Sleep Number Corp (SNBR) 2006 Q3 法說會逐字稿

Welcome to Select Comfort's third quarter 2006 conference call. [Operator Instructions] Today's call is being recorded. If you do have objections, you may disconnect at this time. Now, I will turn the meeting over to Mr. Mark Kimball, Senior Vice President and General Counsel. Thank you, sir; you may begin.

Thank you. Good afternoon, and welcome to the Select Comfort Corporation's third quarter 2006 earnings conference call. Thank you all for joining us. I'm Mark Kimball, Senior Vice President and General Counsel. And with me on the call are Bill McLaughlin, our Chairman and Chief Executive Officer; Jim Raabe, our Senior Vice President and Chief Financial Officer; and Kathy Roedel, our Senior Vice President, Global Operations.

In a moment, I'll turn the call over to Bill; and following our prepared remarks, we will open the call to your questions. Please be advised that 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 includes, 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.

Thank you, Mark, and good afternoon. Today's discussion will include the following. I will frame the third quarter in the context of our strategies and long-term objectives. Kathy Roedel, our Senior Vice President of Operations, will then share some of her team's progress on improvements to service, quality, and cost, which allow us to invest in further growth and competitive advantage initiatives. Jim Raabe, our Chief Financial Officer, will wrap up with a bit more detail on the third quarter as well as outlook for the remainder of this year and next. And then we'll open the call to questions.

I find it helpful to start all reviews by regrounding our missions and goals. At Select Comfort, we are striving to improve people's lives by improving their sleep. We are also building a great company for all constituencies -- for our employees, who then serve our customers, whose satisfaction and advocacy in turn reward our partners and our shareholders. Our goal is to become the leader in our industry -- the leader in consumer regard, in share, profit, and in innovation. To that end, we have set, and will continue to work to achieve, our aggressive annual goals of between 15 and 20% revenue growth and between 20 and 25% earnings growth.

Over all, we had a solid third quarter, continuing a string of seven quarters at or above the high end of our long-term earnings goal. Earnings per share increased by 25%, including all costs, and increased by 35% if you exclude the $0.02 effect of this quarter's asset impairment charge. Earnings per share increased by 45% on an apples-to-apples comparison to last year's third quarter, excluding the combined effects of stock option expense and the asset impairment charge.

We are extremely pleased with the progress made in our service and cost-control programs and with the operating leverage we achieved in the quarter.

The quarter's overall sales gain of 18% was within our long-term annual goal range of between 15 and 20%; yet, it could have been better. The comp store sales gain of 7% was also within our annual goal range, but this was clearly less than what we had expected following a record Labor Day weekend. Over all, sales were strong, with new stores performing extremely well -- 15 new openings -- an average first-year sales trends towards $1.2 million per store compared to our goal for an average first-year store sale of $1 million.

New developing channels of e-commerce and retail partners also performed well, establishing new records.

We approach the long term as a series of short-term races, each to be won, some by a greater margin of victory than others; each strengthening our capabilities to consistently achieve our long-term potential. We strive to hit on all cylinders and to not only meet our goals but to exceed them.

The shortfall in sales following Labor Day was disappointing, specifically in existing retail stores. Because of our direct consumer business model, we may see consumer buying behavior sooner than others. It does appear that, whatever the cause, there are factors impacting consumers' decision-making on consumer durables.

That said, we have consistently stated our belief that we can counter market trends and influence our results to sustain market-leading growth, as we have demonstrated over the past five years, this year being no exception.

To efficiently drive sales, we know that we must efficiently build awareness and drive traffic. The new creative work developed earlier in the year to boost awareness in sales has proven to only be on par with the original campaign so it's fallen short of our goals to date. We are now in a review process to leverage our learnings and to explore new perspectives on our many options to reinforce the Sleep Number brand and our product's unique benefits and strong consumer appreciation. We expect to be testing new material early in the coming year.

Our sales force is also very important. Our sales teams attract and convert customers both by delivering outstanding service that is the first step in turning owners into ambassadors and by helping each customer understand the benefits of sleep and of our product to meet their needs. We are working with our sales teams to help them adjust to be more effective with the evolving consumer needs of our customers.

We entered the year anticipating a more-difficult consumer environment, but certainly not one as challenged and volatile as it's been -- with ongoing war and related concerns, with mortgage rtes rising, and home sales declining. Nevertheless, year to date, Select Comfort's earnings per share have increased 35% reported and 48% on a comparable accounting basis. Sales to date have increased 21% and comp store sales have increased 13% year to date.

We have been fortunate to be able to raise our full-year guidance every quarter from an initial level of between $0.87 to $0.91 adjusted for stock split to between $0.95 and $0.97, currently.

I know you're all more interested in next quarter and beyond -- and this is what we see at the current time. Short term, we believe fluctuations in consumer demand may put pressures on our revenue growth. That said, we will maintain a strong offense. In the fourth quarter, marketing support for the holiday period is planned to be up 16% versus a strong prior-year program. And we plan to open 15 company-owned stores in the fourth quarter and plan to continue to expand our retail partner program.

Also in the current quarter, we expect to maintain the realized gains in gross margin, and Kathy will speak to these ongoing programs in just a minute.

And long term, I remain confident in our ability to achieve our stated goals. Our priorities continue to follow our strategies of first, driving growth by increasing awareness; and then, expanding distribution and selling effectiveness. In time, innovation will also play an important supporting role. We are also pursuing opportunities to expand margins and to continue generating free cash flow.

Looking ahead, I remain confident for the following reasons. We will address our marketing and sales opportunities. Distribution expansion is on track. We expect company-owned store expansion in 2007 to continue to be equal to this year, with approximately 45 net adds at the high end of our guidance.

In addition, we will continue to selectively expand retail partners in 2007 as the incremental benefits of this program are realized. Retail partners offer attractive margins and provide incremental brand-building exposure in their respective markets. We have experienced relationships like this for several years with Sleep Train and Sleep America, and we are seeing similar results as we work with new partners like Mattress Barn and Slumberland.

And e-commerce sales are expected to continue to increase in line with their historic trends. E-commerce serves as both an information source for our customers and adds for our mix of company-owned business growth, growing 31% in 2004; 34% in 2005; and 35% year to date in 2006.

In addition to marketing, sales, and distribution expansion, product innovation is expected to add incremental revenue lift late next year and consistently beyond. Exciting opportunities to further enhance quality and service while controlling costs will enable continued margin expansion and/or fund additional growth initiatives.

And, equally important, work is underway on systems and people development to lead and manage our continuous improvement and growth. We are boldly tackling an ERP solution that will improve our integration, our information and decision tools, and provide capabilities to expand.

So we had a good quarter and our outlook remains strong. We're confident in the superiority of our product, the advantages of our business model, and the quality and dedication of our team. We have important long-term projects underway to build further competitive advantage. We are equally focused on our short-term challenges and on winning this next leg of our race in capping off a very strong year.

Now, it is my pleasure to introduce Kathy Roedel, who joined our team last year and has, with her team, made significant improvements to our service, quality and costs. Kathy?

Thank you, Bill. Let's start with a brief introduction. I've been on the Select Comfort team for about 18 months, coming from GE, where I spent 22 years in manufacturing and service operations and quality and Six Sigma.

I lead Select Comfort's Global Operations team, which includes the traditional supply chain, sourcing, manufacturing, logistics, and quality; plus our unique company-owned services, home delivery and customer service.

In the third quarter, for the total business, blended gross margins increased to 63.2% of revenue, up from 59.6% in the third quarter a year ago. Our company-controlled gross margins increased to 64.2%, up from 62.1% in the same period last year.

Let's put these numbers into perspective. While sales increased 18% in the third quarter, gross profits increased 22%. That's real leverage that we can use to invest in our growth initiatives, or deliver improved bottom-line results to our shareholders, or both.

At Select Comfort, we operate in a unique environment with several competitive advantages. We have a differentiated and technically complex product. The Sleep Number bed is really a sleep system. Unlike traditional innerspring or foam beds, our bed has complex components -- in particular, the air system and electronics. With close to 20 years of experience, we have learned how to design, manufacture, and service it very well.

We have a powerful and flexible just-in-time supply chain that supports a very efficient low-inventory cash model. In our vertically integrated business model, we touch the customer with our own employees in customer service and home delivery every day so we control the quality of the service interaction.

Our unique business model gives us great opportunities to impact our cost structure in materials, manufacturing, and logistics and to deliver a high-quality service to our customers. Our growth over the last five years has provided us with a significant scale that we are just beginning to leverage.

In my discussion today, I'll highlight some of the main drivers of our dramatic gross margin improvements, including material cost reductions through effective sourcing; freeing up manufacturing capacity through productivity; reengineering our logistics models; and technology-enabled home delivery cost reductions.

Let's start with sourcing. Select Comfort has many long-term partnerships with best-in-class global and local suppliers. In addition to our suppliers leveraging our volume in their factories to deliver savings to Select Comfort, with our continued growth, we're now able to employ a dual-source strategy on key components such as our printed circuit boards. With this process, we have secured double-digit savings on targeted components, broadened our sources of innovation, and minimized our risk of business interruption. Our sourcing team will continue this effort and in 2007, we will expand its impact by delivering savings on virtually all company spending, including direct and indirect costs.

Our manufacturing teams, located in Salt Lake City and Irmo, South Carolina, operate in an impressive 17-inventory-turns environment. We continue to expand capacity without the need for bricks and mortar by delivering substantial operating productivity. The teams have improved plant layout and material flow, introduced custom automation, and improved process quality, especially on new product introduction -- as with our Refresh Bed models, introduced in May and June of this year. Additional capacity will still be realized through strategic in- and outsourcing, future lean manufacturing, and additional shifts in some areas, just to name a few examples.

In addition to manufacturing operations, logistics also plays an important role in the gross margin gains that we've achieved this past year. In an environment of increasing fuel costs, and shipping from only two plants to customers across the country, this is critical to our business. We have delivered innovative transportation rate restructuring and employed an aggressive freight cost audit and control process that delivered significant year-over-year savings.

Looking to the future, in Q3 we piloted an all-new logistics network structure that will cut transportation costs, eliminate freight losses, and ultimately reduce delivery time to our customers. This new structure will roll out in the first half of 2007.

Turning to service -- in 2003, Select Comfort launched our company owned-and-operated home delivery service. We now offer the service in 210 of the top 216 markets. Our customers value our white-glove service that includes delivery and setup of the Sleep Number bed and removal of the old bed by trained service technicians who really understand the product. We've worked hard to deliver a great service and improve efficiency. Our customers rate us 4.83 on a 5-point scale for courtesy and knowledge of the crew and overall satisfaction.

By replacing our home-grown, standalone systems with state-of-the art scheduling applications and GPS tracking capabilities, we've been able to create denser routes and improve communications with our customers, resulting in double-digit productivity. Because our home delivery service is increasingly valued by the customer, our attachment rates have increased to about 63% of beds sold in our stores and about 53% of total units in our company-controlled channels. Home delivery is an important after-sales service, and our team of dedicated professionals play a critical role in the overall purchase process and the customers' satisfaction with their purchase decision.

We are pleased with the 270 basis point improvement, but we're certainly not finished realizing gains in gross margins. Our corporate mission is to improve people's lives by improving their sleep. The Select Comfort Operations team is committed to delivering that better night's sleep with superior quality and competitive costs.

With that, I'll turn the call over to Jim Raabe, our Chief Financial Officer. Jim?

Thank you, Kathy. As Bill already indicated, this was another strong quarter. From a financial perspective, I'd like to expand on a few key points, including the sources of our net sales growth; the strength of our earnings growth and, in particular, our continued operating margin expansion. And finally, the strength of our cash generation year to date and in the quarter. I will close with a few comments on guidance for 2006 and 2007.

As noted, net sales increased in the third quarter by 18% and year to date by 21%. Growth in both periods is well above industry trends and within or above our long-term goals.

All channels continue to contribute to overall sales growth. Our retail store sales remain our focal point and continue to perform well, with a 17% increase over a year ago. Retail partners were the next largest contributor to dollar sales growth, with a 179% increase compared to the third quarter last year. E-commerce sales increased by 26% and direct marketing remains on track to maintain single-digit growth while providing cost-effective marketing to consumers. Radisson and QVC sales were in line with last year.

New distribution is contributing a greater percentage of sales growth, as it has for much of the year. This focus on distribution expansion in 2006 was a primary plank of this year's growth plan. Store count has increased by 10% in the last year and company stores opened less than a year continue to exceed expectations, with average first-year sales now trending towards $1.2 million per store. Average sales per retail store open more than 1 year now exceeds $1.5 million, with 84% of retail stores exceeding $1 million in sales.

Retail partner doors selling Sleep Number beds have increased five-fold, representing more than 500 new doors across many new markets during the past 15 months, including our geographic expansion into Canada. Our retail partner doors now exceed the targets we set at the beginning of the year, a significant achievement for our team.

As a result of the increases in sales per new stores and the accelerate of our store expansion, new stores are now contributing 10 percentage points to sales growth, while just a year ago, they were contributing 5 points to growth.

While providing a more predictable source of revenue, our new store and retail partner door expansion continue to impact same-store sales, which in the third quarter contributed 7 percentage points to retail sales growth, which represents the low end of our long-term guidance of between 7% and 12%.

New distribution will continue to contribute to sales growth in the coming quarters. In the fourth quarter, we plan to open 15 company-owned stores and will end the year with 440 stores, while our retail partner doors will continue to expand to approximately 800 doors.

This quarter, we are modifying our discussion of unit growth and average sales price in a way that we believe provides a better understanding of our sales. There are three components of sales growth that we will communicate on a go-forward basis. First, mattress unit; then, mix and pricing; and then, finally, other products and services, which includes accessories, home delivery services, and other products such the adjustable foundations and sofas.

First, during the third quarter, mattress units contributed 8% to growth. Unit growth was depressed by two sources. First, QVC, which experienced strong sales, but at a higher price point and lower corresponding units due to planned year-over-year programming changes. And second, Radisson sales, which we previously communicated would be essentially flat on a year-over-year basis. Excluding QVC and Radisson, unit growth in our core distribution, which includes company-owned sales channels and retail partners, increased by a robust 17%.

The second component of growth is pricing and mix. During the third quarter, the average sales price of mattress units in company-owned channels was $1,713, a 6% increase compared to the third quarter a year ago, and comprised of a price increase taken last December.

A quick reminder that this average selling price is different than what has been communicated in the past. The prior measure included all sales, including accessories, home delivery, and other products, while this new measure includes only mattress revenue. We are making the change to provide more detail and transparency about our sales, including a per-mattress revenue number that correlates more closely to information provided by the International Sleep Products Association as well as other mattress manufacturers; and also provides more clarity around how non-mattress revenue contributes to growth. We also believe this change will help to reduce the confusion created by including multiple product sales in one ASP number.

In an effort to provide a seamless transition to this new method of discussing ASP growth, we have provided the prior ASP measure in the table attached to our press release. We will not provide the ASP measure calculated under the previous methodology in future quarters.

Finally, sales from other products and services in company-owned channels increased by 25%. We continue to see increased accessory sales from purchasers of mattresses and walk-by traffic as well as increased penetration of home delivery.

My second topic for discussion is the strength of our earnings growth. Earnings per share in the third quarter increased to $0.25 per share, a 25% increase over the third quarter last year. Net income increased by 22%, while share repurchases added $0.01 to earnings.

The strength of our earnings growth is masked by two factors -- asset impairment charges of $1.8 million and stock option expense of $1.7 million, which is included in 2006 earnings but not 2005 earnings due to the change in accounting rules. Excluding these costs, earnings per share would have increased by 45% to $0.29 per share.

Overall earnings growth is due to sales growth and margin expansion. The factors noted above also mask the strength of our margin expansion. On a reported basis, our operating margins improved from 10.3% to 10.5%. Excluding the asset impairment and stock option expenses noted above, net impact of our incentive compensation program, our margins would have improved by an additional 1.4 percentage points to 11.9%.

Kathy spoke to the gross margin expansion, which was the most significant contributor to profit margin growth. These gains and the future opportunities provide the flexibility to reinvest in growth initiatives and to extend our competitive advantage.

Sales and marketing expenses as a percentage of sales increased to 42.1% from 41.3% last year. We continue to invest in marketing, especially media, which ranks among the most important areas of investment because it helps increase consumer brand awareness and stimulates retail activation. Media spending totaled $27.7 million, or 13.3% of revenue, in the third quarter, up 26% over the year-ago period. Throughout our business, we remain committed to investing, to improved sales growth, and sustain our competitive advantages. We expect full-year media expenditures to be approximately $110 million in 2006.

General and administrative expenses totaled $18 million in the third quarter and increased as a percentage of sales to 8.8% from 7.8%. The increase reflects stock options expense of $1.7 million, which equates to 0.08 of a point as a percentage of sales, as well as the near doubling of research and development investment.

Finally, the asset impairment charges referred to earlier include two components. The first is $515,000 in store-related asset impairments. We evaluate individual store performance on an ongoing basis and charge off store assets whenever we determine that cash flows generated from store sales will not be sufficient to recover capitalized assets.

The second impairment is for certain software under development totaling $1,248,000. With the arrival of Ernie Park, our CIO, we are undergoing an evaluation of strategies to accelerate the implementation of needed software capability. Within the context of this evaluation, we determined one particular software project would not be viable to continue. We believe that these new implementation strategies will provide operating efficiencies long term, although they may result in near-term cost increases such as the asset impairment charge taken this quarter.

My third point of discussion is our balance sheet and the strength of our cash flow. We ended the third quarter with $112.7 million in cash and investments. The increase includes cash flow generated from operations of $50.7 million in the quarter. Our business model remains strong, with cash generated from earnings and the favorability of our working capital model.

Much of the improvement in the third quarter comes from the reversal of timing items noted in our conference call last quarter. Specifically, our cash conversion cycle was negative 15 days this quarter, the best performance in three years. Day sales outstanding in receivables was 7 days and inventory was 30 days, each favorable by one day compared to last quarter.

Our favorable cash position and increasing cash flow allows us to continue to self-fund our business needs and opportunities. In the third quarter, we invested $25.8 million to buy back an additional 1.3 million shares. Year to date, we have generated $56.4 million in cash from operations and have invested $49.5 million to repurchase 2.3 million shares of stock and $21 million to fund capital expenditures. We now have approximately $120 million remaining against our repurchase authorization.

From a balance sheet perspective, our financial position remains strong, with zero debt and 45% return on equity over the past 12 months.

In closing, I wish to speak to our earnings outlook. Looking ahead, we have elected to be cautious relative to fourth quarter earnings guidance. We feel it is prudent to take the consumer economic environment into consideration as well as our late third quarter sales. Our emphasis is to sustain the company's long-term growth, fund incremental growth initiatives, and continue to capture market share.

We expect full-year revenue growth to be at or above the high end of our targeted range of between 15% and 20%. Full-year earnings are expected to be between $0.95 and $0.97 per diluted share, representing earnings growth of between 25% and 28% over last year's $0.76 per diluted share. Adjusting for the effects of stock options expense, 2005 earnings would have been $0.69 per diluted share, representing 2006-year earnings growth of between 38% and 41%.

Our long-term outlook remains unchanged, with revenue growth of between 15% and 20%; same-store sales growth of between 7% and 12%; and earnings growth of between 20% and 25%.

Our 2007 guidance reflects revenue growth in the range of these long-term targets of between 15% and 20%, with earnings of between $1.18 and $1.25 per diluted share. This earnings guidance represents an increase of between 22% and 32% over revised 2006 guidance.

Several years ago, we set goals for 2007 that we remain committed to achieving. We look forward to the challenges ahead as we pursue the long-term mission of being the leader in sleep.

That concludes our prepared remarks. Brian, I'd now like to open the call to questions.

Sure. [Operator Instructions] We do ask, in order to accommodate everyone's questions, that you limit yourself to one question and one follow-up question. [Operator Instructions] And our first question comes from Mark Rupe with Ryan Beck. Your line is open.

Hey, guys. Good quarter. On the comp, obviously, at the mid-quarter-- or, mid-quarter update, I think you'd mentioned the higher end of the 7 to 12% range. And obviously, it's fallen off. Is there anything that you can target here? You're pretty vague on the call, here. Is it traffic to the stores? Is the ad campaign not doing it, pulling enough weight for you? Or could it be some of the cannibalization of some of the third party retail partnerships?

As we've said, we had the record sales at Labor Day, and we really think that the biggest driver is that we took a lot of consumers out of the market through that period. We have continued with the advertising; we're continuing to see the traffic flow and believe that we will get back on track.

Okay, so there was no change in promotion or incentives to the salespeople at all? It was just [inaudible] fall-through?

Right.

Okay, thank you.

Our next question comes from Todd Schwartzman with Sidoti. Your line is open.

Hi; good afternoon. What are you seeing in terms of trends here -- traffic sales in October versus post-Labor Day, September?

It is not our practice to comment on the current trends. But what I would say is the fourth quarter is a peak sales period, really driven by the holiday period that gets into Thanksgiving and into December. We've got programming that's designed to drive traffic during that period and we'll up date the results when we do our fourth quarter update on the 13th of December.

Okay. I wanted to also follow up on Mark's question on the comp. How much variation was there in the third quarter across geographic segments?

We really see pretty broad trends, both from the consumer standpoint-- And also, if you look at our marketing approach, it's heavily weighted on a national basis, and then we do drop in some local spending. But the trends that we saw were pretty broad spread.

That said, because we do have the regional programming-- but also, our salespeople are so important in the process. We have seen pockets of strength and pockets of weakness as we go through, and we use both as learning experiences to figure out how to better adjust the programming going forward. But the real answer to your question was it was pretty broad-spread.

And what about the new stores? Can you give us a sense of where stores were opened -- the company-owned stores -- during the quarter and which ones were closed?

From a new store opening standpoint, it really is a broad base. In particular, in any given quarter, what we do do is, as we're evaluating new store locations, we are trying to concentrate them into markets where we've got advertising leverage and in those markets that we feel like we've got the room to really-- or, we're most under-stored. But when you look at any particular quarter, they can be spread throughout the country within a variety of markets.

And for this past quarter?

Could you repeat? I was-- I interrupted you.

Where were the-- I saw the net number for the quarter, but I'm just wondering, what was gross number opened, company-owned, and if you can just give a sense maybe by region -- you don't have to go into specific markets per se. But I just want to get a sense of how broad country-wide your openings were in Q3.

We had 15 store openings, two closures. I don't recall, off the top of my head, where the closures were. But like I said, the openings tend to be, really, throughout the country.

Okay. Last question is regarding the EPS guidance, the $0.95 to $0.97. That is GAAP earnings -- is that correct?

That is correct.

Okay, thanks a lot.

Our next question comes from Steve Colberg with Canacord Adams. Your line is open.

Hey, guys, good afternoon. Just so I'm clear -- the 7% same-store sales -- what specifically is the breakdown between AFPs and units?

We typically do not provide the specific breakdown but I think you can see from the information we provided that there's still some pricing that is in that number, in the 7%. As well as the great strength that we've had in selling kind of non-bedding products in those stores.

Okay. Were units positive for the period?

As I said, we don't comment on the specific unit number. But we've given you the breakout of kind of what the various components are.

Sure. And then, can you talk a little bit about the fire-resistant standard and kind of how that rollout is going to look next year?

Yeah. Just a quick background -- We have a product already that we've been selling in California and available to anybody in the country who wanted it that is compliant to the product. We are today working on the systems and procedures with our suppliers to get the documentation support ready to meet the federal regulations. Our plan, at this point, is to roll the product out to the whole country well before the July deadline or-- next year.

Okay. And would that have the same $100 price increase that's seen in California?

No. We are in the process right now of finalizing our plan and our pricing strategies for '07 but we're doing it in the context of the total business. As Kathy shared with you, we've done a nice job on some productivity so we believe that we'll be able to offset some of the incremental costs. And has been our practice, we're pretty stingy on pricing actions and believe that that becomes a competitive advantage as we go forward. So that actual pricing strategies will get resolved here in the next couple of [inaudible].

Okay, I'll get back in the queue. Thanks, guys.

Our next question comes from Joel Havard with BB&T Capital Markets. Your line is open.

Thank you. Good afternoon, everybody. Congratulations. Kathy, your comments, at least per my notes, were specific to the sort of efficiency gains and improvements in South Carolina. Is Utah there yet or following in South Carolina's footsteps, or is Utah already ahead of those measurements you gave?

Joel, my comments were not specific to Irmo at all; they're really to our full system, both factory plants together and our entire logistics network.

Okay, so you're lifting the tide across; you're not experimenting in one plant and then translating it to another at this point?

That's right. And in both plants, we make and sew our covers and do order fulfillment and in Salt Lake City, we build our air controls. But both plants are experiencing great productivity.

All right. And as a follow-up, if I may, to Jim. I believe your comment was to the effect of you could see more of these charges related to sort of refining some of your internal programs. To the degree you can communicate yet, would they be of a similar sort of dollar figure, and what do you think the ultimate price tag could be over the next two to four quarters?

Yes, I think what you're referring to is the systems changes that we're evaluating and that we're looking to put into place. Any time you go through these systems changes, there are costs. I couldn't speak to the specific amounts, but we do anticipate that, as we go into '07, there will be costs to these implementations, but they are factored into our guidance that we've provided so we have factored that in as we've provided that information.

That was the magic word. Thank you very much, guys. Good luck.

Our next question comes from Steve Denault of Northland Securities. Your line is open.

Good afternoon, everybody. It is safe to assume, as I look at some of the metrics provided on the final pages of the report, with the new metric being all sales, average sales per mattress unit being up 8%, that store-level units were probably flat? Maybe down slightly? Am I interpreting it correctly?

Like I said before, Steve, I mean, you've got the information. There was a 6% increase in mattresses and we're certainly seeing very good growth within the overall accessory and other aspects of the business. So I think you can factor those pieces together.

Okay, so no glaring errors in my assumptions there.

No, Steve. (This is Bill.) The one thing, though, that I keep-- that I would just remind you and others about is that we entered this year with a strategy of expanding and diversifying our distribution. That's going very well. Our new store openings are on track and our retail partner performance has been very strong.

And I think the other number that Jim shared in his comments is that overall unit growth of 17% for the quarter is a testament to that diversification strategy. So I think you're seeing more-- we're seeing more pressure on our same-store growth from our distribution expansion efforts as well as some consumer activity. But I think the key takeaway should be the total growth. And we understand that there's some work to be done on the general-- lifting the tide for the whole-- for our partners as well as our stores, and have acknowledged that our marketing program did not meet all of our expectations. But the total program is working very well this quarter.

Right. No, that makes sense. And you know, you're not alone in reporting a post-Labor Day slowdown. As you look at it, how much of it would you attribute to sort of the macro uncontrollable versus maybe the micro controllable?

It's really difficult for us to comment-- not even comment; to assess short-term issues, because one of the things to remember is that our transaction size is actually pretty small. And then, it's high ticket. So you get the movement of a few units within a couple of weeks and it can shoot the numbers around quite a bit. So-- tended to see fluctuations-- we've tended to see fluctuations in the business as long as I've been here in the very short term and you have to look at it in a little bit long-term basis, and especially when you come off a record weekend like Labor Day was for us.

Okay.

Our next question comes from Jeff Stein with KeyBanc Capital Markets. Your line is open.

Jim, I can't recall if you stated this or not, but did you give the average mattress sale-- per mattress unit for first and second quarters, which you had not provided previously?

No, we didn't-- I didn't in the comments. The second quarter mattress per unit is included in the press release if that number-- or, excuse me. Not the second quarter, I guess -- the year-ago number is what's included in the press release. That was 1,621. But that is information, certainly, that we can get out. It tended to be kind of a go-forward number, so we could provide that information.

So will we be able to get that number? Just so we could see, sequentially, what's happening to units per store.

Yes. Well, we can get you the average mattress-- yes, the selling price per mattress unit.

Okay. And when you guys started the year, you were looking at about 600 partners by year end, and obviously, that's increased pretty dramatically. Would you call it just opportunistic and being able to find the right partners, or are you making a concerted effort to just ramp that percentage growth rate up? And where would you see that going in 2007?

Well, I think it has been more opportunistic. I'm not sure that's the word I'd use, but it has been-- as quality partners have approached us and we've been able to gain agreement on how we were going to build the brand together-- And then it's really been controlled a little bit, actually, by our willingness to-- the speed with which we want to roll out. We need incremental training and other resources to support them. So we have not been aggressively pushing it as much as partners have come to us. And as the program has been successful, they've wanted to roll it out, as have we.

In terms of going forward, as I said, we will continue to expand this program as we realize the expected benefits of it, and we haven't put numbers to next year yet. But in general, we have always said we are going to limit this program on a very selective basis because our primary focus is on our stores and our company controls and there just aren't that many partners out there that we've seen that are willing to support the program the way we want to see it run.

Got it; thank you.

Our next question comes from Michael Cox with Piper Jaffray. Your line is open.

Good afternoon. Thanks for taking my call. My first question is on the average selling price. I was hoping you could shed a little light on-- as you anniversary the price increase that was taken last year, what your specific plans are to drive average selling price growth in the fourth quarter. I understand you're just one month into that price increase -- but then looking ahead to '07?

Well, I think I'll talk to, a little bit, the average selling price, I guess, within the context of kind of the way we're presenting it today, and within that revenue per-mattress unit of a little over $1,700. I would expect that that number will stay relatively flat with some fluctuations, potentially, because of mix in the business. But I wouldn’t expect anything dramatic from that standpoint. I think we're kind of reverting, now, to the old terminology where you've seen a lot of the increase in the average selling price.

And one of the reasons we made the change in the way we're talking about it is to be able to talk a little bit about what kind of growth we're getting in that non-mattress revenue. And I think certainly the sources of that 25% growth that we're getting in non-mattress revenue-- there continue to be opportunities in accessory sales. There continue to be opportunities for increased penetration in sofa. We see an opportunity with accessories over all. So I would-- I think we believe we can continue to grow that non-mattress revenue at a pace that's faster than what the mattress revenue growth is, and I think that adds [inaudible].

Michael, longer term, and this is probably beyond '07, a lot of our R&D as we're now gearing it up is going to provide some product innovation news that could affect that down the line. We'll have to see as the programs evolve.

Could you provide any update on that product innovation -- what that might look like for next year?

Not at this time, Michael. This has been the year of building that team and that resource, and that's going very well. But most of these programs have a good 12- to 18-month-type development cycle at this time.

Okay. On the advertising spending, have you set a target for 2007 advertising budget? And if you could provide any update on, or clarification behind, what the changes to the new campaign will look like in early '07? To reinvigorate the unit volume growth?

Michael, this is Bill. No, we have not provided any direction on the 2007 plan details and won't until the year-end conference call, as we get into that. And it is too early to talk about what some of the different marketing initiatives-- modifications will look like. What I can tell you is that it is anchored in Sleep Number and it is anchored in a lot of the learnings that we have about the unique benefits of the product and the high levels of customer satisfaction and really helping our owners to talk with other people and-- turning our owners on as ambassadors for the product.

Okay, thanks.

Our next question comes from Bob Evans with Craig-Hallum Capital Group. Your line is open.

Good afternoon, everyone. Kathy, can you talk about-- the gross margin improvements that you made this quarter -- should we view that as a sustainable level going forward? And how should we look for-- I believe you said you're looking for continued improvements. What type of improvements-- what kind of trend line should we expect as we head into '07?

Bob, I'll speak to that just with regard to the gross margin expectation. We've gotten great improvements, as you've seen, and as you've mentioned, over the past year. We're looking at a gross margin number in the fourth quarter that's probably in line with where we've been in Q3. We'll communicate more on the go-forward as we talk more about '07.

Okay. But is it fair to say '07 should be-- shouldn't be a step back? It should be, if nothing else, flattish?

Yes. I mean, we're still working through that. But as we've indicated, as Bill talked kind of through the fire retardancy type of things, we do have some cost increases, so-- that come along with fire retardancy. And what Kathy's team's been able to do is really identify additional productivity that will help offset those costs. So in the case of 2007, there's potential opportunities but as much as anything, we believe we're going to be able to roll this out and cover some of those-- a good part of those costs with the productivity.

Okay. And would you be willing to elaborate on your '07 -- I believe you said 15 to 20% revenue growth? What components of that is made up by same-store sales or are we talking about the low end, high end? Or give us some sense of magnitude there?

Without getting into a tremendous amount of detail, I think what I would say is you're going to see similar sources of growth, certainly, with same-store growth, new distribution-- as Bill alluded to, a store count number that's going to be similar to what we did this year. We're certainly ramping up the retail partners, which is a multi-year ramp-up for sales so there will be some from there as well. So it's going to be similar sources of growth. It'll probably look a little bit different, but similar kind of geography of the distribution.

Is it-- given kind of the Q3 latter trend and lack of a price increase like you had a year ago, is it fair to say that we should expect more of the lower end of the range from a same-store sales perspective?

I think all I would say at this point is we expect to be in the range of that 7 to 12, and for it to be-- with that component of that 15 to 20% growth.

Okay. All right, thank you.

Our next question comes from Greg McKinley with Dougherty. Your line is open.

Thank you. Guys, I wonder if you can give us a little more color on your comments around accessories growth. I think you said you mentioned-- or, maybe non-mattress sales dollars were up 25% year over year in company-owned channels. Is there something from a merchandising standpoint that's driving that particularly strongly, or is it more what you're doing in terms of attaching accessories once people are in the stores?

It is really more about some product additions. We've rolled out some new sheet items, higher thread counts, and proprietary design, on top of what has continued to be a pretty steady-- maybe a slight increase in the attach rate. But it's been a pretty steady mix, beyond that, of pillows and mattress pads and the rest, all doing very well, but growing more or less in line with the beds. And then, added on a few new products like the sheets and all.

Okay. And then, as you look at the change in the advertising campaign that you implemented this year, what were some of the learnings in terms of the changes in the message that you made? What do you think resonated with the consumer, and maybe what didn't, and why?

First of all, just for perspective, we didn't end up making very many significant changes in the marketing plan this year from an allocation between media types or between national or local. What we were looking for was an increase in effectiveness of the advertising by changing some of the messaging. That's what we've spoken to has been more or less on par with the base model, an that's what we're still going to go back and work on fine-tuning.

I think the learning is that we were attempting to take some of the creative messaging too far towards an emotional payoff where our strength has tended to be more on the fact base of the product benefits and the consumer's appreciation of those consumer benefits. And we've just got to stay focused there more.

Okay. Thank you.

Our next question comes from John Baugh with Stifel Nicolaus. Your line is open.

Thank you. It looked like there was a fairly big jump in payables. I was just curious what was behind that number. And then secondly, it looks like, after backing out options expenses, there's some pretty good leverage on the G&A line. I'm curious as to whether that's sustainable going forward.

I'll answer the second question first. The-- absent stock options, which is worth about 0.08 of a point, we were essentially-- and the R&D additional investment, we were essentially flat. I mean, I think we believe that longer-term, we can get leverage in our G&A. the stock options have kind of muddied the waters a little bit, at least in the kind of on the surface view. But certainly, longer-term, we think we can get some leverage going forward.

With respect to the overall cash, and I guess I'll just step back a second to the second quarter, where the overall cash from operations looked a little bit down. And what we communicated at that time was it was more some anomalies around the timing of things like payables and inventories and tax payments and those types of things. Those items are now more in line with what we expected to have going forward, so the year-to-date cash flow number, I think, is pretty representative of what we expect to generate from our business.

The payables line is up a little bit. Or, it's up a fair amount when you look at it versus the last quarter. That is related to, in a lot of cases, just the business model that we have and the timing of our payables versus a lot of the expense that we have, which is some real strength.

And then, we've made some changes from a process standpoint to improve that a little bit better, as well. So there's a number of factors going into here. But I think if you look at the cash from operations over all for the year to date, it's a pretty representative number of kind of the cash we can get out of our business.

So just to be clear, sort of looking at the nine-month payables, which are all up appreciably from, say, the nine months last year -- that's a sustainable change in working capital?

It is a little bit higher than I think you're going to see on a go-forward basis. But I think it's representative of where we hope it can get to.

Thank you.

Our next question comes from Joan Storms of Wedbush Morgan. Your line is open.

Hi; good afternoon. Jim, could you maybe talk a little bit about your history? You've been with the retail partners now-- some history. You've really increased the ramp significantly this year. What have you experienced in the past as far as sort of what your impact on comps in a region may have been as you've rolled out retail partners?

Well, as I go back to the original-- when we originally tested the retail partner concept, we were in Sleep Train in Northern California, Sleep America in Arizona, and Benchmark in Kansas City. And all of those were leading mattress retailers in their respective markets, very representative of the type of retail partners that we've tried to pursue since that time. And what we would see-- what we saw in those initial tests was that we saw some effect on our stores when we opened them up, but then over the three-year period of the test, our same-store growth in those markets was equivalent to what we were seeing in the markets without retail partners.

So what we are now in, in this ramp-up, is we're obviously in a significantly higher number of retail partners covering a significantly higher number of markets and stores. And I would say that we expected some cannibalization. It's been a little higher than what I think we planned, or what we expected when we rolled them out. But I think we remain confident that the strategy fits well with our overall distribution strategy and that, as we move into next year, that we can get back on track. We can grow those partners as well as get those existing stores in those markets back on track from a comps standpoint.

So it is fair to say we should be looking at this model as sort of a multiple distribution channel model in that as different-- you'd have shifts in sales among the different channels so that we should expect, like you said, the comps to-- as the absorption of the retail partners gets into the marketplace, that the comps should rebuild themselves?

Joan, this is Bill. I would say that's true for this next year or two as we work through the transition. I think the one thing, going forward, is that my expectation is that we will still limit the number of retail partner doors at some point to the high quality and we will continue to grow our company-owned channels. And so if your question was a long-term modeling exercise, I just would not take expansion of retail partners out too far but I would continue to expand our company-owned distribution.

Okay, good point. Are you still-- originally you said 1,000 stores, and then I've sort of heard 1,500 to 2,000, and then I heard 1,000 to 1,500. Do you have a better idea these days?

No, I think we're still in that 1,000 to 1,500 range. And a lot will just depend on the number of retail partners that we find that we're able to work with and develop the brand.

Okay, helpful. And Jim, just one last question. If you could just go over-- when you talked about the components of sales growth and the contribution from mattress units was 8%. You said it had been down a little bit over previous quarters. Could you go over the reasons that you talked about QVC and Radisson? I didn't quite get all that.

Yes. What I said was that the total unit growth -- total mattress unit growth -- in the quarter was 8%, but that there were two factors. The first one was QVC. And the QVC product cycle that we're under is every 12 or 18 months, a new product is introduced into QVC and the old product rolls off.

Well, a year ago-- And then, once a year, we have a very large show called "Toda's Special Value," which I think a lot of you are familiar with. That occurs in the third quarter. Last year, when we ran that QVC show, it was a low price point that sells a lot more units. This year, it was a high price point -- it was on the opposite end of the spectrum. The same types of sales levels over all, but the mix between dollars and units was different. So the unit volume was lower, but the overall sales volume was about the same. So that had an impact on our unit growth.

And then, the second piece was just Radisson. And the Radisson program is about a three-year rollout. The first year-- and our expectation is once we got through the first year, that we were going to have about the same number of units in each of the three years. So that is also one of those that's kind of holding back the unit growth.

When you exclude Radisson and the QVC from the third quarter numbers because of those two factors and just look at our company-owned channels, retail, direct, e-commerce, plus retail partners, the unit growth was 17%.

Okay, that's very helpful. Thank you very much.

At this time, we have time for one more question so our last question will come from Barry Posternak with Conseco Capital. Your line is open.

Hey, guys. Will the-- one question. Will the election-related media spending affect your costs or availability for media spend in the fourth, in the current quarter?

That's a good question. I just went through a review with our marketing team yesterday of that, and there are only about two or three markets, none of them significant, where it looks like we're going to have direct clearance issues, and we can work around that with some radio and some newspaper. So in total, at this point, it looks like we're in pretty good shape to get the clearance that we had planned.

Okay. And also, it seems like some of the traditional manufacturers have been more aggressive recently with promotional activity. At the same time, there's more retail doors carrying other alternative bedding -- Visco and Latex. So just competitively, do you think that those things are affecting you at all?

They could be. We have seen that pattern over-- before over the last five years, and historically, our product differentiation and our unique selling environment have been the difference. And we have flexed with the consumer and the competition a bit in terms of featuring more financing offers at different times to respond. But in general, we've done, by strategy, a pretty good job of holding the line on discounts so that we can invest back in media and more awareness-drivers, which has, we believe, been more important for our long-term growth.

Okay. I guess if the competition is being more aggressive on discounts, might you need to change that strategy?

Again, we have proven, through time, to be able to work through those environments without significantly changing our discount strategy. And then, the other side of it is I guess that we will learn through is more the retail partners -- what happens in that environment. But, again, we have not changed our strategies there.

Okay, thanks.

So with that, I'd like to thank you all for your attention and your questions, and to wrap up our discussion by reiterating how excited and confident that we are about long-term growth prospects. We delivered a strong third quarter in a tough environment, extended our track record of success. And we also completed a rigorous strategic planning process during the quarter that confirmed the appropriateness of extending our aggressive growth goals into the future.

We intend to tell you more about the conclusions from that strategic planning process and to provide additional guidance for 2007 and to discuss our new long-term sales and earnings goals at the time of our 2006 year-end earnings release.

At the same time, we have some work to do. We're disappointed in the results of the last three weeks of the quarter as just meeting our goals has never been in the nature of the Select Comfort team. We understand the short-term imperatives of our business and we are working hard to make sure that we achieve our goals, not only in the years to come but also in the days and weeks to come.

We thank you for your attention. Sleep well; talk with you in a few months.