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Executives

William R. McLaughlin – Chairman of the Board, President & Chief Executive Officer

Mark A. Kimball – Senior Vice President, Legal; General Council & Secretary

James C. Raabe – Chief Financial Officer & Senior Vice President

Analysts

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

Tony Dikas – Piper Jaffray & Co.

Christ Thornsberry – Raymond James

Matthew Nemer – Thomas Weisel Partners

Gregory J. McKinley – Doughtery & Company

Laura Champine – Morgan Keegan

Jeff Stein – Stein Research

Bob Evans – Craig-Hallum Capital Group

Bob Evans – Craig-Hallum Capital Group

Joan Storms – Wedbush Morgan Securities

John Baugh – Stifel Nicolaus & Company

Select Comfort Corp. (SCSS) Q4 2007 Earnings Call February 6, 2008 5:00 PM ET

Operator

Good afternoon. Welcome to Select Comfort’s fourth quarter and year end 2007 earnings conference call. All lines will be in listen-only until the question-and-answer session. This call is being recorded. If you have any objections you may disconnect at this time. I will now turn the call over to Mr. Mark Kimball, Senior Vice President and General Council. Sir, you may begin.

Mark A. Kimball

Good afternoon and welcome to the Select Comfort Corporation’s fourth quarter and year end 2007 earnings conference call. Thank you all for joining us. I am Mark Kimball, Senior Vice President and General Council and with me on the call are Bill McLaughlin, our Chairman and Chief Executive Officer and Jim Raabe our Senior Vice President and Chief Financial Officer. In a moment, I will turn the call over to Bill. Following our prepared remarks we will open the call to your questions. Please be advised this telephone conference is being recorded and will be available by telephone replay and will also be archived on our website. Please refer to the details set forth in our press release to access the replay on our website. The primary purpose of this call is to discuss the results of the fiscal period just ended. However, our commentary and our responses to your questions may include certain forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties outlined in our earnings release and discussed in some detail in our annual report on Form 10-K and other periodic filings with the SEC. The company’s actual future results may vary materially. I will now turn the call over to Bill for his comments.

William R. McLaughlin

Thank you everyone for joining us on our call. As you read in today’s release Select comfort reported a 4% decline in sales for the quarter. Like other retailers across the country we experienced an unexpected and dramatic fall off in consumer buying activity following the Thanksgiving holiday. Because our retail stores are concentrated in shopping malls declining mall traffic had an obvious negative impact on our business especially in December. To add perspective to December’s decline our sales were improving early in the quarter reaching nearly flat comps leading up to the Thanksgiving holiday yet we ended the quarter with a 13% decline in same store sales. Not only were bed units down but average selling price also declined in the quarter due to contributions from lower margin sales channels and a shift toward lower -priced models. The bright spot in the quarter was a highly successful QVC show in December which exceeded our expectations. This show demonstrates continued consumer interest in our unique product. It also shows that effective messaging about our product advantages can drive consumer conversion and sales increases even in a difficult environment. For the quarter we reported earnings of $0.05 per share down significantly from a year ago. The decline in earnings was due to unexpected short fall in December sales on an increased distribution base and at the same time the company had committed marketing programs through the year end.

In response to external challenges we initiated a number of actions in the quarter to reduce costs and mitigate the bottom-line impact of slowing sales. We eliminated 20 corporate management positions and we froze headcount at the current levels. The position elimination resulted in a one-time severance cost of $1.7 million and will save approximately $4 million this year. From start to finish 2007 was a difficult year for Select Comfort while we accomplished many of our objectives that will benefit us in the coming year we clearly missed in important growth areas. We know what needs to be done to regain our position as a growth company and it starts with stabilizing the business in a challenging environment. We look forward to executing against our pipeline of initiatives focused both on cost reduction and revenue generating programs. Clearly understand that now it’s all about execution and results and everyone is on board to deliver. We’ll talk more about 2008 but now I’ll turn the call over to Jim and Jim will provide a more detailed recap of 2007 as well as a framework for 2008 then I’ll return to discuss this year’s priorities.

James C. Raabe

Sales for the fourth quarter totaled $190.7 million 4% lower than a year ago. We opened seven net new stores in the quarter and completed three store remodels utilizing our new store design. Sales from our e-commerce channel and QVC both grew up 4% and 25% respectively. Sales from our retail partner channel declined 3% as we communicated with five retailers our decision to pull back on our retail partner program early in 2008. Gross margins for the quarter were 58.5% 240 basis points lower than a year ago. The decline in gross margins in Q4 was a direct result of higher product costs as well as product and channel mix shifts. Consumers appeared to be trading down to lower priced models in the quarter partly in response to increased advertising of our entry-level price points. We continue to tightly manage promotion of our price points with no significant increase in discounting this year versus prior years. We also experienced a greater volume from our wholesale channel which is a lower margin business for us. Fourth quarter operating margins were 1.5% 660 basis points lower than a year ago. Sales and Marketing expenses as a percentage of sales increased 600 basis points during the quarter. Factors in the decline include costs associated with 36 more stores this year than last and 10% higher advertising costs this year all against a lower sales base. For the year net income decreased 41% on a sales decline of 1%. Gross margins as a percent of sales were flat for the year which was a significant accomplishment as we were able to largely offset the combined impact of higher raw material input costs and $11 million in costs for compliance with fire retardant regulations which became effective during the summer. Operating margins declined 360 basis points in large part due to higher sales and marketing cost. G&A as a percentage of sales were flat year-over-year reflecting no incentive compensation company-wide as a result of below target net operating profits.

We reported operating cash flow of $47 million for the year with debt balances increasing to $38 million reflecting $46 million of capital expenditures and $134 million of share repurchases. Our cash conversion cycle remains strong in the fourth quarter at negative 34 days; however inventories increased to $32.5 million reflecting slowing consumer demands. We see the opportunity to take better advantage of our business model in this area in 2008 and expect inventory levels to return to more normal levels during the year.

Before moving to comments on our outlook for 2008 I would like to comment on a few changes to our investor relations practices. First as you saw in the press release we have made the decision like many other companies to stop providing specific revenue and earnings guidance; however we do intend to outline our key business drivers and trends which we believe should provide sufficient high level information for analyst investors to accurately model our business. Second we are discontinuing our prior practice of providing a prerecorded business update during each quarter. Our next regular market communication therefore is planned to occur after the March quarter is closed.

Now a few comments on our 2008 outlook. Given current market conditions we are expecting 2008 sales to be flat to slightly lower. We are planning for no improvement in macro economic conditions during 2008. Programs that we expect to offset negative market trends include the introduction of two new products, new store openings and the benefits of our new store design. We believe we can improve on execution and anticipate we will receive the full effect of these programs in the second half of the year with improvements in same store comps over the course of the year. Our plans also include 30 new stores to be opened during the year; however we are planning to slow distribution and expansion in 2008 leading to slower growth in fixed distribution costs. We plan to close 15 or more stores. Further we have no plans to increase our store base beyond what we have committed to in 2008 until we see a return to positive same store growth. Other sources of revenue in 2008 include a price increase on selective products that took effect in January, higher contributions from international operations including a full year of results from Australia and a 53rd week in the coming fiscal year. Overall we expect negative sales growth in the first half offset by positive growth in the second half. We also expect that earnings will decline in 2008.

While we believe it is necessary to carefully control costs during this period of greater uncertainty, we also remain confident in our product, our brand and our business model and do not believe it is appropriate to cut significantly into investments we are making for the long term. In addition the increase in store count will result in increasing sales infrastructure costs over the course of the year. We expect gross margins will be flat to slightly lower in 2008 as compared to 2007. Rising commodity costs will be largely offset by our pricing actions but we anticipate that our product mix could remain weighted to entry level models until the economy improves. Sales and marketing expenses will be somewhat higher in 2008. We plan to manage our marketing investment as a variable cost to sales leaving marketing and media flat to slightly lower than 2007 while store costs as I noted earlier will be higher as we add to our store count. We expect to end 2008 with nearly 500 stores compared to 478 stores at the end of 2007.\

We expect G&A to be slightly higher than 2007 while core personnel and occupancy costs are being held essentially flat to 2007. We have restructured our bonus program with a pay-out based on company and personal performance that will allow our mid- and entry-level employees to earn a bonus in this challenging environment. This program will add approximately $6 million to G&A. We expect the effective tax rate to be approximately 38% for the year and our share count to be approximately 46 million shares. Finally we expect to generate free cash flow and reduce debt balances during the year. Capital expenditures are projected to be approximately $32 million versus the $46 million in 2007 with efforts focused on reducing working capital primarily through inventory reduction.

Included in our cap ex forecast for the year in addition to new stores and store remodels is $8 million for our SAPERP implementation the first phase which will go live in the third quarter. This mission critical application is expected to bring cost benefits to the company and improve our data analysis capabilities. We did not repurchase additional company shares in the fourth quarter. We continue to have board authorization to repurchase $207 million in shares under our existing program; however we believe at this time that returning to a debt free balance sheet and maintaining the greatest level of flexibility to pursue actions that drive the long-term growth of the business are the best use of our capital and the most prudent course of action.

I’d now like to turn the call back over to Bill before we open the call to your questions.

William R. McLaughlin

I want to provide some additional insight about our expectations for 2008 before we open the call to your question. Our primary focus as a company this year will be to prudently manage our business in the economic conditions through disciplined controls over costs and cash while executing programs that elevate the brand, drive traffic to our stores and showcase the competitive advantages of our products. This year will likely be an extremely challenging year for us. We believe our underlying volume trend is correlated to consumer confidence. We are not anticipating any improvement in the year particularly in the first half. In addition to revenue challenges there also will be cost challenges as well given incremental fire retardant expenses that took effect nationwide in June of 2007. From this lower base we plan to address the situation through continued and improved execution of productivity, cost restructuring and growth programs.

Improvements are expected to be weighted towards the second half of the year as our most significant programs will not be implemented until late in the first quarter. Jim has already spoken to our cost and cash structure for 2008 so I’m going to elaborate on our media distribution and product programs.

Our new media campaign is set to launch at the end of March led by our new Chief Marketing Officer, Kathy Hall. The campaign effectively focuses on the unique benefits of the Sleep Number bed and our exclusive Sleep Number stores and sales channels. The campaign itself will be national in scope while also recognizing the importance of local market strength and the campaign will be fully integrated for greater impact and efficiency. Everyone is eagerly anticipating the new campaign’s planned introduction in late March. We’re confident in its direction for several reasons. First it evolves from the original and current Sleep Number messaging and it again gives consumers and owners a reason to talk about our brand. Second through broader media it will help new consumers discover our products unique benefit, their ability to actively control their own comfort and achieve better sleep. We know from our past that marketing can be a significant driver to growth for Select Comfort. We also know that it takes time to realize the full impact of a well thought out and well executed campaign so we are making other investments to drive more people to the stores as well as provide a store environment proven to help increase sales.

As for our distribution strategy we will focus on stabilizing company owned same store performance. We are implementing three specific actions that are expected to improve the profitability of our stores over time. First we will moderate the growth of our store base and close lower performing stores as leases expire. As a result our net store growth will be the lowest in four years. Second we will remodel 50 existing stores in our new high return store design. Stores outfitted in the new design continue to enjoy double digit sales increases and by year end we expect close to 20% of our stores will reflect this new design.

And third we have long stated that our retail partner strategy is an opportunity to profitably accelerate brand awareness and market share. The following considerable analysis and discussion we made the decision to reduce the number of retail partners choosing to end relationships with five partners which represented 140 doors. Narrowing our focus will help us to work with existing partners to design programs that insure stronger execution and incremental growth. As important as marketing and distribution are to attracting more customers we are also focused on offering products that meet the needs of the consumer as well as drive sales and stronger average selling prices. We are excited that during 2008 the company will introduce two new mattress models. Our first product which launches nationwide at the end of the month will fill a key price point in our product lineup and provide easier step up opportunities for our sales professionals to provide the best bed possible for each customer. Specifically the new model queen sets are priced at $2,500 and nearly 3/4 of our stores will display this new bed without compromising other selections on the sales floor.

In summary we expect another challenging year in 2008. We are fully committed to take the necessary steps to stabilize our business and establish momentum towards recovery positioning ourselves to take advantage of opportunities that our superior brand and products afford us. Costs and cash are focal points as we leverage our business model to protect shareholder value and to generate funds to invest in targeted growth. We are equally focused on growth and will invest in our brand, our distribution, our product offering and our people emphasizing innovation and execution. A year ago we said that our opportunity was to execute and that same opportunity exists today with even more urgency and even more enthusiasm and confidence in our leadership and our programs. We know its performance that will be measured and though we expect to face challenges particularly in the first half of the year we look forward to momentum building as 2008 unfolds.

Thank you for your interest in Select Comfort and Grace I’d like to now open the floor to questions.

Question-And-Answer Session

Operator

Thank you, sir. (Operator Instructions) Joel Havard of Hilliard Lyons you may ask your question.

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

First a question of - Bill I think you referenced a decline in average sale price. Do you have a sense of units in Q4 specifically?

William R. McLaughlin

Yeah, there was a decline in units as well as average selling price. Is that your question?

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

Yeah, typically you add that commentary in your published reports, I just wondered if you had a handle on what it was yet?

William R. McLaughlin

Yeah, they did decline and we’ll provide that when we file our [inaudible].

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

We can wait for that. Secondly the commentary in the release and your color, the five dealers, 140 stores, the back page references 891 total. Was there an addition or did one of your surviving larger customers dramatically increase store count, the acquisition or something here in the last quarter or two?

William R. McLaughlin

Yes, Joel. First I would say that the reduction in the retail partner doors is not reflected at year end because those reductions will occur in the first quarter, but we did also have in addition to one of our partners in the Northwest where we added a number of doors.

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

Jumping over to the remodel performance, that’s exciting that you’re still seeing double digit, year-over-year increases, I guess you mean on sales trends, where did that process begin? That’s now going back roughly two years, how does that tail extend on the strength of that positive comp performance?

William R. McLaughlin

The first test stores were introduced early in 2007 and rolled out about another five in the third and fourth quarter of 2007, so they’re still within their first year of operations, Joel.

Joel K. Havard – J.J.B. Hilliard, W.L. Lyons, Inc.

To get a sense of 50 this year is the cap ex combination X the SAP implementation, is that pretty clean just down to those remodels plus the 30 or so new stores is that really all that’s left in there?

William R. McLaughlin

Yes, the three biggest components are new stores, remodels, the SAP, there are a few minor other capital items, but those are by far and away the three largest components.

Operator

Tony Dikas of Piper Jaffray you may ask your question.

Tony Dikas – Piper Jaffray & Co.

Maybe you could just comment, start out a little bit by how long you anticipate a business turn around could take. Is this something that’s a six month project or a twelve to eighteen month project? Second question, mall traffic trends have been weak recently, what is your expectations for 2008 and could you comment on January trends? And then I have a couple quick follow ups.

William R. McLaughlin

Tony, I don’t think anybody’s got a crystal ball on exactly where the economy is going to go. As we’ve said, most of the programs that we are really excited about are taking effect here in the first quarter, towards the end of the first quarter, and will take some time to build and so we look for momentum to build through the quarter. Our January trends are quite consistent with the way we saw 2007 end, so not seeing any significant improvement.

Tony Dikas – Piper Jaffray & Co.

Okay, a couple of quick follow ups. Maybe just an update on the accessories business? I know that’s something you guys have been excited about, the sheets and pads, etcetera, and with no compensation or incentive compensation, recently have you been able to maintain critical staff?

William R. McLaughlin

Yeah, on accessories that actually has gotten a nice lift in the remodeled stores. One of the advantages of that store is we put the accessories right up front and that has been effective in helping to increase the drop in or walk-in traffic in those stores. Accessories still remain about 8% of our mix but we do believe there is upside to that. I believe the second part of the question had to do with retention and I think it’s one of the testaments to our company, is people very much believe in the product and the mission and if you actually look at turnover within our sales force, within our store managers there was the same retention rate in 2007 as in 2006 and there’s a slight decline in sales professionals but not significant. At headquarters it’s been relatively stable as well

Operator

[Bud Vugach] of Raymond James you may ask your question.

Christ Thornsberry – Raymond James

This is actually Chris Thornsberry on behalf of Bud. Just drilling down a little bit more into your comments on the retail partner program, you said there were five retail partners and that was 140 doors. What are you down to now? I think you were at 13 if I remember correctly at the end of the third quarter. Where are you at now?

William R. McLaughlin

After the elimination of the five partners, we will be at really five primary partners included in the United States and in Canada.

Christ Thornsberry – Raymond James

Is there a ball park figure as to how much that generated in sales or are you not willing to give that out?

William R. McLaughlin

The partners that we eliminated generated less that 1% of our overall sales.

Christ Thornsberry – Raymond James

Were those partners not as enthusiastic in selling the products, or the sales associates not as good at the conversion in the stores or were they seeing flagging sales themselves in their own chains or what was the major rationale behind that? Were they pulling sales away from some of the stores in those same markets?

James C. Raabe

Bill spoke to the primary considerations and that was we do see the potential with the partners to build the brand and to grow market share. I think we felt as if a narrower focus on a few partners that had a fairly broad distribution created the best opportunity for us to really improve the execution and make sure that we take full advantage of that as opposed to a broader mix of partners across the country where it was not as easy to really have make sure that we have really crisp execution throughout.

Christ Thornsberry – Raymond James

Okay, also on the gross margin just wanted to double check. The pricing actually you said that will not offset fully the commodity cost or will that and then there are other pressures involved there as well?

William R. McLaughlin

Just to clarify on that point the pricing will more than offset from a dollar standpoint but from a margin percentage standpoint will not fully offset.

Christ Thornsberry – Raymond James

And that’s due to the customers trading down and some lower margin channel mix?

William R. McLaughlin

If I understand your question correctly you’re saying that the margin percentage will be down primarily because of an anticipated a little bit of slippage in the mix and we’re just anticipating that while we think there’s opportunity to get the mix back, that may take a little while to happen.

Christ Thornsberry – Raymond James

Okay and then the [F-bar] that anniversary the second half of the year so you could see some benefit there. How about the product roll outs will there be some additional costs on that?

William R. McLaughlin

No, the product roll outs will have a small impact in this first month because of store samples and all the rest but the margins on those new products will be above our company average.

Operator

Matt Nemer from Thomas Weisel Partners you may ask your question.

Matthew Nemer – Thomas Weisel Partners

First question is on the RP retail partner retrenchment. Has that had any impact on the company owned stores in that area in terms of comps and is it possible that you’ll close more doors than what you’ve already announced?

William R. McLaughlin

With regard to the retail partner program the store or the reduction in the partner doors is happening in the first quarter and so they are still selling in the first quarter or for part of the first quarter so no opportunity to really evaluate that at this point. We do not anticipate any further reduction in retail partner doors at this point but as we’ve always said its program that we expect to be incremental and to drive incremental sales market share and brand. And we will continue to evaluate it on that basis.

Matthew Nemer – Thomas Weisel Partners

I guess I would suspect that that shut down is happening with a pretty healthy dose of discounting as well as they reduce inventory that they might have in the store?

William R. McLaughlin

I wouldn’t say that there has been a significant amount of that. The partners do a pretty good job of really maintaining inventory levels and so they have been able to sell through most of their inventory without a lot of discounting. Won’t say that there hasn’t been any but I wouldn’t say [inaudible]

James C. Raabe

Yeah, we communicated with them quite early in the process and worked it out with them. So they had plenty of time to work it off to their benefit with full margins.

Matthew Nemer – Thomas Weisel Partners

And then on the severance charge that you announced, was that taken in the fourth quarter and if so is that a pre-tax number and where is that located? Is it primarily G&A or -?

William R. McLaughlin

The severance charge was taken in the fourth quarter. It is a pre-tax number and it’s primarily going to be in the G&A line.

Matthew Nemer – Thomas Weisel Partners

Okay and then with regards to the bonus plan that you’ve announced, can you give us any sense for what the targets might be for that plan? I know typically you’ve provided that in your proxy but are there specific operating margin or growth targets that that is aligned with?

William R. McLaughlin

It will be aligned with a net operating profit number as well as, as Jim said, a series of individual performance goals for that are tied to the delivery of that plan and that will all come out in the proxy.

Matthew Nemer – Thomas Weisel Partners

Okay and then with regard to the increase in inventory, could you just give us a sense of what that includes? Is it primarily raw materials where you’ve had some orders that were tougher to slow down or is it finished goods?

James C. Raabe

There are a combination of factors there was some, some of it is because of higher commodity costs. Some of it is because of, as we mentioned in the comments, some of the flow through on the overall sales and the inventories that we do carry in our stores and in advance of expectations for sales. And then there is some amount of lead time relative to some of, things like our chambers and overseas supplies on those types of things that we’re also in the increase. And I think the final factor had to do with really, we did have a QVC show that was right at the end of the year. A good part of it got shipped before the end of the year but there was some inventory that was carried over for shipment after the first of the year.

William R. McLaughlin

I think the key point is that, as Jim said in his comments, we believe that is an area that we can manage and get back to our normal levels here in the first part of the year.

Matthew Nemer – Thomas Weisel Partners

And then my last question is given some of the headwinds that you’re facing right now, do you expect to forge ahead on the international expansion plan or should we think that we might not see another announcement like that during 2008?

James C. Raabe

That’s a good question. I think that we clearly will be approaching that international expansion judicially. We’ve got a lot to still learn in how our Australian business develops. And as I think we’ve said before our whole international expansion was somewhat limited until the SAP program was fully implemented and so that’s going to be second half of the year [inaudible]

Operator

Greg McKinley of Dougherty you may ask your question.

Gregory J. McKinley – Doughtery & Company

Two questions, number one could you tell us how many stores in your newly remodeled prototype were in the field being tested to sort of validate your decision to move forward with 50 additional remodels this year?

William R. McLaughlin

The number of stores that we have that are remodeled today is 10. Our new stores that are being built are being built in the new model as well, but I think 10 is the number that really we have enough history on to get a valid read.

Gregory J. McKinley – Doughtery & Company

Okay and those were in operation in that model for the majority of 07?

William R. McLaughlin

About half were in operation for at least three quarters of the year and the other half were different, more in the second half of the year.

Gregory J. McKinley – Doughtery & Company

Okay and you feel that that, statistically speaking, you feel like that’s a pretty representative sample to justify a move forward on the 50?

James C. Raabe

We have those stores in a selection of different markets, different development levels in our markets and different size malls.

Gregory J. McKinley – Doughtery & Company

Okay and then my second question, I know you mentioned two product introductions. I caught the first one. I didn’t know if you elaborated on when the second one might come to us and what it might be. I’m wondering if you could provide some comment on that.

William R. McLaughlin

I’m not going to be able to add to much to that. It will be more in the second half of the year for obvious reasons. I don’t think we want to talk too much about that at this point.

Craig McKinley - Dockerdee

Okay. Is it a mattress?

William R. McLaughlin

Yes, it is another model of a mattress.

Operator

Laura Champine of Morgan Keegan you may ask your question.

Laura Champine – Morgan Keegan

Most of them have been answered, it’s just a housekeeping thing. Where in the year does that extra week fall in 2008 and what do you expect it to account for in terms of sales?

James C. Raabe

The extra week will fall into the fourth quarter. What it really adds is, is that week over New Year’s which is certainly a very strong time of year from a sales standpoint for us historically. But just generally speaking it’s an extra week so it’s worth about an additional 2% on sales.

Operator

Jeff Stein of Stein Research.

Jeff Stein – Stein Research

Bill, wondering if you could talk a little bit about your expectations for the partners because it seems that clearly they’re falling short of expectations. Do they know what’s expected of them in 2008 and what they need to do to stay in the network? And what kind of analysis have you done in terms of what if’s scenarios? If you decide to further contract the net work, any thoughts in terms of what percent of those former partner door sales you can recapture during the first year?

William R. McLaughlin

Well, first of all to keep the retail partner program in perspective, as Jim said, it is in the 4% range of our sales and yes, they do understand what is expected and it is a mutual relationship to build the Sleep Number brand in the market and it really comes down to how much and how they advertise and we advertise in those markets and it’s how they treat the product on the floor and generate incremental sales within the market. And I think that’s exactly why we are pulling back to just three primary retailers in the United States so we can stay focused on working with them to improve that execution to ensure the incrementality of the business.

Jeff Stein – Stein Research

Is there any common theme in terms of what the partners are missing on? I’m sure there is dispersion but is there any commonality across the platform that causes them to underperform? Because it still is -

William R. McLaughlin

I’m not even sure I would call it underperforming. The decision was, as Jim said, was really more about allowing us to simplify and refocus and develop the program with them. The commonality though is that we have to work together to figure out how to develop the brand and the advertising and the approach in an incremental way in those markets.

Jeff Stein – Stein Research

Jim, you were on the program. Is there anything else you would add?

James C. Raabe

No, I think you’ve hit on the main points. That the partners that we are going forward with have shown a willingness and the desire to really help us grow the brand and the distribution of the product and I think we just decided that this is the best way to go forward to make sure that we execute against our goals overall.

Jeff Stein – Stein Research

Jim, I’m wondering if you could just talk for a moment about working capital. Where would you expect to end the year from and inventory standpoint and I presume you can’t possibly expect to get any more accounts payable leverage. They’re over 100% there. Was there an aberration in the fourth quarter due to timing of payments or is that an intended extension of terms with your vendors?

James C. Raabe

Well, I think with regard to the answering the first part of your question on the inventory, we certainly have several million dollars of opportunity I think if we can have within the inventory side. We have been working closely with our vendors on the payable side. We do think that there are some additional opportunities there. The business model that we have and the advantages of that model from a cash flow standpoint as well as we’ve done in executing I do think provides some additional opportunity. You know is it a huge number? I’m not going to quote a specific number but we do continue to see opportunities where we can drive working capital in that model.

Jeff Stein – Stein Research

Okay and then final question. The price increases you implemented in January. were they uniform across your product categories or were they skewed more towards the higher or lower opening price points?

William R. McLaughlin

They were skewed more to our middle two price points.

Operator

Bob Evans of Craig-Hallum Capital you may ask your question.

Bob Evans – Craig-Hallum Capital Group

Could you comment a little further in terms of the total SAP spend in 07 and perhaps a ballpark number for 08?

William R. McLaughlin

Yes, the SAP number for 2008 will be about $8 million from a capital standpoint. The total program is about $18 million over 07 and 08 from a capital standpoint.

Bob Evans – Craig-Hallum Capital Group

How about from a P&L or expense standpoint 08 versus 07?

William R. McLaughlin

08 versus 07 from a P&L standpoint, the 08 number will probably be a little bit higher than 07 just because as we get into implementation and all of the training and testing and ramp up does have some incremental costs in 08 as we go through those processes. But once we get past that training and getting the program running it will reduce the overall costs of operation from an integration standpoint as well as just from an operation standpoint of funning the system.

Bob Evans – Craig-Hallum Capital Group

Okay and can you comment - I apologize if I missed this - but can you comment further in terms of how you plan to allocate your media dollars differently this year and perhaps comment on the gross dollars spent 08 versus 07 in terms of how that may change?

William R. McLaughlin

Let me answer the second part first. As Jim said in his comments we’re gonna treat marketing and particularly media as more or less as a variable cost and so as sales are projected to be flat to slightly down I think that’s what to expect for the total marketing spend as well. The media plan is still getting refined but in general it will involve a bit broader reach type media. In the past you may recall we’ve been heavily reliant on direct response advertising which tends to have a narrower reach, a higher frequency. An element of this new campaign will be broader reach both from traditional electronic mediums but also digital.

Bob Evans – Craig-Hallum Capital Group

Okay and so we should expect to see more national advertising from a waiting standpoint?

James C. Raabe

Well, there will continue to be national as there is today but we recognize that we have pockets of more developed markets and so this plan will support those regional strengths as well.

Bob Evans – Craig-Hallum Capital Group

Can you comment a little bit further in terms of gross margin trends? You talked about 08 but if you look out at two, three years where do you think you see your gross margins going or what opportunities might you have?

James C. Raabe

Well with respect to gross margins I think we’ve pretty consistently been in that range of -over the last four or five years - of that range of about 59% to 62. There are opportunities for productivity enhancements. There are opportunities for product advancements that allow us to show more value into the products. So I think we’re in a little bit of a difficult time right now from the standpoint of consumers and what they’re looking at but I think longer term we certainly feel like in those low 60% ranges is certainly very achievable and something we can sustain.

Operator

Edward Yrumaof JPMC you may ask your question.

Edward Yruma - J.P. Morgan Securities

Can you talk a little bit about the adjustments to the bonus pools, have there been any adjustments made to the executive board?

William R. McLaughlin

Well the executive team is on the same basic metrics and receive no bonus this year. So that was a big adjustment. And as we look forward to next year, there will be similar treatment though our skew will be more heavily weighted to the performance to the company as opposed to the individual elements.

Bob Evans – Craig-Hallum Capital Group

And I know you noted that SAP or the first module will come on line in the third quarter of 08. Was that a delay from what you had previously said?

William R. McLaughlin

No, that project has been scheduled for mid-year 2008 from the beginning and that’s where it’ll be.

Bob Evans – Craig-Hallum Capital Group

And my final question about your new product introductions. Is this a cadence that we can expect from here on out or were these kind of two products this year in kind of a catch-up manner? Thank you.

William R. McLaughlin

I would not say that we’ll have a regular cadence of new products. These are two products that we’ve been looking at for some time and particularly the price points that we’ve been looking to fill for some time. As you know our stores are relatively limited in size so that kind of brackets how many different models of beds we can provide but there will be other opportunities. Virtually every year we’ve had product news and that cadence you can count of. But in terms of bed model expansion I would not look for a regular pattern there.

Operator

Joan Storms of Wedbush Morgan you may ask your question.

Joan Storms – Wedbush Morgan Securities

Jim, I was hoping you could clarify a couple of things on the guidance with regards to, for example, when you were talking about the sales and marketing and G&A, you said you expected a slight increase in G&A. Is that just in dollars or as a percent of sales?

James C. Raabe

The increase in G&A would be in dollars and in percentage on a flat sales number and just to clarify the primary reason for that increase in G&A is because of the bonus program and also the numbers that we spoke to on the bonus is primarily directed towards mid- and entry-level - You know I think having not paid bonus this year it’s important that certainly with the core of our employee base for retention purposes we wanted to structure something that they had control over getting. The senior management is still primarily based off of kind of NOP type targets but we do expect to have a bonus which is the primary reason for the G&A in the mid- and entry-level employee base.

Joan Storms – Wedbush Morgan Securities

Okay so previously, sort of after the mid quarter update, call I had been thinking or I don’t know, that the incentive comp would be higher than that? So is this sort of a revised plan maybe?

James C. Raabe

Well, I think the bonus opportunity over all is a bigger number than the $6 million that we talked about within the script comments but that higher bonus would only be paid out if we performed better than what is outlined in the release or the kind of core outline of the cost and sales structure. So we would need to do better than that in order to get the payouts at the higher level.

Joan Storms – Wedbush Morgan Securities

Okay and then similarly the sales and marketing you had commented somewhat higher, flat to slightly higher and I guess and you had also commented about treating it as a variable cost so is that, that probably is more dollars than percent?

William R. McLaughlin

Right and just to clarify the line item that we have in the P&L in our filings is a combined selling and marketing number and so our comments are really referring to the marketing component of that will be flat and managed on a variable cost where the selling piece is going to increase somewhat on a year-over-year basis just based on the store count increase year-over-year.

Joan Storms – Wedbush Morgan Securities

Okay and then just on the product side, a couple points last year talked about sort of trying to ramp up the R&D and get the new products out. You talked a little bit about really sort of trying to ramp up your accessories business, get some new designs, new patterns, get some excitement going on there, can you update us there? It seems like the two products that you’re introducing you have sort of been working on for while.

William R. McLaughlin

Well, your point, your original point was right on, which is that we have been investing in R&D and R&D manifests itself both in new products but also in some quality improvements and cost reductions and they’ve been contributing in all of those areas. What we did talk about here today were the two new bed models. There will be additional accessories through the year as well, just not in a position to talk about those at this time.

Operator

Our last question comes from John Baugh of Stifel. Sir you may ask your question.

John Baugh – Stifel Nicolaus & Company

It sounds like you’re going to treat marketing as a variable spend. I’m just curious, there are a fair number of fixed items obviously. If you were to break even in 08 it would be because sales fell to what or mix fell to what? Sort of fill in those blanks.

William R. McLaughlin

John, the specifics around that I think it becomes a little bit of a circular reference but I think you make within the business model you can kind of model to those numbers but it really comes down to if we see sales decline we’re going to take actions that are appropriate for that time. What we’ve done and what we’ve provided in the release is what we see in the business in the opportunity and where we are at this point in time, we’ve taken the actions that are necessary both to manage the business to the current levels of profitability but also for the long term because we do really see great opportunity for this business, we’re just in a time right now where we have some executional things to work on as well as an economic environment to work through. But you can rest assured that if we don’t perform to those levels we will take the actions necessary to protect profitability and to protect the long term opportunities that we see with the business.

John Baugh – Stifel Nicolaus & Company

So translated - I don’t want to put words in your mouth - you’re going to try to make a profit regardless of whatever sales environment comes down the pike? Is that a fair restatement?

William R. McLaughlin

Absolutely. We see great profit opportunity in this business and we’re going to balance the near term and the long term requirements.

John Baugh – Stifel Nicolaus & Company

And then just a point of clarification, your guidance on the revenue for the year is that with our without the extra week?

William R. McLaughlin

That is with the extra week.

If there are no further questions at this time then that will conclude our call. Thank you all very much for joining us and thank you for your continued support.

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Source: Select Comfort Q4 2007 Earnings Call Transcript
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