Select Comfort 10K Summary
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By dvcnut
April 11, 2007

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I read SCSS's 10K yesterday; here are my thoughts. I think the 10K helps explain why the stock didn't do too well last year and gives some hints for this year.

While gross margins improved YoY, operational and net margins both decreased. Operational margins dropped almost a whole percentage point (from 9.9% to 9%) and net margins dropped from 6.4% to 5.9%. While some of this came from a more than doubling of R&D spending (a good thing), much of it was from increases in G&A and sales & marketing expenses, which both grew at a faster rate than sales (not a good thing). Sales & Marketing expenses grew 19% to $341.6M (42.4% of net sales). Advertising expenses accounted for $105.3M of this total, which was 18% higher than the year before. They expect advertising to grow another 10% in 2007.

G&A expenses jumped 33%. Subtracting out stock option expenses, G&A still grew almost 22% YoY.

They expect R&D spending to increase by up to 50% in 2007. Again, this is good for long term growth but in the short term it will continue to pressure the bottom line.

Regarding liquidity and capital resources, cash flow from operations dropped 32% and free cash flow dropped 54%. Part of this decrease is due to a doubling of accounts receivables and a decrease in customer prepayments. Even in the so called strong 4th quarter, they only generated $3M of OCF. In 2007 they expect capex spending to increase from $31M to $50M (over 60% increase) due to their SAP rollout and the completion of their new corporate headquarters. They also mention they will probably start tapping into a $100M line of credit, which they attribute to their continued buyback of stock.

On page 30 they re-iterate their long term growth targets of 15% annual sales growth and 20% earnings growth, but they say the challenging economic environment may affect their ability to reach these targets in 2007.

All in all, not a good year, and from reading between the lines I'm not getting a positive feel for this year. While they state they want expenses to grow at a rate less than sales, they didn't say they would do that this year. For the past few years management has done well with increasing cash flow, increasing margins, no debt, etc. They lost sight of that last year and I didn't see much that said they were making an effort to fix it. With the higher R&D spending, another 10% increase in advertising and continued stock option expenses, I foresee continued pressure on margins. I think they're signaling this with the statement of the "challenging economic environment". Also, they're going to have big capex expenditures this year. They only had $59M in operational cash flow last year; $50M in capex isn't leaving much extra cash, which probably explains their need to tap the line of credit.

Now, not everything was bad. ROE increased from an already high 36% to almost 40%. They also bought back $77M of stock. And even though DSOs increased about 68% (due to the higher accounts receivables), they are still very low at less than 6. They had a good control on inventory, and inventory turns were at a very decent 13. But for me, it all comes down to the cash generation. One of the components of ROE is net income, which management can manipulate easier than cash. If one replaces the net income component with operational cash flow in the ROE equation, the results significantly drop from 73% in 2005 to 51% in 2006. Another way of looking at this is the Cash King margin (from the old Rule Maker spreadsheet), which is the FCF/Sales ratio; in 2005 it was 8.9%, in 2006 it dropped to 3.5%.

So the question is, was last year just a fluke? Or is it the beginning signs of a management team losing focus? One of the hallmarks of SCSS was their great cash flow generation. I'll be very interested in seeing their first quarter report to see if it's turning around. I'm also looking forward to their annual proxy information to see what's going on with management compensation. Finally, living here in MN where SCSS headquarters is located, I'm looking forward to their annual shareholder meeting.


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