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Tempur Sealy International Inc (NYSE:TPX)

Q2 2013 Earnings Call

July 25, 2013 5:00 pm ET

Executives

Mark Rupe - Vice President of Investor Relations

Mark A. Sarvary - Chief Executive Officer, President and Director

Dale E. Williams - Chief Financial Officer and Executive Vice President

Analysts

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Budd Bugatch - Raymond James & Associates, Inc., Research Division

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Peter J. Keith - Piper Jaffray Companies, Research Division

Jessica Schoen - Barclays Capital, Research Division

Joshua Borstein - Longbow Research LLC

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Joan L. Bogucki-Storms - Wedbush Securities Inc., Research Division

Jon Andersen - William Blair & Company L.L.C., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Tempur Sealy International Conference Call. [Operator Instructions] I would now like to introduce your host for today's conference, Mark Rupe. Sir, you may begin.

Mark Rupe

Thanks, Sharda, and thank you for participating in today's call. Joining me in our Lexington headquarters are Mark Sarvary, President and CEO; and Dale Williams, EVP and CFO. After our 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, adjusted EBITDA, earnings or adjusted net income, or the integration with Sealy, 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, regulatory, competitive, operating and other factors discussed in the press release issued today. These factors are also discussed in the company's SEC filings, including, but not limited to, annual reports on Form 10-K, and the company's most recently -- recent quarterly report on Form 10-Q under the heading Special Note regarding forward-looking statements and/or risk factors, as well as the company's press releases. Any forward-looking statement speaks only as of the date on which it is made. The company undertakes no obligation to update any forward-looking statements. The press release, which contains reconciliations of non-GAAP financial measures to the most directly comparable GAAP measures, is posted on the company's website at tempursealy.com and filed with the SEC.

With that introduction, I will turn the call over to Mark Sarvary.

Mark A. Sarvary

Thanks, Mark. Good evening, everyone, and thanks for joining us. Today, I'll provide an overview of our performance in the second quarter, discuss our growth initiatives including the progress of new products and advertising, and then provide an update on the Sealy integration. I'll then turn the call over to Dale, who will provide details on the second quarter financial results and discuss our updated financial outlook.

The second quarter didn't turn out as we expected. The steps we have taken to return Tempur North America to growth are appropriate but they are taking longer than we would like. And as a result, we're lowering our financial outlook for the full year. Having said that, we're pleased with the performance of the rest of our portfolio and the integration with Sealy is proceeding ahead of schedule.

In Tempur North America, we faced several challenges that impacted our overall second quarter performance. We experienced softer than expected demand for our older products, and in particular, didn't experience the seasonal lift in demand around the Fourth of July holiday. In addition, new products contributed less than we expected as rollouts were slower than planned. Notably, the TEMPUR-Choice rollout has been slower than we'd hoped due to initial startup delays that are now resolved.

In addition, the transition to the new Ergo Premier adjustable base took longer than anticipated as retailers sold off existing floor models. In short, we had less sell-through opportunity given the later rollout timing. But we're confident that the steps that we're taking to return to growth are appropriate and beginning to work. We are committed to sustaining and growing the premium portion of our retail customers business by continued focus on product innovations that drive AUSP, investment in advertising to drive consumer demand and store visits and improving how we serve our customers.

In the second quarter, sales of products priced at $2,000 and above were positive for Tempur North America, and we saw an overall AUSP increase. Our Retail business, particularly with our largest customers, is improving. Our advertising has been refreshed, and we plan acceleration in advertising spend in the back half. We continue to invest for the long term, and the 2 areas that we believe will lead to long term success are product innovation and advertising. Everywhere else, we are very cost-focused to enable us to invest in these 2 strategic priorities.

Looking at the rest of our portfolio, Sealy sales were in line with our expectations during the second quarter. The rollout of the new Sealy Posturepedic offering is essentially complete. Both the Posturepedic innerspring and the hybrid series, which is constructed of half memory foam and half springs, are performing well. In addition, we've seen continued momentum from the Optimum Collection. Adjustable base sales and our joint venture with Comfort Revolution also contributed to the growth. While Stearns & Foster is down versus last year, following the very successful launch in late 2011, we are pleased with its performance. Sealy-branded value products are down year-over-year.

Tempur International sales were essentially flat on a constant currency basis. Our Asia Pacific business continued to perform well, with positive results in all of our key markets and in particular, Korea and Japan. Since establishing our Korean subsidiary in 2011, we have experienced solid growth and it has quickly become an important part of our international business. While Japan has been part of the Tempur portfolio for many years, we have seen it have significant growth recently from our company-owned stores.

The economy in Europe, on the other hand, has been challenging for us and the industry. There have been pockets of strength, but not enough to overcome the overall malaise. However, we believe that we've continued to take share in the major markets.

Now I'd like to discuss our critical growth initiatives related to our new products and our advertising. Demand for our TEMPUR-Breeze products, which were introduced last year, continue to be high and are a perfect example of consumers' willingness to trade up for innovation. We have added a top-of-the-line Cloud Luxe Breeze this quarter, which has been positively received. The introduction of TEMPUR-Choice in North America enables us to leverage our brand to enter a segment of the market previously not available to us. With Choice, we and the majority of our retail customers have a clear opportunity to take market share. We've seen good performance so far from customers who've supported Choice with advertising and whose RSAs have been well-trained. Initial feedback from end consumers is also positive.

However, many of our customers have only just received it. In the third quarter, we plan to finish the rollout, increase the amount of training and support the launch with Choice-specific national advertising.

We also completed the rollout of our Ergo Premier adjustable base. The Ergo Premier, priced at $1,999, replaced the $1,700 Advanced Ergo, which had been introduced in 2008, and had grown placement to multiple slots on most retailers' floors. The new Premier has advanced features, including the ability to control it with a mobile app. Clearly this product, too, contributes to retailer opportunity to drive AUSP.

Next week, at the Vegas Bedding Show, we'll be launching several new products across our brand portfolio, notably from Tempur, Stearns & Foster and Optimum, all of which are designed to improve retailers' average tickets. To support these launches and our future product development efforts, we have bolstered our talent by bringing in some excellent senior level product management capabilities in recent months, and we will continue to invest in R&D to leverage the combined technologies of our portfolio to deliver a stream of innovative products that will resonate with consumers and grow our retailers' business. Our pipeline of new products is robust, with the anticipation that 2014 will be another year of delivering significant innovation across our entire brand portfolio.

Now I'd like to address our advertising initiatives. In early May, we launched Tempur North America's new advertising campaign into a crowded advertising environment, and we were optimistic that it would increase retailer foot traffic, lead to improved Tempur-Pedic conversion, and over time, benefit our direct business. After a review of the first 2 months' performance, there are elements of the campaign that are doing very well. The "You are how you sleep" ad is clearly making an emotional connection with our target consumers. However, we believe we need to run, in conjunction with it, an ad with a stronger rational message and a call to action. As a result, we're making adjustments, including bringing back the highly successful Ask Me campaign. Our plans include running Ask Me commercials tagged with a unique promotional event for Labor Day, that our retail customers are excited about. We're committed to accelerating our advertising investment in the back half and we'll also be making adjustments to our media mix to improve the overall effectiveness. Also we're very pleased with the consumer reaction to our new Sealy ad campaign, Life Before Your Eyes.

The integration with Sealy continues to progress well. Cost synergies are being realized ahead of plan, and we're more confident than ever that the combination provides significant competitive advantage. We know that this early stage of the integration is critical to achieving the long-term potential of the deal, and we are placing the appropriate level of focus on it. We have now integrated most functions of the business, including the management of sales and marketing. We have integrated these areas earlier than we had originally projected, but have done so very thoughtfully and in consultation with our retail customers. Recently, we conducted an employee survey across the organization and employee morale, engagement and support for the combined company are very high.

When we announced the deal, we expected to achieve $40 million in cost synergies by the third year. We now expect to realize upwards of $18 million in cost synergies in 2013, and have good line of sight to achieve the $40 million in the second year. We plan to provide a more detailed update on these synergies at our upcoming Investor Day.

In closing, we remain confident in our company's long-term potential. Our pace of innovation will remain vibrant and we're committed to brand marketing investments. In addition to the very attractive cost synergies we expect to achieve, in the next few years, we expect to realize attractive upside from revenue synergies as a result of a broader product offering and access to more channels, including international expansion.

At our Investor Day on September 10, we'll share our new long-term plan and provide details on how we are approaching our cost and revenue synergies.

With that, I'll now hand the call over to Dale.

Dale E. Williams

Thanks, Mark. I'll focus my commentary on the second quarter financial results, and then our updated 2013 guidance. For the second quarter results, I will address the performance on a consolidated basis, then speak to the performance for each segment and provide commentary on the key areas or items where there's a notable variance from the prior year.

As a reminder, the company completed its acquisition of Sealy in March 2013, and results for 2012 do not include the Sealy results of operations.

Consolidated net sales for the second quarter was $660.6 million. Tempur North America net sales were down 4.9%, and Tempur International net sales were down 2.3%. On a constant currency basis, Tempur International sales were down 0.6%. Sealy sales were $344.6 million. By product, bedding net sales for Tempur North America decreased 5.2% to $199.5 million, on a unit decline of 11%, principally driven by a year-over-year decline of Simplicity units. Tempur International bedding net sales declined 6.1% to $73.9 million, on a unit decline of 1%. Sealy's bedding net sales were $325.1 million.

By channel, Tempur North American retail net sales declined 2%, and direct net sales declined 40%. Tempur International direct sales increased 48% to $11.4 million, driven by growth in company-owned stores and e-commerce. Sealy's sales of $344.6 million during the second quarter were in line with our expectations. Sealy's growth was driven by specialty products at premium price points, the new Sealy Posturepedic offering and increased consolidated Comfort Revolution joint venture revenue. Partial offsetting factors were lower demand for Sealy and Stearns & Foster products.

Second quarter gross margin was 38.6%, and included an inventory step-up charge, as well as a full quarter of depreciation related to the Sealy purchase price allocation or PPA.

As we stated on our last conference call, there are 2 key points that investors need to consider when reviewing our consolidated gross margin. One, Sealy traditionally operates at a lower gross margin than Tempur North America and Tempur International. And two, Sealy historically recorded freight costs in SG&A while Tempur segments have recorded it in COGS. As a result, by conforming to Tempur's accounting, Sealy's historical gross margin would be lower. In addition, Sealy's overall gross margins are influenced as a result of the consolidation of the Comfort Revolution joint venture, which tends to operate at a lower gross margin.

On a year-over-year basis, second quarter gross margin declined to 38.6% from 50.7%, primarily due to the following: The inclusion of Sealy; product mix; and higher new product introduction costs as we shipped a significant number of floor models. These impacts were partially offset by improved efficiencies in manufacturing and distribution and lower sourcing costs.

On a sequential basis, gross margin decreased to 38.6% from 48.3% as a result of the inclusion of Sealy for the full period, product mix, higher new product introduction costs. These impacts were partially offset by improved efficiencies in manufacturing and distribution.

Consolidated advertising spend, which includes both national and cooperative, was $73.1 million or 11.1% of sales in the second quarter. As Mark indicated, we remain committed to building our advertising investment as the year progresses to reinvigorate consumer activity around the Tempur-Pedic brand, as well as the other key brands in our portfolio. All other operating expenses were $143 million or 21.6% of sales.

Consolidated operating income was $44 million or 6.7% of sales, as compared to $47.5 million or 14.4% of sales in the second quarter of 2012. Operating income included $11.9 million of transaction and integration costs related to the Sealy acquisition. Excluding these costs, the higher operating income reflects the inclusion of Sealy.

Interest expense was $35.7 million, and included $8.7 million in prepayment premium fees related to the company's refinancing of its Term B loans under its senior secured credit facilities, which was completed in May 2013. The tax rate was 131%. The tax rate for the second quarter reflects tax provision adjustments related to the repatriation of foreign earnings utilized in connection with the Sealy acquisition and the adjustments to PPA, as well as nondeductible transaction expenses. As a reminder, the company was able to create a tax-efficient structure through the Sealy transaction, which provides us the ability to utilize in excess of $1 billion of future foreign cash flow to be principally used to reduce debt. The normalized rate for the quarter was 31.1%, which was influenced by a shift in the geographic mix of our second quarter profits.

Second quarter GAAP earnings per share was a loss of $0.03, as compared to $0.45 per diluted share in the second quarter of 2012. Adjusted earnings per share were $0.36 in the second quarter of 2013.

Next, I'll turn to the balance sheet and cash flow for a brief review. As shown on the balance sheet, the primary changes are related to the acquisition and related accounting treatment. Our total cash cycle on a year-over-year basis improved 3 days, primarily related to improved payable days, up 5, and inventory down 3 days, offset partially by an increase in DSOs, up 5 days.

During the quarter, we had an operating cash use of $16.7 million, primarily as a result of working capital, prepayment premium fees and transaction and integration costs related to the Sealy acquisition. Capital expenditures were $13.7 million. As it relates to our capital structure, the company has consolidated funded debt less qualified cash of $1.9 billion. The ratio of consolidated funded debt less qualified cash to adjusted EBITDA was 4.6x, calculated on a combined basis in accordance with the company's senior secured facility. A calculation of this ratio is included in the press release.

In addition, the company completed the repricing of its senior secured Term A facility. Combined, the Term A and Term B transactions are expected to reduce our annual cash interest costs by more than $13 million.

Now I'd like to address guidance. As a reminder, our guidance and related commentary reflects a full year of Tempur results, but only Sealy results from March 18, 2013. Today, the company lowered its outlook for full year 2000 (sic) [2013] net sales and earnings. The company currently expects net sales to be in the range of $2,425,000,000 to $2,450,000,000, adjusted EBITDA to be in the range of $370 million to $385 million for the stub period. On a trailing 12-month basis, the adjusted EBITDA would be $31 million higher. Adjusted EPS to be in the range of $2.25 to $2.40, including $0.14 per share of depreciation and amortization related to the Sealy purchase price allocation.

We're also providing the following additional full year 2013 guidance assumptions: Depreciation and amortization of approximately $90 million, with an annualized run rate of approximately $100 million. This includes PPA depreciation and amortization of $13 million in 2013, with an annualized run rate of approximately $17 million. PPA depreciation is lower than previously communicated due to adjustments to the valuation of certain assets. Interest expense of approximately $83 million excluding transaction-related charges, with an annualized run rate of approximately $95 million. Tax rate to be approximately 31% for the full year, 31.5% for the balance of the year. Share count to be approximately $61.6 million for the year and $61.7 million for the balance of the year. Capital expenditures of approximately $60 million.

For Tempur North America, our guidance assumes a continuation of the trends we experienced in the quarter. As we indicated, sales slowed toward the end of the second quarter, and July has started off similarly slow. For the second half of 2013, our projections are as follows: Tempur North America sales to be down 5% to 10%; Tempur International sales to increase low single-digits; and Sealy to grow mid single-digits. In total, this represents flat to 2% second half year-over-year growth for Tempur Sealy International.

It's important to note that our 2013 adjusted EBITDA and adjusted EPS guidance does not factor in transaction and integration costs related to the acquisition of Sealy or interest expense costs on the financing transactions prior to the March 18 close, or expenses incurred on the recent repricing financing transactions.

In considering our guidance, it is possible that our actual performance will vary depending on the success of our new initiatives, macroeconomic conditions and competitive activities or the consequence of other risk factors we've identified in our press release and SEC filings.

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

With that, operator, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Brad Thomas with KeyBanc Capital Markets.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

First, just wanted to kick off diving a little bit more into what you saw in Tempur-Pedic North America. Maybe, first, I could just ask about some of the dynamics in the quarter. This is a big quarter in terms of new product launches. What does the underlying sell-through rate look like when you're trying to adjust for the sell-in?

Mark A. Sarvary

That's right, it was a big quarter for new product introductions. And the big swing factors for Tempur North America were -- the 2 big product lines were Choice and the Premier, the Ergo Premier. And the -- it's frankly very early to tell. So if I look at Choice and the places where it is rolled out, the sell-through is sort of consistent with what we had expected. And it builds as, A, the customers get more used to selling it and, B, it's supported by advertising. It's in limited -- we have limited data, but where it is, it seems to be going quite well and consistent with what we expect. But it is a new type of product to sell from most of the RSAs. So the training is critical. And one of the things that we're very committed to doing for all of the customers who have it is making sure we have a high level of training. But it is something that will -- that we anticipate will build over time, both because of training, because customers will support with their own advertising, but importantly, because as of the beginning of August, we're going to support it with national advertising. So I would say, on that front, it was later to get to the floor than we would have liked, but the trends so far are approximately what we'd expected. On the Ergo bases, the transition there required retailers to sell off their floor models. So essentially what happened was, the sell-in was almost a one-for-one with a sellout of existing floor models. So that took time to go through. And now, it's largely -- we're well through it. I won't say completely through it, but well through it. And there, what we were expecting and our plans have always been that, roughly speaking, the attach rate would be the same as it was before but, because of the increased price, there would be a lift as a benefit of that. And again, it's early days but it still looks like that's about what we're getting.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Okay. And so just to be clear, the Tempur North America in the first quarter, though, was down about 5%. And going forward, you're now modeling, I believe, a decline of 5% to 10%. There won't be as much benefit to sales from sell-in. Is that kind of the way to think about how you guys are looking at guidance for the back half of the year?

Mark A. Sarvary

The one thing I'd be cautious about is thinking about this sell-in. The fundamental way we're looking at the trend is this, the way we're looking at the projection is this, is we're looking at the recent trends of Tempur sales and projecting that forward, recognizing that we anticipate and are working toward a turn so that we move back into a growth mode. For projection purposes, we're using a continuation of the current trend. But when you look at sell-in, I would suggest that you'd be cautious, and we certainly are as well as we do our analysis, of not thinking of sell-in as incremental sales per se. And what I mean by that is this. If you take a, as I said, if you take an adjustable base, if you sell -- if we sell a new floor model adjustable base, one-for-one, another one has to be sold to the consumer that would otherwise have bought a full-price one. So in effect, the sell-in is almost a wash. And especially when we give a similar thing of a discount to the retailers to buy the new ones. So for an adjustable base, it's almost a one-for-one and it's a wash. If you look at mattresses, in general, people who have taken Breeze -- sorry, people who have taken Choice have added slots. But roughly speaking, we've estimated for the 2 new products, they've added 1 new slot, which means they have to sell off another existing product. And given that we sell these products with a -- the floor models at a significant discount, when you look at the cash value or the dollar value in terms of sales, new product sell-ins are not net -- they're close to a wash in terms of incrementality.

Bradley B. Thomas - KeyBanc Capital Markets Inc., Research Division

Got you. That's very helpful. And then, maybe just one point of clarification on the advertising. Mark, you mentioned a few refinements that you'd like to make, specifically ahead of Labor Day, I think it sounds like. How quickly will we see those new commercials? Will you start running them before Labor Day or is that really when we should start looking for them?

Mark A. Sarvary

We'll have the new commercials, the modified Ask Me commercials will be on air next week.

Operator

Our next question comes from the line of Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

I'd like to focus on guidance, if I could, for the rest of the year. Confused a bit. And maybe, Dale, you could walk us through what the GAAP guidance is and then where the adjustments are, both in the amortization and the add-backs, how do we get there?

Dale E. Williams

Budd, I don't have a GAAP guidance for you. We're providing the pro forma guidance consistent with the -- for second quarter, we gave you the GAAP results and then the adjustments to the GAAP results by essentially area, and most of those adjustments are across the P&L. A significant portion, for example, PPA, but that's not in our adjustments, but just from an ongoing standpoint, is in gross profit. But the other areas, transaction costs, et cetera, a lot of those are in G&A. Some would be in selling. So I'm not sure exactly what to do to help you there.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Well, are there -- do you see further adjustments coming into third and fourth quarter?

Dale E. Williams

These will be -- I would expect that there will be some small adjustments as we go through the year but the big adjustments are behind us.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. And you say that there's $18 million worth of synergies this year. How much have we had year-to-date so far?

Dale E. Williams

In second quarter, we probably had $4 million or so of synergies.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

So $14 million in the second half?

Dale E. Williams

Yes. It kind of builds on itself.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. You were going to ship 70,000 new product SKUs, I think, in the second quarter, if I recall what you said on the first quarter call. Can you give us an update on how many you did ship and how many are left to ship?

Mark A. Sarvary

It was very -- I mean, Budd, I don't have the exact number but essentially, we shipped essentially what we thought we were going to ship, but we shipped them later than we thought we were going to ship them.

Dale E. Williams

On the Tempur side, they shipped a little bit later than we thought. On the Sealy side, they pretty much shipped on schedule.

Mark A. Sarvary

On schedule if not ahead. But they were planned for this quarter and they happened in this quarter.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

And I would take it that the bulk of them were Sealy SKUs, given the price points. Is that correct?

Mark A. Sarvary

Many of them were Sealy, but there were a lot of the Ergo adjustables.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. Can you give us maybe a run rate on Tempur for -- by month? You said that if fell off late in the quarter. Can you give us an order of magnitude of how much maybe we saw in the June -- in June, of the Tempur North American sales? I think that's where the bulk of the problem was, right?

Mark A. Sarvary

Correct.

Dale E. Williams

We were -- when we talked about the second quarter, we expected Tempur North America to be mid single-digit growth. Obviously, we thought that, that would -- Tempur North America would improve across the quarter as new product got out into the market, as the new advertising started to hit. Obviously, we didn't see that improvement. In fact, as Mark mentioned, things slowed down a little bit towards the end of the quarter, as we really didn't have impact that we normally see around the Fourth of July holiday. So that kind of affects pre Fourth of July and post Fourth of July. So we've seen some softness in July as well, post Fourth of July. But what we have seen is what we use to build our guidance, along with expecting things that we are doing as a business. The thing that we are being cautious of is, as Mark mentioned, we're not trying to call the turn anymore. So things that we are doing, we expect the business to turn and start to grow again, but we're not going to try to call the date of the turn.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Well, you've done that before. I mean, that was the way you handled guidance, I think, several years ago, when we were going through the Great Recession, if I recall. Where you took the run rate at the end of the quarter and said that was your guidance. So I understand that and I appreciate that. So I'm not -- there's no criticism there. But what it says to me is it looks like June was down probably down 10% if the first 2 months were up mid single-digits or maybe even a little better, is that fair?

Dale E. Williams

No. We never expect -- as I said, we -- when we gave the guidance on the second quarter, we expected the performance of the business to improve as the quarter progressed. What we've tried to do with this guidance is take -- for the second quarter, Tempur North America was down 5%. So we're carrying that forward. We saw a little bit of softness at the end of June and into early July, so we're just trying to bracket what is a reasonable potential outcome.

Budd Bugatch - Raymond James & Associates, Inc., Research Division

Okay. And I thought you said you had guidance like down 5% to 10%. So gave yourself a little bit of run -- a little bit of leeway on that. Final question for me is if I look at Sealy pro forma, and I know we don't exactly have the same matching of periods, but it looks like their business on a pro forma basis was up about 10%. Is that fair on looking at it?

Dale E. Williams

I'd say ballpark 9%, including Comfort Revolution joint venture.

Operator

Our next question comes from the line of John Baugh with Stifel, Nicolaus.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

I just wanted to follow-up on the guidance methodology, Dale. So the sales a year ago, are you looking at year-over-year, just to be clear? Because the sales in the second half of last year were down pretty substantially at Tempur North America and would suggest, at least year-over-year, a somewhat easier comparison going forward and yet you've got a steeper decline of 5% to 10% versus the 5% decline in Q2.

Dale E. Williams

We're using the percentage.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

Okay. So you're using the percentage year-over-year as your guide to go forward and not some kind of sequential look?

Dale E. Williams

Correct.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then, on advertising, you mentioned an acceleration of -- I'm just curious, is there any way to talk about what numbers around Tempur, what numbers around Sealy, what rate of acceleration? I assume that's a sequential comment, not a year-over-year comment. And is there any way to think about, particularly Tempur-Pedic North American advertising, when that goes into a positive year-over-year comparison on an ad spend basis?

Mark A. Sarvary

John, what we're expecting is that the full year spend of Tempur North America, which obviously is the bulk of the spending, is going to be approximately the same as last year. But the difference is last year, the bulk of the spending was in the first half and there was very little in the second half. And this year, it's going to be that a greater proportion of the spending is in the second half than the first. So the first half was down year-on-year. Tempur North America's spending in the first half was down year-on-year, because bear in mind, last year, we were spending with an expectation of a run rate of sales of a much different level. But our spending in the second half is going to be up very substantially. So we're seeing a spend increase in the second half of a substantial amount.

John A. Baugh - Stifel, Nicolaus & Co., Inc., Research Division

And the new Ask Me, is that -- that's already done. I mean, I guess there's just a slight tweak or some kind of update to the old program, so it's quick and easy to do?

Mark A. Sarvary

Yes. I mean, I think -- I mean, the plan is that we want to be sure that we have something on air that's good and proven and it has an advantage that we can -- it is designed and you'll remember this, that it's quite easily modifiable to include other new products or promotions. And that lends itself to what we need for Labor Day. And so we'll get that on air right away and it's something that is proven and works well. And we will -- we are continuing to develop different copy, which we will decide when we see it and when we've evaluated it, when we've measured it, to transition from beyond Labor Day and beyond -- in the fourth quarter, we would anticipate being ready with new copy. But if we are, splendid, and if we are not, we still have this Ask Me in the can. And we will also run some Choice advertising which is developed specially for Choice. And over the -- we anticipate other parts of the campaign "You are how you sleep" will continue to run in the second part of the second half i,n the fourth quarter. But for right now, we're going to focus on Ask Me.

Operator

Our next question comes from the line of Keith Hughes with SunTrust.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

To build on John's question on ads. If I look at the first half of last year, Tempur-Pedic standalone, you're seeing 12%, 13% as a percentage of sales on ad. Are we talking about that magnitude of spending or exactly what level?

Mark A. Sarvary

It's comparable -- I don't have -- let me just check the number, but it is comparable. And it's -- the spending in the second half is significantly higher than it was in the second half of last year. So let me just see if I've got this here. About 12%.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

12%. And that's Tempur Sealy combined, correct? The revenue, combined, of the 2?

Mark A. Sarvary

Yes.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

And you talked about a September promotion on matched. When will that be sort of launched to the channel?

Mark A. Sarvary

We're not going to -- I'd rather not talk about it in detail right now, just given its -- just for competitive reasons. But it has been communicated to our major retailers already.

Keith B. Hughes - SunTrust Robinson Humphrey, Inc., Research Division

Okay. And if we look at the amount of that spend, how -- do you have a rough break of how much is going to be Tempur-Pedic or I guess Sealy brand-focused and how much is going to be product-focused? Even rough numbers would be fine.

Mark A. Sarvary

I'm not going to get into too much detail, but I think the one -- I mean, as I've said, the bulk of our advertising, clearly, is going to be behind Ask Me. And Ask Me is a product -- is a brand, and the way it's customized is brand and product. So we can do -- it depends on how you count it but it's essentially both. But it is -- largely, it's going to be focused on brand. We are going to have special -- what do you call it, customized, unique advertising for Choice which will run over Labor Day and afterwards, but it will run before Labor Day.

Operator

[Operator Instructions] Our next question comes from Piper (sic) [Peter] Keith with Piper Jaffray.

Peter J. Keith - Piper Jaffray Companies, Research Division

It's Peter Keith, of course. I was curious to more on the gross margin line. You came in at 250 basis points lower than where you had originally guided in Q2. I wasn't quite clear on the dynamic. Was that certainly -- or just specifically attributed to the lower sales for the quarter and the deleverage of fixed costs? Or were there some other puts and takes that we should be aware of?

Dale E. Williams

Well, Peter, it's also a function of the mix of the revenue. TPNA being a higher-margin business being where we were off, Sealy coming in -- the Sealy brands coming in where we expected, so that mixes you lower. Also from a TPNA standpoint, based on the timing and velocity of the floor models going out, what we missed was the sell-through of them generating more business. So you have a higher percentage of your revenue was floor models. So it's really a mix factor as opposed to -- both from a segment, where the revenue was coming from, and then within TPNA, its gross margin was off also because of the higher mix of floor models.

Peter J. Keith - Piper Jaffray Companies, Research Division

Okay. And I guess, related to the, I guess, gross margin for the year, you reduced the PPA by $0.07. You had said it was -- it reduced the valuation of certain assets. So I guess I'm curious on what was reduced so quickly.

Dale E. Williams

Well, basically, Peter, all this is an estimate until it gets ultimately resolved and finalized and thrown in the system. You're changing a value and a life on a fixed asset and, at a very high level, you're trying to estimate it. And once it's thrown into the fixed asset system and adjustments are made, it's all calculated. So essentially, there's a recognition that this stuff takes time, which is why from an accounting rule standpoint, you've got a year to sort it all out. It tends to be a bit of a moving target until it's final. It's possible that it could change a little bit again. We think that we're pretty close to getting there but it's one of those things as you continue to work through these processes, some things tweak around a little bit. That's why the repatriation tax moved again. As the valuations are fully vetted and fully analyzed, things tend to move a little bit.

Peter J. Keith - Piper Jaffray Companies, Research Division

Okay. All right. Just one other separate question. I was curious on the success of the hybrid launch from Sealy and maybe some of the other hybrid beds out there. Do you have a sense, as those are rolling out, that they actually may be taking a little bit of business from that Tempur North America mattress sales?

Mark A. Sarvary

I would say that, first of all, the Posturepedic hybrid is doing really quite well, better than anticipated and well and it's a premium product within the Posturepedic range and we're all very pleased with how it's doing. And it is clearly in the $1,000 to $2,000 area, and it is the $1,000 to $2,000 area that has been, collectively, for want of a better word, cannibalizing or taking away from the $2,000 plus area which is the Tempur-Pedic's normal bailiwick. And so it does -- I think that there is a degree to which it is likely that it is contributing to the overall pressure on Tempur. But frankly, it's part of our family and I'm pleased to have a powerful brand like -- a powerful product like that in the group. I think what we recognize is that Tempur's focus has to be on the $2,000 plus area and that the remainder of our portfolio, including Posturepedic and Optimum, is focused on this $1,000 to $2,000 area, and that includes Stearns as well, but it includes spring, it includes memory foam products and it includes hybrids. But just to be clear, I mean, I think that while it has taken away, some of the research that we've done does say that although it takes away both from memory foam and from spring, it's more toward the spring is where it's going to cannibalize from.

Operator

Our next question comes from the line of the Jessica Schoen with Barclays.

Jessica Schoen - Barclays Capital, Research Division

My question on the revised synergy forecast for the higher forecast for this year and next is, I was wondering if you could give a little bit of color on your philosophy around reinvesting those synergies?

Mark A. Sarvary

Well, clearly, the synergies were, and we're talking here about the cost synergies, were an important part of the logic for the acquisition of Sealy. And what -- the way we think about it, from using your word, a philosophical point of view here, is that it gives us a war chest to invest in building the brand of Tempur and the rest of the portfolio. So as we -- as the world has evolved, as there are now multiple -- Tempur is now the leading visco-elastic uniplane [ph] in this market, it gives us, effectively, ammunition to continue to invest. So we -- our first -- clearly, we're going to drive profits, and clearly, we're going to drive growth at the top line. But we believe that these synergies are something that can be powerfully utilized to maintain a unique positioning in the market.

Jessica Schoen - Barclays Capital, Research Division

Okay. Great. And then, as we think about gross margin for the back half of the year, is there any way to quantify the impact from the higher level of floor models that might not repeat in the third and fourth quarter as we try to forecast those levels?

Mark A. Sarvary

Well, one thing is that you must remember that Choice is still not fully rolled out, and there will be new products that we'll be announcing next week in Vegas which also will roll out. So it will be diminished. I don't know if we have an exact number, Dale?

Dale E. Williams

Yes. No, Jessica, I would say, on the April call, in our guidance then, we said that we thought, in the back half of the year, after we got through the bulk of the floor model issues, that we would have gross profit, company-wide, in the $43 million to $44 million range. I would say now, based on the mixed impacts that I was talking about before, less Tempur business, so the mix of Sealy is a little bit higher also, just the overall things like volume, leverage, et cetera, more Comfort Revolutions as Comfort Revolutions is performing well, we're now looking for gross profit on the overall business to be in the low 40s, as opposed to $43 million, $44 million.

Operator

Our next question comes from the line of Josh Borstein with Longbow.

Joshua Borstein - Longbow Research LLC

Just a follow-up on the synergies. I thought you had mentioned that -- I know, in the past, you had talked about 3 different buckets that you were focusing on, but it seems like in this call, you mentioned also sales and marketing as a new bucket. Did I hear that correctly?

Mark A. Sarvary

No, not as a synergy. As a use of the savings. The way I would think about it is fundamentally, the buckets of savings are going to come from the purchasing power and the strength that we have in manufacturing, distribution and so forth. Obviously, there are some G&A savings that we'll anticipate getting. But where we see using those savings is to invest in marketing. I mean, not exclusively, not entirely, it's not a one-for-one but what it does is it makes the combined entity of Tempur and Sealy by having us be able to run more efficiently, thanks to the combination, to have effectively the ability to invest some of that back in marketing and particularly advertising.

Joshua Borstein - Longbow Research LLC

I see. Okay. And then in terms of the guidance, could you talk a little bit about what's baked into your guidance for Tempur North America in terms of volume and price and what you expect there?

Dale E. Williams

From a volume and price standpoint, we -- in the second quarter, as I mentioned, the volume was down more than the revenue was down, and that was really a function of Simplicity. And so on a go-forward basis, that will still be a factor. We don't expect Simplicity to do a lot. And so I would think that we would see positive ASP in Tempur North America, particularly now that we've gotten through the bulk of the floor model rollout. Now there's still more floor models to go on Choice, but we're about 60% rolled out there as of the end of June. And we're -- for the most part, we're rolled out on Premier, which also affects that. So in the back half, we would expect to see some ASP benefit versus volume.

Joshua Borstein - Longbow Research LLC

Okay. And then, just the last one for me. On the overseas or international advertising strategy, I've noticed the past 2 quarters, your company-owned stores and e-commerce has increased a lot. Have you changed your strategy internationally; are you doing something different?

Mark A. Sarvary

We haven't changed the strategy. For some time, we've said -- the 2 things that you referred to, the advertising and the company-owned direct sales both have been, for some time, key focus areas. What we're seeing is in Europe right now, there's just such a -- as I'm sure you know very well, there's a malaise there. So the return on investment on advertising is less promising there, whereas direct stores has actually work quite well, even in this time. So we're continuing to see the benefit of our direct sales. But the big place where that's paid dividends -- well, the greatest amount of dividends in the most recent period has been in Japan. So they're both important. They both continue to be important and they both will be important for as far as we can see. Right this minute, in Europe, given the economic environment, we're finding that advertising investment is not as productive as it is, either in other parts of the world and also in terms as much as using direct sales as a method of getting to consumers.

Joshua Borstein - Longbow Research LLC

Okay. And you mentioned a few pockets of strength. Internationally, you called out Korea, Japan. Were there any pockets of strength in Europe as well?

Mark A. Sarvary

Well, there were. There's France. France is a pocket of strength. But I mean, quite honestly, it bubbles. I mean, it's not like it's -- there and some of the Nordic countries. But generally, it's pretty -- in Europe, the malaise is pretty widespread.

Operator

[Operator Instructions] Our next question comes from the line of Joe Altobello with Oppenheimer.

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Just a couple of quick ones for you. The Choice rollout, how many doors do you expect that bed to ultimately get into in terms of your overall North America retailer base?

Mark A. Sarvary

The majority of them. We expect the majority of our retailers to carry it, but we haven't given an exact number. You're asking about Choice?

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Yes, exactly.

Mark A. Sarvary

Yes. I mean, the majority, the majority, but we just haven't -- we're not giving an exact number.

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Okay. And then, just secondly, I'm looking at your sales guidance. Obviously, it's down $50 million to $75 million or so from where it previously was, and I heard you guys talking about the issues there. I mean, a lot of those sound like Tempur-specific issues, but are there other industry issues? I mean, are you guys seeing a slowdown or a lack of a lift or tailwind, if you will, from housing, for example, that's partly to blame for that?

Mark A. Sarvary

The -- I don't want to get -- I'm only [indiscernible] justifications, but I will say that what I am hearing from speaking to customers across the country is that there is a degree of weakness in the industry that we are -- that is certainly contributing to our slow performance in Tempur North America. I mean, there is a degree of...

Dale E. Williams

Traffic.

Mark A. Sarvary

Traffic. There's a general concern about lack of traffic. Now that's a commonly said thing. Nobody ever thinks they have enough traffic. But I do believe that there is a degree of that. And moreover, there is a degree to which it's becoming more spiky around the promotional periods, too.

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Okay. And just one last one if I could. The PPA's at $0.14 for this year. What do you expect that to be for next year?

Dale E. Williams

I'm sorry?

Mark A. Sarvary

PPA.

Dale E. Williams

Oh, PPA?

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

Yes.

Dale E. Williams

At $0.17, that would translate to roughly about $0.20.

Joseph Altobello - Oppenheimer & Co. Inc., Research Division

About $0.20 for next year?

Mark A. Sarvary

We'll just check that. Let's just check that and we'll get back to you.

Operator

Our next question comes from the line of Carew [ph] Martisan [ph] with Deutsche Bank.

Unknown Analyst

When you guys talk about integrating most of your sales and marketing and consulting with the retailers, I mean, what exactly have you guys integrated? I mean, are these the sales force that are actually knocking on the doors or is this more of a high-level back office type function?

Mark A. Sarvary

Yes. I mean, the answer is it's -- what it absolutely isn't is a smashing together of the 2 organizations. In fact, to a large extent, most of the people who are in both of the organizations are continuing to do the same job. What we've done though is this, is for the largest of our customers, we have combined the teams who support the head office, who support the chief buyers and the owners of the big retail stores so that they have a one face to the customer, so that they can -- we can coordinate across the whole Tempur-Pedic portfolio and work to optimize everything from deliveries to promotional schedules to everything else, done at one point with a central coordinator. However, that individual will have a person who -- will have a representative, there will be 2 representatives, one from Tempur, one from Sealy, because we want to maintain that expertise of the brands and the special -- all of the components of the brands. So there will be a single face to our biggest customers. But to the people who are calling on the stores, there will still -- we will have, as we have in both companies, an East and a West leadership, and then organizations, regional managers below that. But there will be Tempur and Sealy people calling on the stores. So that those, the people who are calling on the stores will remain specialists in their areas. They will be coordinating with their colleagues, but they'll be remaining specialists in their area.

Unknown Analyst

Okay. And when we look at the slower-than-expected rollout on TEMPUR-Choice, ultimately my sense here is that it is still an incremental product. Are you getting those slots on the floor space or are you feeling that you need to replace an existing Tempur or an existing Sealy product on that front?

Mark A. Sarvary

As I've said, it's halfway through the rollout. But where our expectations are is in general, we are getting incremental slots but roughly speaking, for the 2 products, we're getting an incremental slot. And what is less of a tradeoff, than it's just that customers are continually evaluating which products have gotten turns to justify that position. And so we're seeing that it's essentially a two-for-one, give or take.

Unknown Analyst

All right. And just in terms -- lastly, in terms of the rollout costs. Certainly, this is a rollout that you guys do every year. I mean, do you feel that when you look at the rollout and the complexity of the product that you've put out, the rollout costs for the whole year will be greater than prior years or would this be kind of in average, on average with what your expenses have been in prior years?

Dale E. Williams

Well, I mean, I think...

Mark A. Sarvary

Forgive me, just one comment and then you can make -- I think, the thing is -- I think from a point of view of a rollout, this is a more complicated product and so on. But I think when you look at it over a whole year, we're going to say it's about comparable to a normal rollout. It's going to be more or less, but it's going to be comparable. The thing that is important to note, though, is that we are now in a world and we have been now for 18 months, where new product rollouts are part of our DNA. That's what we're going to -- that's the way that we're going to need to compete more and more going forward. And so it's like the rest of the industry, but it's an important thing that we're getting, it's more and more part of our DNA.

Dale E. Williams

And I was just going to add, if you're looking just at Choice, for the balance -- for the full year, the product rollout costs this year may not be different than what they were last year, a little bit more concentrated. The thing that was a little bit of an anomaly this year and made product rollout costs higher this year for Tempur was the Ergo Premier. As Mark mentioned in his prepared comments, it replaced a product that was introduced in 2008, and built distribution over a number of years, where we're replacing all of those in one shot. So the Ergo Premier is a little bit of an unusual expenditure this year on the Tempur side. Now for the Sealy brands, Posturepedic is a big rollout for Sealy, and also very concentrated. But over the last year or so, they did Stearns & Foster, they did the Sealy brand. So there's a continuous stream of rollout. Sometimes in a given year, it's more concentrated than possibly another year, depending on what exactly is being rolled out. But on a continuous basis, for the most part, the rollout costs should be in the same neighborhood.

Operator

Our next question comes from the line of Joan Storms with Wedbush.

Joan L. Bogucki-Storms - Wedbush Securities Inc., Research Division

I was wondering if you could be -- there was a couple of questions on the call about sort of the synergies and Mark mentioned sort of some of those buckets. Can you give us some more specific examples or maybe quantification, just as an example, like maybe combined back operations and finance and whatever area, and that's going to save you x million dollars, and same thing with purchasing, the volume purchasing. Can you be a little bit more specific there so that we can see some of the progress that you're making?

Dale E. Williams

Yes, here's what I would suggest, Joan. We're not really prepared to get into that level of detail on this call, but at the Investor Day on September 10, we'll commit to give you a little bit more color in terms of the areas of the synergies and some ballparks in terms of the savings that we're seeing.

Joan L. Bogucki-Storms - Wedbush Securities Inc., Research Division

Okay. And then, just to clarify, on the second half gross margin, you originally had been at $43 million to $44 million, and now you're saying low 40s. So does that mean like $41 million or $42 million, or how do we get to these numbers?

Dale E. Williams

Yes, ballpark.

Operator

Our final question comes from the line of Joe Andersen with William Blair.

Jon Andersen - William Blair & Company L.L.C., Research Division

It's Jon, of course. I just have a couple of quick questions. The -- if you'd be willing to comment, I don't know if you can, Sealy's net sales for the second quarter, I think you called out at $345 million. Would you provide the EBIT or operating income for Sealy in the second quarter?

Dale E. Williams

It'll will be in the Q.

Jon Andersen - William Blair & Company L.L.C., Research Division

Okay. It will come out in Q. I guess, the other question I had was on the advertising spending. I know you commented on it, Dale, I may have missed it. The $73 million in the quarter, what did that include? I mean, does that include co-op? And I think you indicated that, that will build through the year. Will that build as a percentage of sales and how should we think about that?

Dale E. Williams

Yes. The $73 million is global consolidated including co-op, the portion of co-op that is included in advertising. There is a portion of co-op that is treated as a reduction of sales also. So that's TPNA, that's international, that's Sealy. We do expect the advertising to build as the year goes on. Most of that build would be coming on the Tempur side, Tempur North America side.

Jon Andersen - William Blair & Company L.L.C., Research Division

And as a percent and as dollars?

Dale E. Williams

Yes, on both a dollar spend and a percent, most of the build that we'll see in the balance of the year is Tempur North America.

Jon Andersen - William Blair & Company L.L.C., Research Division

Okay. And the last one. I think, when you mentioned the rollout of Choice being somewhat slower than planned, I think you mentioned some startup issues. I guess, I just was looking for some more clarity there. Was that production startup issues? Was it anything else? And have those been resolved at this point?

Mark A. Sarvary

They have been resolved. I mean, it was -- the thing is, it's a more complicated product because it relies on third-party suppliers for components of it. It relies on quality checks that we have to do coming in and then going out as a completed product. And candidly, we were learning a little bit how to do that. I'm quite pleased, frankly, how we're doing it now. It took a little longer to get going in the way that we would have liked. But it was that sort of -- those sorts of issues.

Operator

I would now like to turn the call back over to Mark Sarvary for any further remarks.

Mark A. Sarvary

Thank you very much. Thank you, everybody, for joining us. We look forward to talking with you all again on September 10 when we host our Investor Day in New York City. Thanks for joining us this evening.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does concludes today's program. You may all disconnect. And everyone, have a great day.

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