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.

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.

At July 1,September 30, 2017 and December 31, 2016, we had deferred revenue totaling $67$71 million and $61 million, of which $25$28 million and $21 million are included in other current liabilities, respectively, and $42$43 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$41 million and $33 million, of which $14$16 million and $11 million are included in other current assets, respectively, and $24$25 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.

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 sixnine months ended July 1,September 30, 2017, excess tax benefits of $0.4$0.2 million and $1.2$1.4 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$0.2 million and $2.1$2.3 million for the three and sixnine months ended July 1, 2017.September 30, 2017, respectively. We elected to apply the new cash flow classification guidance prospectively. The prior-year statement of cash flows has not been adjusted.

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.

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 originallywill be effective for fiscal yearsus 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).January 1, 2018. 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 continuingBased on our analysis thus far, we believe the impact of adopting the new guidance will not be material to evaluateour consolidated financial statements. As interpretations of the effectnew rules continue to evolve in the fourth quarter of fiscal 2017, we will monitor developments and will finalize our conclusions on our revenue recognition policy, 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.2018. 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. This new guidance is effective for us beginning December 30, 2018.

At July 1,September 30, 2017 and December 31, 2016, we had $2.9$3.4 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$3.4 million and $2.3 million at July 1,September 30, 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.

Inventories consisted of the following (in thousands):

Goodwill was $64.0 million at July 1,September 30, 2017 and December 31, 2016. Indefinite-lived trade name/trademarks totaled $1.4 million at July 1,September 30, 2017 and December 31, 2016.

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,September 30, 2017, we had $14 million inno outstanding borrowings and $3.15 million in outstanding letters of credit. We had additionalOur borrowing capacity of $136was $150 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.

AsEffective as of JulyOctober 1, 2017, theour Board approved an increase in our total remaining authorization under our Board-approved share repurchase program was $170authorization to $500 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.

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

 

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,September 30, 2017 and July 2,October 1, 2016, our contributions, net of forfeitures, were $1.21.4 million and $1.01.1 million, respectively. During the sixnine months ended July 1,September 30, 2017 and July 2,October 1, 2016, our contributions, net of forfeitures, were $2.5$3.9 million and $2.3$3.4 million, respectively.

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

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

For the three and nine 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,September 30, 2017 and the three and six months ended July 2,October 1, 2016, anti-dilutive stock-based awards excluded from the diluted net income per share calculations were immaterial.

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

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 partiesoral arguments are expected to be heard in the process of preparing and submitting briefs.near future. 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.

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:

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

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.network. In 2017, we began evolving our supply chain including the transition of more than 20 suppliers with whom we are partnering with to support our innovations and profitability goals. Changes to the supply chain also include in-hub assembly of our new 360 smart beds and optimization of our outbound logistics network. These multi-year initiatives, coupled with our innovations, are expected to drive accelerated profits and cash flows over time.

 

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.

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.

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

Other sales metrics were as follows: 

The number of retail stores operating was as follows:

Net sales increased 3%9% to $285$403 million for the three months ended July 1,September 30, 2017, compared with $277$368 million for the same period one year ago. Net sales for the three months ended July 1,September 30, 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 $49$35 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $53$23 million increase resulting from net store openings; and (ii) a $1$17 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 unit sales were in line with the prior year. Average revenue per mattress unit in our Company-Controlled channel increased by 11% to $4,385.

The $83 million net sales increase compared with the same period one year ago was comprised of the following: (i) a $76 million increase resulting from net store openings; and (ii) a $17 million increase in sales from our Company-Controlled comparable sales; partially offset by (iii) a $10 million decrease in Wholesale/Other channel sales. Company-Controlled mattress units increased 7%4% compared to the prior-year period. Average revenue per mattress unit in our Company-Controlled channel increased by 2%5%.

Gross profit of $423$677 million for the sixnine months ended July 1,September 30, 2017 increased by $43$64 million, or 11%10%, compared with the same period one year ago. The gross profit rate increased to 62.3%62.6% of net sales for the first sixnine months of 2017, compared with 60.4%61.4% 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.implementation during the first six months of 2016. The current-year gross profit rate improvement of 1.91.2 ppt. was primarily due to manufacturing and supply chain efficiencies, including lean initiatives, 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 for the sixnine months ended July 1,September 30, 2017 increased to $314$489 million compared with $285$443 million for the same period one year ago, and increased to 46.2%45.2% of net sales compared with 45.3%44.4% of net sales last year. The 0.90.8 ppt. increase in the sales and marketing expense rate was mainly due to the deleveraging impact resulting from the $25 million net sales shift froman increase in customer financing expenses, as a larger percentage of our second quarter to our third quarter;customers took advantage of promotional financing offers, and an increase in selling compensation expense, including performance-based incentive compensation. These increases were 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 (G&A) expenses totaled $63$95 million, or 8.8% of net sales, for the sixnine months ended July 1,September 30, 2017, compared with $58$86 million, or 8.6% of net sales, in the prior-year period, but the expense rate remained consistent with the prior year at 9.2% of net sales.period. The $5$9 million increase in G&A expenses consisted primarily of the following: (i) a $1.0$4.0 million increase in employee compensation, including a year-over-year increase in company-wide performance-based incentive compensation, enhanced digital marketing capabilities, and salary and wage rate increases that were in line with inflation; (ii) $2.1$2.3 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$2.7 million net increase in miscellaneous other expenses. The current year G&A expense rate while consistentincreased by 0.2 ppt. in the current-year period compared with the prior-year, was negatively impactedsame period one year ago due to the increase in expenses discussed above, partially offset by the deleveragingleveraging impact fromof the $25 million net8% sales shift from our second quarter to our third quarter.increase.

Research and development (R&D) expenses for the sixnine months ended July 1,September 30, 2017 were $14$21 million, or 2.1%1.9% of net sales, compared with $15$22 million, or 2.3%2.2% 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.

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,September 30, 2017, cash and cash equivalents totaled $230 million compared with $12 million as of December 31, 2016. The $1018 million decreaseincrease was primarily due to $89$176 million of cash provided by operating activities, which was more thanpartially offset by $2738 million of cash used to purchase property and equipment and $80120 million of cash used to repurchase our common stock ($75115 million under our Board-approved share repurchase program and $5 million in connection with the vesting of employee restricted stock grants).

 

Cash provided by operating activities for the sixnine months ended July 1,September 30, 2017 was $89$176 million compared with $47$145 million for the sixnine months ended July 2,October 1, 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 sixnine months ended July 1,September 30, 2017, compared with the same period one year ago; (ii) a $46$37 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$31 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)period); 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$34 million for the sixnine months ended July 1,September 30, 2017, compared with $9$30 million of net cash used in investing activities for the same period one year ago. Investing activities for the current-year period included $27$38 million of property and equipment purchases, compared with $24$39 million for the same period last year. We decreased our investments in marketable debt securities by $15$9 million during the sixnine months ended July 2,October 1, 2016. We did not hold any investments in marketable debt securities as of December 31, 2016 or July 1,during the nine months ended September 30, 2017.

Net cash used in financing activities was $74$123 million for the sixnine months ended July 1,September 30, 2017, compared with $57$91 million for the same period one year ago. During the sixnine months ended July 1,September 30, 2017, we repurchased $80$120 million of our stock ($75115 million under our Board-approved share repurchase program and $5 million in connection with the vesting of employee restricted stock awards) compared with $71$96 million ($7095 million under our Board-approved share repurchase program and $1$1.4 million in connection with the vesting of employee restricted stock awards) during the same period one year ago. Short-term borrowings increaseddeclined by $3$6 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 byprimarily due to 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 3.14.3 million shares at a cost of $75$115 million (an average of $24.57$26.52 per share) during the sixnine months ended July 1,September 30, 2017. During the sixnine months ended July 2,October 1, 2016, we repurchased 3.64.6 million shares at a cost of $70$95 million (an average of $19.70$20.78 per share). At JulyEffective as of October 1, 2017, theour Board approved an increase in our total remaining authorization under our Board-approved share repurchase program was $170authorization to $500 million. There is no expiration date governing the period over which we can repurchase shares.

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,September 30, 2017, we had $14 million in outstanding borrowings and $3.15 million in outstanding letters of credit. We had additionalcredit and no borrowings under credit facility. Our available borrowing capacity of $136was $150 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.

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,September 30, 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.

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):