase of $20 million during the comparable period one year ago. In September 2015, we completed the acquisition of BAM Labs. We previously held a $6.0 million minority equity investment in BAM Labs based on the cost method. In connection with the acquisition, our equity investment was remeasured to a fair value of $12.9 million and we acquired the remaining capital stock in BAM Labs for $57.1 million for a total enterprise value of $70.0 million. See Note 2, Acquisition of BAM Labs, Inc., and Note 4, Investments, of the Notes to Condensed Consolidated Financial Statements for additional details.

Net cash used in financing activities was $64 million for the nine months ended October 3, 2015, compared with $37 million for the same period one year ago. During the nine months ended October 3, 2015, we repurchased $70.3 million of our stock ($68.6 million under our Board-approved share repurchase program and $1.7 million in connection with the vesting of employee restricted stock grants) compared with $31.5 million ($30.0 million under our Board-approved share repurchase program and $1.4 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 2,301,779 shares at a cost of $69 million (an average of $29.78 per share) during the nine months ended October 3, 2015. During the nine months ended September 27, 2014, we repurchased 1,572,708 shares at a cost of $30 million (an average of $19.10 per share). As of October 3, 2015, the remaining share repurchase authorization under our Board-approved share repurchase plan was $166 million. There is no expiration date governing the period over which we can repurchase shares.

In September 2015, we entered into a new revolving credit facility (Credit Agreement) with a syndicate of banks (Lenders). The Credit Agreement provides a revolving credit facility for general corporate purposes with net aggregate availability of $100 million. The Credit Agreement contains an accordion feature that allows us to increase the amount of the credit facility from $100 million up to $150 million in total availability, subject to Lenders' approval. The Credit Agreement matures in September 2020. The Credit Agreement replaced our $20 million credit facility that was set to expire in August 2016.

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 October 3, 2015, we had no outstanding borrowings or letters of credit and 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 $115 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 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 October 3, 2015 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

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
 
 
October 3,
2015
 
September 27,
2014
Net operating profit after taxes (NOPAT)
 
 
 
 
Operating income
 
$
133,640

 
$
83,514

Add: Rent expense(1)
 
63,078

 
54,983

Add: Interest income
 
537

 
398

Less: Depreciation on capitalized operating leases(2)
 
(15,809
)
 
(13,830
)
Less: Income taxes(3)
 
(58,896
)
 
(42,501
)
NOPAT
 
$
122,550

 
$
82,564

 
 
 
 
 
Average invested capital
 
 
 
 
Total equity
 
$
271,923

 
$
249,032

Less: Cash greater than target(4)
 

 
(47,881
)
Add: Long-term debt(5)
 

 

Add: Capitalized operating lease obligations(6)
 
504,624

 
439,864

Total invested capital at end of period
 
$
776,547

 
$
641,015

Average invested capital(7)
 
$
710,701

 
$
617,599

Return on invested capital (ROIC)(8)
 
17.2
%
 
13.4
%
___________________
(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 32.5% and 34.0% for 2015 and 2014, 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.

(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.

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Non-GAAP Data (continued)

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
 
 
October 3,
2015
 
September 27,
2014
 
October 3,
2015
 
September 27,
2014
Net income
 
$
31,854

 
$
23,554

 
$
90,638

 
$
55,452

Income tax expense
 
13,623

 
11,888

 
43,452

 
28,418

Interest expense
 
44

 
10

 
87

 
40

Depreciation and amortization
 
11,643

 
10,125

 
43,100

 
37,095

Stock-based compensation
 
3,125

 
2,259

 
11,457

 
5,467