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Executives

Barry Hytinen - Vice President of Investor Relations and Financial Planning & Analysis

Mark A. Sarvary – President and Chief Executive Officer

Dale E. Williams - Chief Financial Officer

Analysts

Mark Rupe - Longbow Research

Bob Drbul – Barclays Capital

Ruma Mukerju - JP Morgan

John Baugh – Stifel, Nicolaus & Co.

Chad Bolen – Raymond James

Keith Hughes – SunTrust

Joseph Altobello – Oppenheimer & Co.

Albert Kabili – Goldman Sachs

Joan Storms – Wedbush Morgan Securities

Tempur-Pedic International, Inc. (TPX) Q3 2008 Earnings Call October 16, 2008 5:00 PM ET

Operator

Welcome to the Tempur-Pedic third quarter 2008 earnings conference call. (Operator Instructions) For opening remarks and introductions, I will turn the call over to Barry Hytinen.

Barry Hytinen

Joining me in our Lexington headquarters are Mark Sarvary, President and CEO, and Dale Williams, CFO. After prepared remarks we will open the call for Q&A.

Forward-looking statements that we make during this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements, including the company’s expectations regarding sales and earnings, involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company’s business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating, and other factors discussed in the press release issued today. These factors are also discussed in the company’s SEC filings including the company’s annual report on Form 10-K under the headings special note regarding forward-looking statements and risk factors. Any forward-looking statements speak only as of the date on which it is made. The company undertakes no obligations to update any forward-looking statements. The press release, which contains a reconciliation of non-GAAP measures to the most comparable GAAP measures is posted on the company’s web site at www.tempurpedic.com and filed with the SEC.

And now with that introduction I will turn the call over to Mark.

Mark A. Sarvary

I would like to start by saying that having been CEO for nearly three months now, I am more convinced than ever that we have a great company with enormous potential and I am very happy to be here.

Now, obviously we are in a very tough market right now which is significantly impacting our business, so we are taking steps to ensure that we are well positioned when the economy recovers to capitalize on our potential.

On today’s call we will provide our view on our performance in the third quarter and will outline those steps we are taking now to mitigate the impact of the current environment. And I will share my perspective, as the new CEO, on the company’s situation and give you an overview of the areas we’re going to focus on to drive growth in the years ahead.

In the third quarter we executed well, given the circumstances. We delivered sales and earnings in line with our expectations. Gross margins were down sharply but we were able to respond quickly across the P&L to offset the impact.

Right now we are facing the most challenging economic environment in memory and we see no reason to assume this will improve in the short term. Retailers continue to report their traffic is off sharply. So we are taking significant actions now to further improve our financial flexibility and our business.

We are repatriating approximately $140.0 million from our overseas operation. This will materially reduce our outstanding debt. In addition, we are suspending our dividend to further reduce debt. Together, these actions will give us the flexibility to operate without risk of breaching debt covenants, even if the market continues to deteriorate.

We will continue our tight fiscal discipline and focus on cash to give us the ability to continue to invest in marketing and R&D. When the economy does recover we will be even stronger and very well positioned to benefit from the latent consumer demand that will have built up.

Dale will spend his time focused on reviewing the third quarter results in more detail, explaining the proposed repatriation, and providing our updated guidance.

I will now talk about what I see as the significant opportunities for Tempur-Pedic. First of all, we are very well positioned. We are, and we remain, the world’s most profitable mattress company, both in dollars and margin. We have the leading share in the growing specialty market and while this category has been significantly impacted recently, I am confident it will resume its growth when the economy recovers as consumers continue their decade-long trend away from spring mattresses.

Tempur-Pedic’s brand recognition is comparable to the leading s-brand and consumer’s understand it’s unique proposition. Our owners are extremely satisfied with their Tempur-Pedic mattresses and they are enthusiastic promoters to their friends. We spent over $600.0 million building the brand during the last six years and this has provided us a significant competitive advantage.

And this marketing brings consumers to retailers asking for Tempur-Pedic by name, and as a result we have a network of great retail customers, several of whom I had the chance to meet already and I will meet many more in the coming months. I look forward to forging long-lasting relationships with them.

We also have an advantaged business structure. We have a single product line to all retailers and a unique pricing and promotion strategy and we’re vertically integrated and we have a differentiated R&D capability.

And finally, we have an experienced executive team, dedicated to growing the business and one that works exceptionally well together. Indeed, throughout the company the employees are talented and productive.

With this strong foundation we have identified three areas where we can clearly see opportunity for growth over the longer term. These are all significant long-term initiatives but I anticipate substantial progress by the end of 2009.

Number one, we will improve our effectiveness with the retailers. Historically we were a direct response company. Today we predominantly sell through retail. This change occurred relatively recently and like any business going through such a change, we can identify things to do better.

Our growth with the retailers has been achieved because we offer great products, a consistent pricing model, and a level playing field with promotions. We also offer high margins and products which consumers are prepared to pay a premium for.

However, for us to become an even more important part of our retail customers’ mix, we are going to make ourselves easier to do business with. And a key component of this is a program currently underway to streamline our distribution network.

Number two, we will broaden and strengthen our product line. Our Tempur material provides extraordinary support and great comfort but we offer much more than that to our consumer. Today we offer ten mattresses, each topped by Tempur material but each different in feel, with different characteristics designed to appeal to different consumer preference groups.

Now, we can improve our effectiveness at communicating the range of different products that we sell, and we can also create new products that meet the needs of premium consumers that we don’t currently address. I can’t give away secrets here, but suffice it to say that we’ve already identified several significant opportunities.

And number three, we can improve our gross margin. Over the last few years our gross margins have decreased significantly. We can and will address the three key reasons for this. Firstly, we will take steps to slow and reverse the decline of our direct response business, our highest margin channel. Secondly, rising costs, particularly in chemicals, can be offset by improved productivity throughout our supply chain. And finally, our high fixed costs associated with our new plant in Albuquerque will be diminish in significance as our volume grows. Today I’m not going to communicate our numeric targets for these key focus areas, but you can be assured that we are tackling them internally.

We have a very strong business and a clear plan for how to improve it, and while the environment we find ourselves in today is literally unprecedented, we are taking those steps necessary to get through this period and to be in a position to capitalize on the recovery.

I will now hand over to Dale.

Dale E. Williams

I am going to focus my discussion on the third quarter financial results, the proposed repatriation, and our current outlook.

Third quarter EPS was $0.32 on $24.1 million of net income, which compares to $0.49 and $38.8 million respectively in the third quarter of 2007. In what was a challenging quarter for the consumer sector we aggressively took costs out of the business to deliver this level of earning.

In total, Tempur-Pedic achieved net sales of $253.0 million, a decline of 14% over the same period last year. Domestic sales were down 17%. International sales were down 7% and on a constant currency basis our international sales declined 13% with the difference accounted for by favorable exchange rates.

Our international business experienced further weakness from the trends seen in the first half, and the results were below our prior expectations for this segment.

By channel, our U.S. direct business continues to be impacted, down 39%. The U.S. direct channel generally serves the lower consumer demographic than our retail channel so direct is more affected by economic slow down.

Turning to the retail channel, we posted domestic net sales of $148.0 million, a decline of 17%. Internationally, retail sales were down 8% to $68.0 million.

On a product basis, globally mattresses were down 16%, driven by a 15% decline in units. Domestic mattress sales declined 19% on an 18% decline in units, reflecting flat pricing. Declines in the direct business negatively impacted domestic blended average selling price while retail channel ASPs continued to grow. In the international segment, mattress sales declined 8% on a 10% unit decline.

In total, pillows were down 9%, driven by a 10% decline in units. Domestic pillow sales declined 19% on an 18% volume decline. International pillow sales were up 3% but flat unit volume.

Gross margin for the quarter was 41.7%. Compared to the prior year, gross margin weakened primarily related to three factors. First, the sales decline in our high margin direct business was a big factor. This channel serves a lower consumer demographic which we believe has been particularly impacted in this environment.

Second, despite oil prices coming down in the quarter, the cost for the raw materials we use were up substantially versus last year. And in fact they continued to go higher during the quarter. We are coping with cost increases in the vicinity of the mid-20%. While our sourcing team in working to drive these and other costs lower, currently we are still experiencing very elevated levels.

Lastly, fixed cost de-leverage was a significant head wind, given the decline in sales and our efforts to lower inventory levels. These factors were partially offset by improved manufacturing efficiencies in our operations.

On a sequential basis, gross margin was down 270 basis points. This decline was driven by unfavorable channel and segment mix, as well as continued increases in the cost of raw materials, including freight. Improved efficiencies in our plants partially offset these factors.

During the quarter we were carefully monitoring sales trends and cost trends. As conditions worsened we adapted quickly to adjust our spending levels. With these actions we delivered operating income of $42.9 million, or 17% of net sales. This is a 180 basis point improvement from the second quarter and a 350 basis point improvement from the first half.

Third quarter results reflect bad debt expense of approximately $1.0 million related to a specific customer bankruptcy. However, our DSOs are coming down and our accounts receivable aging is improved.

Turning to the balance sheet, we took steps to improve our financial flexibility. Operating cash flow was $73.0 million, a 30% increase. We lowered inventories to $70.0 million, a $24.0 million reduction. While accounts receivables were up with a sequential increase in sales, we generated substantial benefit from working capital. I would like to thank our operating teams around the world for their efforts in this area.

As a result of that great cash performance, we reduced debt by $38.0 million to $519.0 million. In addition, cash rose to $88.0 million, up $19.0 million.

I would like to spend a moment reviewing some thoughts about our $640.0 million credit facility. Given the environment, we believe our credit facility is quite attractive in many ways. It is a revolving facility where we can borrow or pay down debt as we see fit. The relative borrowing cost is low. At current leverage levels we pay LIBOR plus 100 basis points and our facility fee is only 20 basis points more. Our pricing grid for margins fluctuates based on leverage levels. It has a maximum margin of 125 basis points and can step all the way down to 63 basis points. The facility has no mandatory principle payment and does not mature until 2012.

In our industry, we believe these terms are a significant, competitive advantage and a significant benefit to our shareholders. As of the end of the quarter, our funded debt-to-EBITDA ratio was 2.45x, well below our debt covenant of 3x, and so we are taking steps to ensure this favorable credit facility remains in place.

To that end, today we are announcing initiatives to further improve our industry-leading financial flexibility. Over the coming months the company plans to repatriate approximately $140.0 million of foreign earnings. As of the end of the third quarter we had $75.0 million in cash in our international operations and this actually will allow us immediately to utilize much of this cash to pay down debt.

As part of the repatriation, we will simultaneously de-leverage our domestic business, while modestly leveraging our international business, thereby allowing for more rapid overall debt reduction resulting from cash flow in both businesses in the coming year.

We anticipate recording a tax charge of approximately $13.0 million in the fourth quarter, related to the repatriation. As a result of the timing of this activity we would anticipate the repatriation effort alone will enable us to lower debt in the fourth quarter by at least $80.0 million.

As Mark mentioned, we are also suspending the dividend and redirecting those funds to pay down debt. This activity will allow for $30.0 million of incremental debt reduction between now and the end of 2009.

Now, while we believe de-leveraging is a prudent course in this environment, we will continue to have access to substantial incremental borrowing capacity under our existing credit facility. We will be able to access this liquidity in the future, as appropriate, to invest in such activities as growth initiatives, stock buy backs, and reinstating the dividend.

Now I would like to address our revised guidance for full year 2008. Given the extraordinary events of recent weeks, the company now believes fourth quarter sales and earnings will fall below prior expectations. For sales the company currently expects full year net sales to range from $930.0 million to $950.0 million. For earnings, the company currently expects diluted earnings per share for 2008 to range from $0.90 to $1.00. This guidance does not take into account the potential tax charges related to the proposed repatriation.

At the mid-point of our range, we are assuming a fourth quarter sales decline of 30% versus the 14% decline in the third quarter. We expect a larger decline in the domestic segment. This would be consistent with the trends we have seen recently.

I note that while we have experience foreign exchange benefit on sales through the first three quarters, at current rate foreign exchange would be a modes negative in the fourth quarter.

Further, our updated guidance assumes gross margins are flat to slightly down from the third quarter as favorable market mix, reductions in distribution costs, and productivity would be offset by elevated levels of raw material costs and fixed cost de-leverage.

While we have taken actions to further reduce expenses, we do expect some operating expense de-leverage, given these sales levels. We are using a share count of 75 million shares and a full-year tax rate of 34.5%.

As noted in our press release, our guidance and these expectations are based on information at the time of the release and are subject to change and addition, many of which are outside the company’s control.

This concludes our prepared remarks and at this point we would like to open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Rupe - Longbow Research.

Mark Rupe - Longbow Research

Just two questions. One, when you mentioned that you were talking about some new broadening the product offering, were you speaking to mattresses or were you speaking to possibly opening it up to other types of products?

Mark A. Sarvary

Fundamentally I’m talking about mattresses. Obviously we have other products like pillows and the Ergo space systems so there are other things, but fundamentally I am talking about mattresses and sleep systems.

Mark Rupe - Longbow Research

Okay. And then secondly, any insight that you could give on some of the cost leverage you have, or cost containment or cost reduction you have on the operating side looking into 2009, whether it’s fixed costs or some more of the variable stuff that you can do if volumes are like this, continuing into next year?

Dale E. Williams

From a cost standpoint, obviously we will tightly control all of our costs, make sure that the things that we’re spending money on are things that will give us quick and immediate pay back. We will continue to advertise. We will continue to invest in R&D. but the advertising will be in line with the sales. Beyond that, we are tightening our expenses, we had a large headcount reduction earlier in the year. We are continuing to allow headcounts to decrease across the business through attrition. And so we’re just trying to make sure that everything that we’re spending money on is prudent and things that we absolutely need.

Mark Rupe - Longbow Research

As it relates to the domestic kind of trends, obviously I think you mentioned 30% overall and more domestically, I’m assuming that is kind of based on kind of the last three quarters of trend. Is that fair to say, how things have gone domestic, a little bit worse than 30%?

Dale E. Williams

You said last three quarters.

Mark Rupe - Longbow Research

I’m sorry. The last three weeks of the month of September.

Dale E. Williams

The domestic business, as you can imagine, has slowed down significantly with the financial crisis that has impacted almost all consumer companies.

Mark Rupe - Longbow Research

But I mean as far as the assumptions for the fourth quarter, are they in line with kind of how things have trended during the last part of the quarter, or are they worse than the last part of the quarter?

Dale E. Williams

Basically, what we are expecting, this guidance is saying that what we have seen here in the most recent time period, the financial crisis will not change.

Operator

Your next question comes from Bob Drbul – Barclays Capital.

Bob Drbul – Barclays Capital

You mentioned that it was bankruptcy with one customer. Can you just talk a little bit about how you are managing and sort of focusing on your customer base, given the fragmentation with the number of powers that you have and how you are managing the receivables side of it. And then the second piece of it is can you maybe just talk about the mix of sales in terms of some of the higher-end launches versus the open end price points and sort of the trends that you’re seeing around that and how you are managing for that in this environment?

Dale E. Williams

In terms of mix of sales, other than the channel mix and DR being weaker than the resale business, our mix of sales has been fairly standard. We haven’t seen the pricing or the products that are selling change dramatically across the line. The weakness has been broadly across the line. Each of the products has been down within a relative percentage of each other. So we are seeing weakness across the whole line. It’s not just the low end or the high end of our line.

So that’s something that has been a little bit curious but also something we have seen consistently throughout the year and it hasn’t changed in the last quarter.

On the receivables side, we do have a very fragmented industry. It’s a very fragmented customer base so obviously the larger customers, we are monitoring on a daily basis, the other customers we are monitoring on an exclusionary basis, looking at receivables, anytime somebody gets past due it pops up and they get looked at.

We have always been pretty tight on our receivables control and we have put even more focus on it during these economic times. The large bankruptcy we had in the third quarter, that customer was current. So it’s something we have a lot of focus on, our credit and collections team, and executive management is looking at this on a daily basis in terms of how customers are doing, where they’re going.

And as I say, our aging is actually better. We have been able to improve our aging. We have been able to reduce our DSOs, even if this tough economic environment, however, in this environment you are going to have people go under.

What we’ve done is in the second quarter we beefed up our receivables reserves, we beefed up our expense in the quarter, so we’re trying to stay ahead it.

Operator

Your next question comes from Ruma Mukerju - JP Morgan.

Ruma Mukerju - JP Morgan

Could you just talk about trends in floor space at retail in terms of [inaudible] store and what you’ve seen there?

Mark A. Sarvary

We don’t share the exact numbers on them, but even in this period we have been growing our stocks with stores throughout the year and it has continued in this last quarter.

Ruma Mukerju - JP Morgan

How much did you spend on R&D in the quarter and how much on advertising?

Dale E. Williams

Advertising spend in the quarter was $18.5 million and R&D spend in the quarter was $1.3 million.

Operator

Your next question comes from John Baugh – Stifel, Nicolaus & Co.

John Baugh – Stifel, Nicolaus & Co.

The ad spend going forward trying to stay in line with sales, would that be 9%ish of revenues so if revenues track next year, wherever they come out?

Dale E. Williams

Yes.

John Baugh – Stifel, Nicolaus & Co.

And then could you walk us through again kind of the fixed versus variable costs, because we need to make our own volume assumptions about 2009 but some help there. And then some color on the quarter that just ended where you obviously reduced inventories a lot so I assume you didn’t run the factories very well and there’s something to draw off on your gross margin performance in the third quarter from under-utilization of plant and equipment relative to the revenues generated.

Dale E. Williams

In terms of fixed versus variable, we’ll talk about it in a couple of different pieces. From a gross cost of goods standpoint, our fixed cost typically runs in the neighborhood of about 20%. The rest of the cost structure is fairly variable, chemicals, other materials, direct labor being a small component of our cost structure. Freight and transportation, there’s an element to freight and transportation that is fixed but a large piece of that is variable related to moving goods around.

And in the third quarter, as you can imagine, significant fuel surcharges given the way that diesel spiked up late in Q2 and really diesel hasn’t dropped a lot. It has started to come down here recently and will be part of the factors giving of us a little bit of relief in the fourth quarter as diesel has started to drop some.

What did go up quite a bit, though, in the quarter, it was expected but it kind of hit us a little harder than we [thought], was chemical costs. Oil has dropped significantly from its highs in late July but as often happens in the chemical industry, we’re not seeing a response yet from the chemical companies to react to the change in oil prices. They tend to be a little bit slow to react on the way up, but not as slow as they are on the way down. In fact, historically we’ve never seen a big reduction on the way down, but certainly we’re pushing hard for it.

Getting down to the operating expenses, from a selling and marketing standpoint, we typically look at selling and marketing expenses as being roughly in the neighborhood of 75% variable. G&A is probably about 75% fixed. And R&D is probably about 75% fixed but we try to keep R&D pretty sacred and keep money into it.

John Baugh – Stifel, Nicolaus & Co.

And beyond the gross margin impact negatively from bringing inventories down in Q3.

Dale E. Williams

Certainly we did have inventory reductions over the last two quarters and we saw the brunt of it occur in the third quarter so the factories were running at a much lower rate than the sell through. So one of the positives, if you can call it positive in this down environment, is that we were expecting the factories actually to pick up in those production volumes, to get more in line with what we were selling, because we’ve been producing a lot less than we were selling.

With the recent trends, because of the financial crisis, our production volumes will be fairly stable. And when we start to see some uptick in demand is when we will see immediate need to increase our production volumes.

We have wrung out the inventory out of the system at this stage.

Operator

Your next question comes from Chad Bolen – Raymond James.

Chad Bolen – Raymond James

Did you give an updated retail door count?

Dale E. Williams

No, we didn’t in the script. Retail door count was 6,800.

Chad Bolen – Raymond James

6,800 U.S. and what about international?

Dale E. Williams

International was flat at 5,100.

Chad Bolen – Raymond James

And do you have U.S. furniture and bedding sales in front of you?

Dale E. Williams

Yes. U.S. furniture and bedding sales was $130.5 million.

Chad Bolen – Raymond James

I think Mark in his comments alluded to some steps or some planned actions that you would have to hopefully improve the performance of the direct business. Is there anything you can elaborate on or share with us in that respect?

Mark A. Sarvary

Sure. It clearly is a very important part of our business, but at the same time as you know, this is not a simple or quick task. I mean, fundamentally it used a DR company exclusively and now we are knocking on 7,000 doors selling the product alongside.

But I think that DR is an important component of our business and it meets the needs of a significant place of our consumers. And I think that one of the interesting facts about it is that we know that about 50% of the people who buy a Tempur-Pedic mattress from a retail store have checked out the website before they do that. So we are an incredibly important communications tools, at least.

I think we have the opportunity to even strengthen the services and the functionality and the way that we use that direct communication, using the Internet in particular. So we do think that there are opportunities. It’s not going to be a quick turn. But it is important and it is something that we see a long-term future for.

Chad Bolen – Raymond James

You had mentioned in your comments over the last several years we have seen a specialty in premium and Tempur gaining share at the expense of other categories and with the down turn that we’ve seen it has been a pretty startling reversal. When we start to feel a recovery, or see a recovery, in demand for the broader industry, would you anticipate that the high-end stuff would coincide with that recovery, would lag the recovery, or would lead. Any thoughts you have in that respect.

Mark A. Sarvary

It is certainly a crystal ball type of question but I think that there are some fundamentals here. I think that the trend towards specialty, and particularly the trend toward the Tempur material, is a very long-running trend and has, is an ongoing thing, it’s happened for some time over an extended period of time.

In addition to that, I’ve seen a lot of data, there is a lot of data in the company that shows how customers, consumers significantly prefer the quality of sleep they get on a Tempur-Pedic mattress. I mean, they really do. It is something that blind tests will validate. So it is a superior thing and people really do value the difference. And increasingly people care about sleep as a component of their overall health program. So I believe the fundamental, long-term demand is as strong as it ever was.

And I think that the other thing that’s going on right now is that people can defer this decision relatively easy. And right now people, I think what’s happening to a large extent is that people, in this incredibly uncertain period, I think are deferring their decisions to upgrade their mattress.

So when the world becomes more normal again, I think we’ll go back to normal. And then we come to the question of will they go to the high or the low end. And I think what has been the trend that’s lasted much longer than even the trend I just referred to is the fact that consumers increasingly, across all product types, are dividing into those types of products that they will pay a good price for a functional product, a base product. They expect to pay a relatively modest price for many things. But for the things they really care about, they’re going to invest to get a premium item. And our mattresses, and sleep in general, definitely falls into that category.

So I believe both of these meta trends really point to the fact that we will be well positioned when this economy comes back to normality.

Operator

Your next question comes from Keith Hughes – SunTrust,

Keith Hughes – SunTrust

You had discussed new products, shrink the product lines in your prepared comments. Historically you have not gone below about $1,500 for a queen set. Is that just a barrier that doesn’t make sense for Tempur-Pedic to go below or would you consider that in the future, particularly given the economic situation.

Mark A. Sarvary

Well, there was some arbitrary golden little number that we would never cross below, but the truth is this: we are a premium product. Consumers are paying for a premium product. And what we have identified already is that within the premium consumer set, those people who are prepared to pay more than $1,000 or $1,500 for a bed, there are significant opportunities for us to meet the needs of consumers that we quite frankly don’t yet meet.

So while I will never say never, at the moment we see no need for that. And we can see quite a lot of opportunities in the area that we are. And frankly, we are a premium product, consumers value, we are premium compared to other products in this category, but on the other hand, in terms of the amount of money that we are asking people to pay to improve their sleep, their life really, is a relatively low cost of improving of your life. And that’s how we think about it.

So we will continue to make sure that our products are genuinely valued and differentiated for the consumer. And of course we will make sure that our margins remain strong.

Operator

Your next question comes from Joseph Altobello – Oppenheimer & Co.

Joseph Altobello – Oppenheimer & Co.

I just want to make sure I heard Mark right. Obviously we’ve all seen the ISPA data and the category is pretty weak here, but you guys are gaining share it sounds like in specialty.

Mark A. Sarvary

Well, the latest ISPA data that’s been released is second quarter and we were gaining share there. The latest data hasn’t come out yet.

Dale E. Williams

On the monthly data, ISPA doesn’t break out specialty on a monthly basis. Obviously we have seen ISPA data through August but we have no input on specialty after June.

Joseph Altobello – Oppenheimer & Co.

In terms of your raw material, outside of diesel, how much do you purchase in the spot market and how much do you purchase forward?

Dale E. Williams

Basically what we have is contractual relationships with a number of chemical companies. It’s not really a spot market thing. It’s a contract price but they can change their pricing on a notice basis. So this year, particularly all the way through July, as oil kept increasing and kept increasing, we kept periodically getting notices of price increases.

The funny thing is it’s not happening in reverse, at least not yet. But believe me, we are hammering that point home. And we hope to see a turn around there. But it’s not something that we have yet so therefore we’re not counting on it in our guidance for the rest of the year.

One of the issues that the chemical companies raised for a while was the Hurricane Ivan did disrupt production. There was about three weeks of a couple of factories being down, shortages of supplies. There was about a 50% allocation for about three weeks and then it went to about a 70% allocation for another week or so after that before we got back to full supply. Essentially we’ve just been back to full supply here in the last week or so, so now is when we’re trying to press them on getting some cost reduction for the drop in oil prices. When it will come, I don’t know.

Joseph Altobello – Oppenheimer & Co.

Any reduction probably won’t be seen until early 2009 at the earliest it sound like.

Dale E. Williams

We’re not counting on it this year but I would certainly like to see something before then. But I’m not counting on it.

Joseph Altobello – Oppenheimer & Co.

And in terms of the international pillow business, one of the bright spots in the quarter, was flat, which is actually much improved from what you’ve done in the past. I’m not sure if you could give any color there.

Dale E. Williams

We did and we can. The U.S. business obviously has been struggling with the economy. Internationally, the European business, you know we saw some weakness in certain countries and we saw it spreading as the year progressed. In the third quarter we saw it spread even further. So basically now the entire European continent is suffering to some degree in terms of the economic weakness.

However, our Asian business continues to perform very well and our pillow business is skewed a little bit to Asia because of Japan. And we had a good pillow quarter. Our pillow business, if you look at it quarter-to-quarter was basically flat and on a year-over-year basis it was up a little bit. So the pillow business is skewed a little bit to Asia and we’re continuing to have pretty good business performance in Asia.

Joseph Altobello – Oppenheimer & Co.

On the mash leverage ratio for your covenant, does that step down in 2009?

Dale E. Williams

No, there is no step down, no provision for our covenant to change. It’s 3x debt-to-EBITDA and there’s no provision in the agreement for that covenant to ever change. What can change, as I mentioned in talking about the credit agreement, is our spread above LIBOR can change based on our leverage levels. Today at our current leverage levels, 2.45x, we pay LIBOR plus one. If we get about 2.5x I believe it is, it goes to LIBOR plus 1.25. If we get below 1.75x, it drops to LIBOR plus .75. So there’s a grid within the covenant in terms of the spread, but the covenant does not change.

Just to be clear on that, I have the agreement in front of me, if greater than 2.5x, 1.75 to 2.5, it’s 1 to 1.75 and less than 1. Less than 1 is when it drops to 63.

Operator

Your next question comes from Albert Kabili – Goldman Sachs.

Albert Kabili – Goldman Sachs

Quick question on the outlook on the fourth quarter. If you could just talk about the range, what you’re kind of assuming of the high end and the low end. Does the high end assume current trends in the last four weeks stay the same?

Dale E. Williams

No, in fact what we said in my prepared comments was that the mid-point assumes that we will see the trends that we’ve seen here over the recent weeks, during the financial crisis. We don’t think that there’s going to be a dramatic recovery, but it’s possible that if things calm down we might see a little bit of pick up and the high end is not dramatically different. And it’s possible things could further deteriorate, hence the low end.

We’ve got two and a half months to go, so in terms of it’s a fairly tight band but with a lot of uncertainty we’re trying to have as tight a band as we can but still give you decent information. But I don’t think, particularly in the fourth quarter being a seasonally weaker quarter for mattresses, if consumers suddenly start feeling better, they’re really more likely to go buy flat screen TVs than they are mattresses, with Christmas coming up.

Christmas has always been a little bit seasonally slower for the mattress business anyway so that’s why we’re not expecting any dramatic change, certainly not for the upside, this quarter.

Albert Kabili – Goldman Sachs

And I wanted to talk about the gross margins, you were expecting flat to slightly down, but the last time that we saw a dramatic step down in volumes fourth quarter to first quarter you know you saw your margins decline 500 basis point sequentially. How do you handle the step down in volumes on the fixed cost side?

Dale E. Williams

As we were talking about with one of the prior questions, from a production volume standpoint, because we were running productions significantly less than sales to bleed out the inventory, even at this lower revenue level the production volume doesn’t change much. Because we were already producing at a significantly lower rate than we were selling.

What we had been planning for and hoping for before the financial crisis hit several weeks ago, was that we would actually see production volumes pick up in the fourth quarter. Now it looks like that will be delayed. But the overall production volume is not dramatically different this quarter than it was last quarter.

And we did see significant cost pressure in the last quarter around diesel pricing. We are seeing some relief there so our freight cost is coming down this quarter compared to what we experienced last quarter. That is one element that is turning favorable, given the drop in oil prices and starting to see a reasonable drop in diesel prices.

We’ve got some other productivity initiatives, some things that have been in the works for a while that are starting to kick in and deliver some benefits. But we’re expecting that chemicals will continue to be high.

Albert Kabili – Goldman Sachs

But I just want to clarify, I understand that you are producing well less than you are selling in the third quarter, but given the dramatic reduction again in volume for the last few weeks, wouldn’t that eventually have to translate to even further lower production volumes to kind of keep your inventories in check?

Dale E. Williams

Yes and we will keep the inventories in check but what we are not expecting is the kind of inventory reductions that we saw over the last couple of quarters. We have wrung out the inventories. The inventories are at the lowest level that they’ve been since 2004 and we feel like the inventories are at the right level now and they will adjust from here with sell through volume.

Albert Kabili – Goldman Sachs

On the new products, any meaningful impact in the third quarter and can you talk about fourth quarter, is there any continued impact from fill in on the new products?

Mark A. Sarvary

Two of the new products were shipping in the third quarter and they did contribute, although not dramatically or meaningful to the overall results. And the Bellafino, the third line, is just going in right now. So it’s going to affect the fourth quarter. All three products have been received well. Retailers have responded very well to them and they have been getting the sell through that we’ve expected, if you take the proportion of sell through that we’re getting on everything.

So they’re going okay. I can’t talk about Bellafino, the third one, but the first two are doing quite well. But on the other hand, the [inaudible] is not a material contribution to the overall performance.

Operator

Your next question comes from John Baugh – Stifel, Nicolaus & Co.

John Baugh – Stifel, Nicolaus & Co.

I just wanted to circle back, Mark, maybe with your philosophy on ad spending in a very unusual period. A lot of the ad spending you do is brand or long-term oriented. And there is some philosophy that you advertise when they ducks are flying, and the ducks are not flying right now. Is there a scenario where you may cut back to well below a 9% of sales ad spend, if there’s a choice between busting covenants, or is that a variable you just won’t touch?

Mark A. Sarvary

First of all, let me just explain a little bit of philosophy on this and then I will answer the specific. But the philosophy is we have a really rather remarkable situation here in that our brand is remarkably well known. But it’s more important than just that it’s well known. If you ask consumers to describe a Tempur-Pedic they can. If you ask them to describe the difference between a Tempur-Pedic and another brand, they can. If you ask consumers about many of our competitors’ products and ask them to tell the difference, they really can’t.

So we really do have, it’s not just philosophy, it’s a crucial part of our whole, the way that this business works. And it’s been systematically something we’ve invested in. As I said in the prepared comments, $600.0 million over the last six years. And we certainly are going to continue it. And right now, so far this year, our spending on advertising is almost exactly on trend with what it was last year, in terms of percent of sales. It’s very close.

And we anticipate for 2009 and beyond that we will continue to have investment levels at the same rate.

However, having said that, I think whatever you said, ducks are flying or fish or feeding or whatever the analogy that one uses, there is a period right now where advertising right at this moment is not as effective as it would normally be. Consumers are really skittish at the moment about what they’re doing and the return on investment of advertising in this environment is not nearly as good. So we’re going to be thoughtful about it in the fourth quarter and in possibly in the beginning of next year.

And we will do it appropriately. We are going to do it because we want to make sure that when we do spend the money, it has the greatest value. We don’t do this sort of blindly or because there’s a formula that you always do this. We are going to do it sensibly and thoughtfully. But we definitely, as we model out going forward, our anticipation is to maintain this 9% to 10% range, in a normal period, but we may move it from period to period, especially in environments like this.

Dale E. Williams

I wanted to just add one other thing [as to the covenant]. The actions that we are taking give us significant room on our covenant sales. Around the repatriation, bringing $140.0 million back, that is going to, not immediately but over the course of the fourth quarter and into 2009, end up taking debt down by $140.0 million. So we are developing a lot of breathing room on those covenants.

John Baugh – Stifel, Nicolaus & Co.

$140.0 million or $75.0 million?

Dale E. Williams

Our repatriation is going to be $140.0 million. We won’t have $140.0 million move in the fourth quarter, but the money will come in two traunches. I said with the repatriation alone reduce debt in the fourth quarter by about $80.0 million. We have a lot of cash overseas. That cash will come over. We also have some unused borrowing capacity within our existing credit facility, where we will draw on that credit facility on the European side, reduce the use of the credit facility on the U.S. side.

that doesn’t immediately impact the overall debt level but what that does for us is it sets up so that cash flow next year in the international business goes to reducing part of the debt as opposed to just the U.S. cash flow reducing debt. So within the next 6 to 9 months, we’re going to see debt, just because of repatriation, down $140.0 million.

John Baugh – Stifel, Nicolaus & Co.

And did this discussion possible for some time eliminating the tax on repatriating money, does that factor into your thinking here or does this just make sense irregardless?

Dale E. Williams

It makes sense irregardless. You can see on a $13.0 million potential tax charge related to bringing in $140.0 million back, that’s a pretty efficient mechanism for us. Back in 2005 there was a temporary reduced tax related to the Reinvest in America act. Going back a year or so ago, it appeared that there may have been the potential for Congress to pass a similar legislation again. That has not come up at all, even in the last few weeks of the recent financial crisis. The idea of having another Reinvest in America act has not come up at all in Congress. The only thing that has come up is being able to borrow money from your overseas businesses, but that’s only for 60 days. So it doesn’t appear that Congress is going to do anything so we’re acting to protect ourselves.

Operator

Your next question comes from Joan Storms – Wedbush Morgan Securities.

Joan Storms – Wedbush Morgan Securities

When you gave the guidance for the second, by the way, solid, really good execution in the quarter, when you were giving that guidance sort of the long end was, our the high end, whatever, depending upon the new products less the seasonality and I was wondering if you could comment at all. Obviously we know the last couple of weeks, or four weeks in particular, have been really tough where the consumers have just, you know, shut their pocket books. But can you comment at all about Labor Day, that’s traditionally one of the strongest selling periods of the year and did that come off for you as expected?

Mark A. Sarvary

Labor Day was actually pretty good. We don’t talk about holidays usually, but this particular Labor Day was pretty good. And it looked like the sun was coming out again. And I think that the crisis happened just about after that. And so, yeah, it was around that time that the turn happened.

Joan Storms – Wedbush Morgan Securities

And we talked to a number of the spring companies at the show in July and one of the retailers then asking what the demand seemed to be was sort of in the lower priced mattresses. So I know you had commented from another question about how the new mattresses that you introduced were doing, but will there be any consideration to, in order to drive some business, developing something below the $1,000 price range?

Mark A. Sarvary

As I said before, we are not going to say that it will never be done, but I think that what we need to do is to maintain products that deliver on the Tempur-Pedic quality and premium at a good margin and meet the needs of consumers. And frankly, there are [inaudible] opportunities available to us.

And one of the things that we’ve notice is that, Dale referred to it earlier, if you look at our portfolio as a whole, it is interesting how the impact of the crisis has been very, very even across the different price points of our whole range. And you would have thought if there was a sort of latent demand for a lower priced Tempur-Pedic product that our lower priced items would be doing disproportionately well and really we’re not seeing that. And neither are we seeing the reverse.

So quite honestly, right now we don’t any need for this environment to change our fundamental strategy. Especially since we can see opportunities for more products to fulfill significantly.

Operator

And Dale, are you commenting still about number of doors opened during the quarter or are you still generally saying about 100 a year?

Dale E. Williams

In terms of future expectations, no we haven’t commented on our future expectations for quite some time. But we do comment on what we opened. We ended the third quarter domestically at 6,800 furniture and beddings doors. The door count was up about 150 doors in the third quarter. Internationally that channel was basically flat on a door count basis.

Joan Storms – Wedbush Morgan Securities

You did a great job getting the inventories down. I just wanted to clarify and make sure I understand. Right now, the inventory levels as you said, are the lowest since in a few years and that sort of at a level now that you’re comfortable with and that sell in will continue to adjust. So we should expect similar level in inventory at year end.

Dale E. Williams

Yes.

Operator

There are no further questions.

Mark A. Sarvary

Thank you everybody and we look forward to talking with you again in January when we will review the fourth quarter.

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Source: Tempur-Pedic International, Inc. Q3 2008 Earnings Call Transcript
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