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Tempur-Pedic International Inc. (NYSE:TPX)

Q4 2009 Earnings Call Transcript

January 26, 2010 5:00 pm ET

Executives

Barry Hytinen – VP, IR, Financial Planning & Analysis

Mark Sarvary – President and CEO

Dale Williams – EVP, CFO and Secretary

Analysts

Mark Rupe – Longbow Research

Brad Thomas – KeyBanc Capital Markets

Anthony Gikas – Piper Jaffray

John Baugh – Stifel Nicolaus

Joseph Altobello – Oppenheimer & Company

Budd Bugatch – Raymond James

Jack Murphy – William Blair & Company

Matt McClintock – Barclays Capital

Operator

Good day, ladies and gentlemen, welcome to today's Tempur-Pedic fourth quarter 2009 earnings call. This call is being recorded. Now for opening remarks and introductions, I would like to turn the conference over to Barry Hytinen. Please go ahead.

Barry Hytinen

Thanks, Jay. And thank you for participating in today’s call. 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, and the company undertakes no obligations to update any forward-looking statements. The press release, which contains a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures is posted on the company's website at Tempurpedic.com, and filed with the SEC.

Now with that introduction, it is my pleasure to turn the call over to Mark.

Mark Sarvary

Thanks, Barry, and good evening everybody. Thanks for joining us tonight. Today I'll provide a brief overview of our performance in the fourth quarter and an update on our key initiatives for 2009, and then I’ll outline our strategic focus areas for 2010 and beyond. Dale will then provide a detailed review of the fourth quarter, and full-year results as well as our guidance.

During the fourth quarter, we continued our focus on maximizing sales, improving margins, and generating cash flow. And sales were up 29% from last year, and 9% sequentially. Sales exceeded our expectations, both in the US and internationally, partially due to the gradual improvement in the macro environment, and partially due to the success of our sales and marketing initiatives. Our productivity projects, and fixed cost leverage help increase gross margin by 550 basis points year-over-year to 48.5%. And reflecting some expense leverage, operating margin was up 590 basis points year over year to 19.3%. Our focus on cash continued to drive results. We lowered debt $18 million during the quarter and our funded debt to EBITDA ratio stands below 1.7 times for the first time since the first half of 2007, and Dale will provide more detail on the financials in a moment.

I'll now move to a recap of the progress we made on our key 2009 initiatives. You will remember that we had five initiatives that we focused on throughout the year. The first was to improve gross margins, where we made solid progress with a full-year improvement of over 400 basis points. While commodity costs were helpful, the primary driver of improvement was our ongoing productivity program.

Our second initiative was to improve our retail effectiveness. In 2009, we launched traffic driving and in-store promotions. Overall we were very pleased with these programs, and we learned a lot from them. In 2010, we will apply these learning’s to make these events even more effective. In addition, our recently launched advertising campaign, called “Ask Me” is showing strong traction, as you all know our ongoing investment in highly effective advertising is a primary driver of customers to our retailer stores.

Third, we set out to broaden the range of product that we offer. In the fourth quarter, we rolled out our TEMPUR-Cloud Supreme, the first in the softer feeling TEMPUR-Cloud line. To some consumers our existing mattress offerings just feel too firm, and our Cloud line is aimed at broadening our appeal to this consumer segment. We have been very pleased with the rollout so far. Our retail partners and consumers have been very enthusiastic about the new edition to the TEMPUR-Pedic portfolio.

Internationally, the Sensation mattress line, another unique and differentiated product that we started shipping earlier in 2009 is also expanding our appeal to a broad new group of consumers all around the world. Our fourth initiative is to stem the declines and ultimately grow our direct channel. Here we made excellent progress in 2009, with sales up 9% for the year and with exceptional growth in the fourth quarter. This time lastly we made progress improving our household penetration in our international markets. The sensation (inaudible) is expanding our addressable market and we have started implementing plans to significantly grow our retail distribution across many geographies.

Now, I'm going take a minute outline our strategic focus areas for 2010 that are design to drive growth, which we first discussed at our October investor event. And from time-to-time this year we'll update the investment community on our progress against these focus areas. First, we will make sure that everyone knows that would they sleep better on the Tempur mattress and pillow.

Our new 'Ask me' marketing campaign with a big factor in this area. This campaign focuses on our brands best differentiators, positive word of mouth referrals. The campaign is cutting across all forms of media, from digital marketing and social networks to TV and print. And in the first quarter we're launch TEMPUR-Cloud specific TV advertising. In addition, we're working with some of our retail partners to incorporate our marketing message directly in to their ad campaign.

Next, we'll make sure that there is a Tempur mattress and pillow for everyone. As we have discussed before, our new cloud and Sensational lines will be a big drivers in this area. And in 2010 we'll continue to fill our new product with compelling products that expand our reach. Thirdly, we'll a make sure that Tempur is available to everyone.

In 2010, we will expand our square footage at retail and we will begin to add doors again, especially in our international markets. We will also improve the reach and effectiveness of our direct business, particularly through the internet. We will update our website and implement customer relationship management tools in the first half of 2010.

And lastly, we will make sure that Tempur continues to deliver the best sleep. We are increasing our investment in R&D and consumer research, so that we ensure that we stay at the forefront of innovation.

While these four strategic areas are focused on growing our sales meaningfully faster than our industry, we intend to do so while improving our margins. Through sales leverage, our productivity program, and selective price increases, we expand – to expand our gross margins out there the year. And while we will expand our investment in advertising and R&D as well, we will tightly manage expenses and anticipate even greater improvement in operating margins. This also means that we project continued strong cash flow, which coupled with our much-improved balance sheet will give us strategic flexibility and will allow us to institute a new share-repurchase program which Dale will speak about shortly.

However, as we plan for 2010, we recognize that the macro environment continues to be unsettled. Our retailers tell us that while they are starting to see customers come back to their stores, their business is still not back to normal and people everywhere are still very cautious about spending. So we will continue to manage the business very closely, monitoring sales weekly and adjusting our costs to match.

We're projecting sales in 2010, much the same we projected during 2009, using our most recent quarterly volumes as the basis for our going-forward plan, and augmenting the plan with a review of seasonality and market conditions across each of our major markets.

In summary, we had a good quarter and a good year in a challenging economic period. We're pleased with the progress against our key initiatives in 2009, and we have significantly strengthened our balance sheet. Looking forward to 2010 and beyond, we have great potential for growth and have a clear plan to capitalize on this potential and out there the organization, we're executing the plan.

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

Dale Williams

Thanks, Mark. I'll focus my commentary on the financials and our 2010 guidance. As we look at sales let's begin with an overview. In total fourth quarter net sales was $245 million, an increase of 29% over the same period last year. As we projected on our last call, foreign exchange rates turned favorable during the quarter and on a constant currency basis net sales increased 24%.

Our revenue improved sequentially, 9% in total and 4% in the US, which is counter seasonal and speaks to the gradual economic recovery and the success of our sales and marketing programs Mark referenced earlier.

Now let's turn to the details of our fourth quarter performance. Domestic sales were up 40%, and international sales were up 15%, on a constant currency basis, our international sales were up 3%. By channel, in domestic retail, net sales were $131 million, an increase of 40%, as Mark m mentioned our domestic direct channel was up over $6 million or 74%. Internationally retail sales were up 16% to $74 million. On a constant currency basis, international retail sales were up 3%. Looking at products mattresses were up 26% driven by a 17% increase in units. Domestic mattress sales increased 34% on a 35% increase in units. The modest decline in average price reflects the impact of deeply discounted floor models related to our new product rollout.

We anticipate a similar headwind in the first quarter as we continue to rollout. In the international segment, mattress sales increased 12%. On a constant currency basis international mattress sales were essentially flat. International mattress units declined 1%. In total pillows were up 23%, driven by an 18% increase in units. Domestic pillow sales increased 39% on a unit growth of 41%, while international pillow sales were up 13% on a 1% decline in volume.

Our other product line includes items are normally sold along with the mattress such as foundations. Other product sales were up 46%. In the U.S. other product sales were up sharply 60%. This partially reflects the first quarter promotion on (inaudible) adjustable basis. Gross margin for the quarter was 48.5%, up 550 basis points year-on-year, and 90 basis points sequentially. On a year-over-year basis, the gross margin improved principally related to the following factors. First, our ongoing productivity program continued to generate improve efficiencies in manufacturing. Next, lower commodity costs, as compared to last year continue to be a big help. However commodity costs rose in the fourth quarter as we projected on our last call. We experienced the cost increase late in the quarter which will be a factor going forward.

Next we generated incremental margin from mixed-cost leverage as production volumes turned positive on a year-over-year basis. Lastly, the pricing action we took earlier in 2009 continued to be beneficial. These factors were partially offset by unfavorable geographic mix, and new product introductions. Regarding geographic mix, as our investors are aware, our international segment is a higher gross margin business. Our domestic segment as a result of its faster growth represented more of the company's business than last year.

Regarding new product introductions, our new model, the TEMPUR-Cloud Supreme began its rollout in the first quarter. We are very pleased with purchase [ph] rollout and fail to date. As we projected on our October call, floor model discounts impacted our fourth quarter gross margin rate. While floor model discounts pressured margin in the short-term, we view this as a great investment as the incremental floor space we are gaining should help us meaningfully grow sales and margins in the future.

As we projected on our last call, we increased our commitment to driving brand awareness with over $21 million spent on advertising, including 9.1% of sales spent in the domestic segment. This represented a 14% sequential increase in advertising expenditures. Our G&A expense up compared to last quarter and last year. In the fourth quarter, we incurred extra expense to catch up our bonus pool for the full year as a result of better than expected performance. Our bonus plans generally have a maximum payout and based on the fourth quarter performance, many of the plans hit this level.

For 2010, these plans reset to new performance targets. Interest expense was $4 million, down $1.5 million year-on-year, reflecting lower debt levels. Our fourth quarter tax rate was 32.7%, consistent with the third quarter and our projection on our last call. Net income was $29.1 million.

Given our improved profitability, EPS was $0.38, up versus our adjusted EPS of $0.17 last year. As a reminder, in the fourth quarter of 2008, we incurred a tax charge related to our repatriation of foreign earnings; GAAP EPS in the fourth quarter of 2008 was $0.01.

Now let me briefly summarize the income statement for the full year of 2009. Sales were down 10%. On a constant currency sales declined 9%, reflecting the negative effects of foreign exchange rates earlier in the year. Domestic sales were down 8%, and international sales declined 14%. On a constant currency basis, our international sales declined 11%. Reflecting our initiatives to drive profitability, our gross margin was up 420 basis points to 47.4%. Our operating margin was up 300 basis points to 17.4%. Full-year EPS was $1.12. This compares favorably to our adjusted 2008 EPS of $0.94, and our 2008 GAAP EPS of $0.79.

Now I'll turn to the balance sheet for a brief review. Accounts receivable balance was essentially flat sequentially, despite higher sales as we lowered DSOs by 3 days from the third quarter. Our accounts receivable continued to be in very good shape despite the economic environment and we have lowered DSOs by 9 days over the course of the year. Inventories were up $9 million sequentially, consistent with our projections on our last call when we highlighted that our inventory levels were running below our internal targets. We generated $15 million of operating cash flow during the quarter, and capital expenditures were $5 million.

We reduced debt $18 million to $297 million during the quarter for a total annual reduction of $122 million. A funded debt to EBITDA ratio was 1.68 times at year end, down sharply from last quarter, and far below our debt covenant of three times. Just to provide an historical context, the last time our debt was below $300 million was in the second quarter of 2005.

Now I would like to make a few comments about our share repurchase program. Earlier today, we announced our Board of Directors has authorized the repurchase of $100 million of the Company's common stock, pursuant to the program described in our press release. We are very pleased to make this announcement. It's a strong indicator of our confidence in the company's future, and as we have said before, we believe share repurchases are a highly effective means to increase stockholder value over the long term, particularly since our cost on any incremental borrowings is approximately 1%.

Now I would like to address our guidance for full year 2010. First, let me address recent order trends. So far, three and half weeks in to the first quarter, we have experienced strong order momentum, especially in our U.S. retail business. However navigated through the macroeconomic events of the last couple of years we recognized things can change quickly and it’s a long year.

Receivables is prudent the continued guiding sales based on our most recent quarterly volume levels, augmented with a review of seasonality and market conditions across each of our major markets.

Based on that methodology, the company has set its sales and EPS guidance for full year 2010. We currently expect net sales to range from $90 million to $970 million. And we currently expect EPS to range from $1.40 to $1.50 per diluted share.

We project our gross margin to be up for the full year, yet down modestly on a sequential basis in the first quarter. We expect to complete the Cloud Supreme rollout, and begin the rollout of the TEMPUR-Cloud this quarter, so formal discounts will have an impact in the first half and a bigger impact in the first quarter.

We anticipate interest expense for the full year to be approximately $12.5 million, which includes the impact of our interest rate swap as well as facility fees.

We anticipate capital expenditures will be $20 to $22 million. We anticipate the full-year tax rate to be in line with 2009 at 33.5%. And we are using a share count of $78 million for the year. This share count projection does not assume any benefit from a potential reduction in shares outstanding related to the company's share repurchase program.

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 change in conditions many of which were outside the company’s control.

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

Question-and-Answer Session

Operator

(Operator instructions) We’ll go first to Mark Rupe with Longbow Research.

Mark Rupe – Longbow Research

Hi congratulations once again on the quarter. As it relates to the Cloud – it is still too early to give a sense on whether or not it’s a meeting kind of the expandable market opportunity expectations?

Mark Sarvary

Well, as you said, look, it is still too early, I mean, it’s just been really in the market for eight weeks really. And the initial take on is it that it’s performing, at least as well as we expect it but may be a little better. It’s doing quite well and from what we can tell, our expectations about expanding beyond to a new user, or say it another way, the level of cannibalization is relatively where we thought it would be, but it's early days. So it looks like it’s on track, but it’s early days.

Mark Rupe – Longbow Research

Okay and as far as kind of the recent order momentum quarter to date, is the Cloud having a decent portion of that benefit?

Mark Sarvary

Having, it obviously is a participant in the performance year-to-date, but it is roughly in line with what we would expect it.

Mark Rupe – Longbow Research

Okay. And then as the product-specific advertising rolls out, do you have any kind of expectations on what they could do for general (inaudible) traffic or Cloud related business?

Mark Sarvary

Well, as you know, we have until now never run a commercial, I mean a TV commercial which is been product specific. And so this is going to be a new thing for us. And part of the purpose of it is, obvious to advertise the Cloud, but it is partly to give news, which us always been effective advertising message in its own way. And it’s partly to make sure that we communicate to consumers that there are a range of Tempur Pedic that there is not just one Tempur Pedic, which is one of our key communication challenges.

Exactly, how that is going to lift the business, to be quite honest, I'm not quite sure, we’ll run, we’ll run that as the Cloud add and we’ll run the other add in parallel and we’ll measure the relative effectiveness. It will be interesting to see. Quite honestly, I think it will definitely lift the Cloud, it just can be a question of how it balances the whole and we will watch and learn as we do. But I think what it will do is, it’s going to bring new news to the consumer about Tempur Pedic, which I think is the key message.

Mark Rupe – Longbow Research

Okay, perfect. And just lastly on the product segmentation strategy that you’ve announced late last year, have the retailers gotten on board on with that? You get a sense of bring kind of adoption rate on the from the retail standpoint on getting the soft, medium term and a strategy down.

Mark Sarvary

Well to some extent we get very quick adoption, because the foot covers and the (inaudible) retailers will quickly take that they will like it. But what I'm hearing from retailers and the people if they are key people or guys, the RSAs, the people in stores selling the product; they really are giving us positive feedback on it. Because it makes it quite easy for them to explain to the consumer what the differences are between three different categories. And it’s only anecdotal but the data that we are hearing is quite positive people have really responded well to it.

Mark Rupe – Longbow Research

Perfect. Congrats again, thanks.

Mark Sarvary

Thank you.

Operator

We'll go next to Brad Thomas with KeyBanc Capital Markets.

Brad Thomas – KeyBanc Capital Markets

Thanks, good afternoon. And let me add my congratulations as well.

Mark Sarvary

Thank you.

Dale Williams

Thanks.

Brad Thomas – KeyBanc Capital Markets

I wanted to talk about, say a little bit more, it is a number of initiatives that you have in place that seem to be working well, when Cloud rollout, the macro environment is improving, it seems like you are gaining effectiveness in working with retailers. As we try and strip those apart, could you help maybe quantify how much some of those different initiatives are benefit in sales?

Mark Sarvary

Well, not exactly is the answer. I mean, there is clearly the three things that you mention, the new products, the marketing programs that we're doing with the retailers, like the Ergo promotion that we talked in the comment. And of course, the economy all contribute, and we're not really sure how much is each. And there's a degree to which a lot of people – again, it's hard to put an exact number on it, but we know there is a significant portion of people who during the recession were putting off purchasing products, and some proportion of those people are now reopening their wallets and their purses.

And it’s hard for us to split out, what is driving what, to be honest. Right now for planning purposes inside, we're sort of assuming it is a bit of everything, because we don't know right now. Honestly, it's very hard to split it out, what is driving what. We get the feeling that all of those things are contributing. We're getting positive enough feedback from the retailers that we come away, saying that, yes, the programs are working. We know from consumer research that the new products are being well received. And we know from just measuring or commentary from our retailers that the foot [ph] people coming into the stores is somewhat increasing, but splitting that which is which it's very hard.

Brad Thomas – KeyBanc Capital Markets

But if we look at just the Cloud specifically, could you quantify for as how much of a benefit that had on sales in the quarter, and how much of a tailwind it may be in the current rollout trends continue through the first half of the year?

Dale Williams

Yes, Brad, this is Dale. For the fourth quarter, Cloud represented just a little less than 5% of our sales, but, obviously, the bulk of the fourth quarter we didn't have the Cloud, it was just in a rollout phase. We got it by the end of the year in to about half of our stores. So, here in the first quarter, you'll see roughly the other half of our stores get the Cloud Supreme, hence a lot of additional floor models, plus here in the first quarter, the first phase of retailers will get the TEMPUR-Cloud.

So, we'll have that phase of rollout beginning here in this quarter as well, and then the TEMPUR-Cloud rollout will continue in to the second and third quarter, and then later in the year, we'll start shipping the TEMPUR-Cloud Luxe. So, for the fourth quarter it wasn't a big driver. Certainly, it was a positive impact. TEMPUR-Cloud Supreme as we said earlier is performing well, but it's early.

Brad Thomas – KeyBanc Capital Markets

Okay. Sorry, just to be clear, you said that the Cloud is 5% of sales in the quarter?

Dale Williams

Yes.

Brad Thomas – KeyBanc Capital Markets

Okay, great. Thanks so much, and congratulations again.

Mark Sarvary

Thanks.

Operator

We'll go next to Tony Gikas of Piper Jaffray.

Anthony Gikas – Piper Jaffray

Thank you. Good afternoon, guys. Great job on the quarter. I have a few questions as well. Could you talk a little bit about why the international business is underperforming by such a margin compared to the US? Second, Dale, maybe you could help us out with what is the mix between mixed and variable cost today and perhaps 12 months ago? And then I have a couple of follow-ups.

Mark Sarvary

Okay. Let me give you a headline on the international then Dale give you little color. The first thing, you really have to take into account is that the easy comps, frankly that the US had. The US fell a lot further than the rest of the world did, so if you just compare apples-to- apples, international has a much harder compare than does or not much harder – was not nearly the compare that the US had. So, I would say the first thing that it's a macro environmental thing; that it's primary driver.

Secondly, I would say also, for example, the Sensation, which we don’t talk about as much which is the product launched in the rest of the world has been quite successful. Maybe not quite the level of the Cloud, but still very successful, and it has been effective in multiple countries. And there are other things going on in international which are quite encouraging. But having said all of that, we are seeing greater growth in the US, and particularly if you ask me marketing programs have been more effective, or have been useful here, and we haven't had the equivalent overseas, but we intend over the near future to be able to take some of the learning from the US and apply them in international.

Dale Williams

And on your question around fixed versus variable, the question is one that's at this moment a little bit hard to quantify, you almost have to look at it in steps. If we go back to 2007 we had a fixed variable component, and it varies by type of cost. For example, within our COGS, we have traditionally seen roughly about a 20% fixed component within COGS over the last two years with volume decline in the business, the business is less at this stage than it was in 2007. The fixed component of COGS is little bit higher, and as volume is starting to come back in the business, we'll see the fixed component shrink as a proportion of the total COGS as we get some volume leverage.

And the same thing can – on operating expenses; you have a little bit of the same thing throughout the recession while we are cutting fixed costs, fixed costs were a larger portion of our expenses because you can't cut them all, and you can't cut them all at the same rate, but the key is we have been able to reduce some fixed costs in the business over the last two years of the recession, and so we are in a much better position to get operating leverage both in the gross margin standpoint and in the operating expenses as we see volume come back into the business. Is that helpful?

Anthony Gikas – Piper Jaffray

Yes. So on those fixed costs, you know, you guys have done a great job over the trailing 12 months of cutting costs, how much do you expect will be permanent, you know, once the business is, you know, fully rebounding the consumers coming back? And then my last question would be on the calendar '10 margin expansion, you talked about, Dale, where is that coming from more specifically, maybe just a little clarity around that?

Dale Williams

Well, let me address the second part of that first, on the margin expansion for 2010, we would expect gross margins to be up, you know, about a 100 basis points, and operating margins to be up a little bit more than that, and, you know, from a gross margin standing point, that’s going to come from continued productivity on our four-year productivity plan. We expect to see some volume leverage on the business, you know, $950 million to $970 million is a lot more than 830 that we just finished in 2009. So we will see some volume leverage throughout the P&L, not just gross margin but also in the operating expenses. And, you know, from an operating expense stand point, we cut a lot of costs throughout the downturn.

However, we are also looking to continue to – you know, invest in certain parts of the business. We’ll increase, as Mark said, our R&D expense. We will increase our advertising. We have here, in the short-term, some increase in selling expense because we have restructured our sales organization a little bit to have better coverage of the stores. And, you know, another component of margin growth in the business is price. We took a price increase earlier in 2009, and as Mark said, we will take some price this year selectively on certain products.

Anthony Gikas – Piper Jaffray

From a gross margin, primarily productivity and leverage, not input cost, how should we look at the input cost proportion of that?

Dale Williams

We expect commodity costs to be up this year. We took a price increase, we got a price increase; we didn’t like it. But we got a price increase in our commodities in December, kind of mid-to-high single digit. Our expectation is that we will see some additional commodity price pressure this year, as the year progresses, but we will offset that as the year goes on through productivity, through leverage, and also through some selective pricing actions of our own.

Anthony Gikas – Piper Jaffray

And then the cost cuts you have made over the last year, maybe just characterize how much of them are permanent?

Dale Williams

Well the cuts that we made are primarily permanent, but as we are looking at the business in terms of starting to see some growth again, we are identifying different areas of the business where we feel it’s prudent to make some additional investments, as I mentioned earlier, we are going to invest more in R&D. We are going to ramp back up our advertising spend rate a little bit, and we have made some additional investments in our selling organization.

Anthony Gikas – Piper Jaffray

Okay. Thanks, guys. Good luck.

Mark Sarvary

Next?

Operator

(Operator instructions) We go next to John Baugh with Stifel Nicolaus.

John Baugh – Stifel Nicolaus

Good afternoon. Thank you. Could you give any more color on pricing, number one or whether we just have to wait on that? And then, if you could just walk us through, again, a methodology of the sales guidance for the year, in what’s in there and what’s not in there as it relates to the Cloud rollout, for example, and the first strong three or four weeks of orders? Thank you.

Mark Sarvary

Hi, John. Let me go first, and then I will ask Dale to add to it, but, as Dale said, we do anticipate taking some pricing impact. We will be taking selective pricing. We will be announcing those changes in Vegas next week. So, I don’t want to give any details, now but we will be able to, in just a few days, asked to be spoken to our retailers. In terms of the sales guidance, our method is in sort of broad terms, quite simple. We have taken the full quarter and assumed that that will continue for the rest, that level of sales will continue for the rest of the year, and it’s a pretty blunt instrument. But it’s deliberately so, because it still remains very hard and has degrees of unpredictability in a market that we are seeing. It makes it very hard to be more, much more scientific than that.

What we are doing as well is by geography, we look at seasonality and things like that, but particularly seasonality just to make sure that we are allocating it correctly across, but fundamentally it’s a pretty simple system and we are not getting it down to the level of product by product because quite honestly it’s very hard to know, if you think about the benefit of a product should you take the negative of a country that is having a particularly difficult – well particularly slow response to the recovery from a recession. So, it's a fairly simple system, and it's the best one we have been using it for some time. It has worked for us so far and that’s one that we’re continuing to use.

John Baugh – Stifel Nicolaus

So even though Cloud was not in – Supreme was not in half the stores in the – or just by the year end, though it contributed 4 to 5% of the revenues. It sounds like, you haven't, you know, assumed, well, if it's in all of the stores at this rate that – that part is not – or that piece is not part of the 950 to 970 guidance; is that correct?

Dale Williams

That's right. But as I said, please – really it's not as though we’ve some secret formula that we're not sharing.

John Baugh – Stifel Nicolaus

Okay. No, that's fine. And then, the last question, what would be your expectation once we have all three of the Cloud products out, and I realize that's late this year, but what would be the hope or the goal for slots per door, you know, amongst the three? Do you have some kind of internal plan you might share or thoughts there? Thank you.

Mark Sarvary

I mean it's not – it will depend by customer and so forth, but we think of that order – it will be – some will have three and some will have one but it’s going to be – that's what we're hoping for.

John Baugh – Stifel Nicolaus

Great. Thank you.

Operator

We'll go next to Joe Altobello with Oppenheimer & Company.

Joseph Altobello – Oppenheimer & Company

Thanks, good afternoon guys. First question I just wanted to delve into the macro environment for a second and, obviously the last couple of years have been sort of – two years that we have not seen this industry, maybe ever – probably ever I should say. So is it your sense in what you are seeing in terms of the pickup in demand here, and what you are hearing from retailers that there is a lot of pent-up demand amongst consumers, because I would imagine that mattress purchases are something you can defer for quite a long time, but not forever. So it seem like after the last two years of double-digit decline that there is, I won’t call it a bubble but there is a lot of pent-up demand out there that take multiple quarters to show through.

Mark Sarvary

I think you right. I'm sure you are right. I'm sure you are right that there is a pent-up demand. And it is even possible – it is even likely, frankly that the degree to which the pent-up demand affects the premium mattresses affects is probably greater than the not the sub-premium, merely because if you to have a mattress you just have to go and get one, whereas the premium mattress is often a considered purchase or a purchase that you could defer. But how much of it that is, and whether it has started to come through yet, and how much of it has come through yet, really we don't know, and it's part of why we'll being, as we say there are multiple things affecting us, We think that that's is component but we don’t how much.

Joseph Altobello – Oppenheimer & Company

And it sounds like your retailers are...

Mark Sarvary

Several quarters for it to play through or longer

Joseph Altobello – Oppenheimer & Company

Right, right. And it sounds like your retailers are sharing that cautiousness at this point?

Mark Sarvary

Yes, there's no doubt that the retailers – as I said in the comments they are seeing some returns to some form of, it’s more predictability, but it is still very different from what it was just a little 18 to 24 months ago.

Joseph Altobello – Oppenheimer & Company

Okay. And then secondly, have you started to repurchase shares yet this quarter and your thoughts on reinstituted the dividend at some point?

Mark Sarvary

No, we have not. We're just announcing the share repurchase today. And the company has been in a blackout period. So, we have not started repurchasing. In terms of dividend that's something that is on the table but not something that we felt was the right thing to do yet at this time.

Joseph Altobello – Oppenheimer & Company

Got it. And I'm sorry just one more if I could. The other sales you mentioned in the US were up pretty solidly. It looked like a lot of that came from the success in the Ergo promotion. How much of that is sustainable?

Mark Sarvary

Well, the Ergo [ph] promotion was a good event for the fourth quarter no doubt about it. There are two things about it. The first is that we don't and won't do promotions on mattresses, but doing promotions on ancillary things like foundations. We did a closeout on the old foundation. Middle of the year we did the Ergo [ph] foundation at the end of the year. It's something that makes sense. The retailers like it. It gives a reason for the consumers to shop now, and it works well with the retailers go to market strategies and we will continue to do promotions like that going forward.

So that particular one we will repeat probably at some stage, but we have no plans to do no so at the moment, but we will have promotions like it. On the other hand, speaking of the Ergo [ph] itself, one of the things, that is an important part of our overall strategy is that the Ergo [ph], adjustable base is now attached to a significant number of our sales. A significant proportion of the people who buy Tempur Pedic buy an adjustable base. And obviously that's a good ring for us, but also consumers who have them, love them. And one of the tricks to be effect of it to get the retail salespeople to be used it to, and have confidence of doing it. And this promotion gave a lot of people the experience of selling Ergo [ph] and realizing how consumers can (inaudible) to them. And so it was both a practical promotion but also a strategic thing to help us in getting the salespeople across the country used to selling what is a – has not been a normal sale item.

Joseph Altobello – Oppenheimer & Company

Got it. Okay. Thank you very much.

Operator

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

Budd Bugatch – Raymond James

Good afternoon and good evening, and add my congratulations on the operating performance of the quarter. Couple of questions, if I could. Mark, I know you don't want to talk much about the selective price increases, but in the way just thinking about it in kind of a gross amount, would we be, fair to add something on the order of $30 to $40 million to sales for that in 2010 or is, are we way out of the ballpark?

Dale Williams

The price, but the price increases were contemplated as part of the guidance. We had price that kind of was a factor all through 2009.

Budd Bugatch – Raymond James

Well, I understand that Dale. And I'm looking at it as a base of 2009 on top of that, just building it, the way that John wanted to build the sales up from, essentially 2009 is, another way to look at how do you get to a sales number?

Dale Williams

You'll have a better understanding of the opportunity next week when we announce it to our retailers.

Budd Bugatch – Raymond James

Okay. About what the ad budget is for next year? Are you going back up to closer to 10% to 11% that you have historically spent and targeted? How should we think about that?

Dale Williams

We're going to go back to about nine. I think it's nine, just a little bit more than nine. But, I mean it's something that we, as we've talked before about, it’s something that we believe, I mean it’s absolutely critical to the company, it's something that we believe very strongly is an important part of our overall investment.

We have moving as we've said by 2014, in our long-term plan; we have a target of 10% as a percent of sales in investment and marketing in advertising. And we're moving on that part. This year we’ll get nine, it's something that if you think about the company, the two really big things that we have going for us is a product that is preferred by consumers and a very, very top brand. And we intend to invest in both of them, I mean in advertising and R&D.

Mark Sarvary

I concur I think here you asked me about Tempur is a very, very powerful campaign, so I understand that. You did say something about integrating it with retail more closely, that's something that historically has kind of a buzz word in the bedding industry. Can you help me understand what that means?

Dale Williams

Yes, we're not doing co-op [ph]. We're allowing the retailers to use our commercials and our copy –

Mark Sarvary

It's really important and I think Dale makes a good point. It's not co-op, we're not talking about moving to co-op, what we are saying is that we made these commercials, and we made versions of these commercials that are frankly user friendly for the retailers to be able to use in their advertising, provide them the opportunity of high quality advertising and allowed them to add their own tags, or add their own brand names and so on around it. It just makes it very easy to use. But it is a provision of copy and material and collateral and so on, not by co-op advertising.

Budd Bugatch – Raymond James

Okay. And R&D you talked about increasing that. Can you give us kind of a number of what you think that is going to run to?

Mark Sarvary

It's about 1%, give or take. And R&D is, again, another important thing. I mean, obviously we're very pleased with the results of the Cloud so far, and that was the direct result of R&D, the creation of the new ES material was a very specific and aggressive R&D project in 2009, and we will continue to do that during 2010.

Budd Bugatch – Raymond James

And the bonuses, Dale, I think you said you accrued for them again in the fourth quarter. How do we think about that for 2010? Are you going to accrue all year, and is there any level of increase that we should?

Dale Williams

In fact the bonuses in 2010, starting here today will be less than they were in 2009. What I was trying to say and maybe it wasn’t clear enough is the way that the bonuses work is there are certain targets set out, and if you meet those targets and go beyond those targets then the bonus can accelerate. So, you know, we mentioned in the third quarter that part of the reason G&A was up in the third quarter was because we were catching up for the year, not that we weren’t accruing all year, but we were accruing based on what the projections were. And when we got to the third quarter, and had a very strong third quarter, we had to catch up for three quarters, and then the fourth quarter was significantly above our expectations, so we had to not only accrue for the fourth quarter, but catch up for the full year, based on overachieving the target levels, so as we sit here today looking at 2010, we have a plan and targets for the bonuses, and we’ll be accruing that target.

Budd Bugatch – Raymond James

And just to be clear on the targets, are they changed at all in terms of what – and what are they now?

Mark Sarvary

I am sorry?

Budd Bugatch – Raymond James

What kind of targets are they? Are they sales, operating income hour, where is the emphasis on targets?

Mary Sarvary

Our bonus structure has always had a component of revenue and earnings, and then, also, a component of objectives, personal objectives for each employee, and so those elements will be, you know, maybe slightly different in 2010, but they are still key elements of the bonus plan and compensation philosophy of the company.

Budd Bugatch – Raymond James

Okay. My last area of questions is on the cash return to shareholders, with the share authorization and the history of paying a dividend for seven quarters in the past, do we take it from what we have heard today that you are – your emphasis will be on share repurchase above – before share – share dividend, is that a fair comment or is that that just too aggressive?

Mark Sarvary

Yes, I think that’s a fair comment, since we have authorized a share repurchase program and not reinstated a dividend at this stage.

Budd Bugatch – Raymond James

And you seem to indicate that you would borrow to repurchase shares when you were talking about the incremental borrowing costs, and the fact that debt is down below $300 million for the first time in a long time if not always. So do we…?

Dale Williams

We did not let’s say, say that we were going to borrow to buy shares, although that's a possibility. However, the alternative is to continue to pay down debt. And so the key thing I was trying to point out is our incremental debt cost is about 1%. Now that's not our full debt cost, but our incremental debt cost is about 1%, so the alternative of continuing to pay down debt or buy some shares is a choice of what you do with the cash, and that's about a 1% cost difference.

Budd Bugatch – Raymond James

Okay. And so for modeling purposes, should we take free cash flow and do a percentage of that to share repurchase, would that be a feasible or a rational way of doing it, thinking about it?

Dale Williams

We’ll try to factor in some share repurchase, that's a reasonable way to do it. Share repurchase is not reflected in our guidance. So as we purchase shares, at the end of each quarter we'll tell you what we bought, and we'll tell you what impact it has on interest expense and on share count on a go-forward basis.

Budd Bugatch – Raymond James

Okay. And my last question, Mark, for you, any peak at Las Vegas next week as to what we might see new? I guess we'll see the ES-LUX [ph]; is that true?

Mark Sarvary

Yes, you can be the first to know, Budd, but, yes, you will. In four days advance notice, but yeah. No, we'll have the LUX [ph] there. We had talked about it last time but now we have it. And there's a couple of other interesting things there too should be a fun event.

Budd Bugatch – Raymond James

Okay. Look forward to seeing you again. Thank you very much, and again congratulations.

Mark Sarvary

Thanks, and we look forward to seeing you too.

Operator

(Operator instructions) Our next question will come from Jack Murphy with William Blair.

Jack Murphy – William Blair & Company

Hi, good afternoon. I'd like to ask just first sort of a broad question about the brand architecture strategy and then something a little more specific. In terms of looking at what you have done so far with the Cloud, can you give us any thoughts, updated thoughts on what else might be in store in terms of filling out that brand architecture? And then also, I'm not sure if you have mentioned in the past what the pricing may look like on the next two cloud products. If you could just address those two points, I would appreciate it.

Mark Sarvary

From the point of view of the architecture, one of its – the architecture as a whole is both to clarify for the buyer, for the consumer, and frankly for us as well, what it is we're trying to do with the product range that we offer. Because we want to make sure all of the products that we offer have a role to play and are kind of earning their keep within the portfolio of products that we offer.

And so, the way that we think about the current portfolio is that with the TEMPUR-HD, and the ES, we have the three different fields, and within each of them we anticipate having a range of good, better, best the typical merchandising strategy. And so in a simple sense that's what we're going to have. We're going to have the three different fields and a good, better best version in each one.

Now we may have instead of three, we may have four or five depending on what some of the different categories, but in broad terms that's what we'll do. And we anticipate that that will that they will continue to evolve. It's not like we'll keep adding completely new products – our new completely new products. We'll have the set group and then we will evolve them over time and as both our technology continues to evolve but our ability to meet consumer needs becomes better refine. We'll upgrade or update different items within different products within each range. We don’t anticipate growing and growing and growing.

And having said all of that, though, it's conceivable that – at some stage we could add another category. We haven't got plans to do so but it's conceivable that we could. So it's not as though three is by – is for sure the end. It's just that it certainly we are not going to get much more than that. And what we want to do is to make sure that every product within each architectural pillar finds its way. And then in terms of pricing, the – again, we'll announce the actual prices next week in Vegas for the new product, but I can tell you that one will be at a lower price than the Cloud Supreme, and one will be higher. And the one that will be lower will be squarely aimed in this one to $2000 what we call entry level premium market, which is something we have been talking about for sometime it's important (inaudible) place for us to focus. And the other one will be a more premium. And thus, we will have our good, better, best in – within the Cloud range.

Jack Murphy – William Blair & Company

Okay, great. And just one sort of unrelated question. I know direct is still a fairly small percentage of the total sales, but you are putting up very strong growth there. Could you, Mark, talk a little bit about your initiatives with the online channel, how you are looking at that strategically? And then, Dale, if you are willing to talk a little bit about what your expectations are for direct?

Mark Sarvary

Okay. Let me go first. I want to answer the question, though, in two ways, because it's important to see that direct is a channel in its own right, but it's also part of the overall communication with the consumer. So we can't think of direct as something else. It is a consumer who buys, one of the statistics that we find very, kind of important because it governs a lot about how we think is that of everybody who we contact directly and what we call a lead who we get through our direct business, either internet or by telephone who ends up buying a product, three out of four of them end up buying in a retail store, so it really tells you the story that there are not two different types of purchases that we have, the direct purchase and the retail purchase they are all the same people.

So first of all, we have to think of it as very integrated. And so or marketing and everything else, e think of it as very integrated. But if I think specifically about that portion of business that is done directly on the internet, or directly or either internet or by phone, we are, we are doing a variety of things. One is the effectiveness of our internet marketing is something we have stepped up significantly, both the amount, but also the effectiveness.

The other is the way that we worked on how we sell to consumers, and how we're aware of their needs. A simple thing is that we, we had, during the Christmas period last year, we had a brochure, a catalog, I mean, with gift-type ideas, which we've never done before, and this was quite a big success, both on the phones and on the internet.

But, thinking of it like we are thinking of ourselves much more as a more typical internet merchant. And the one that we, that I refer to briefly in the comments is the customer relationship management, which is in the end it’s a long past because there is a lot to do there. But improving our effectiveness and our knowledge of our consumer base is going to be something that we believe we have a little long way to go and great opportunities ahead with that. So with that, Dale, what about for numbers?

Dale Williams

Yes, from a looking forward standpoint, we've the direct has two very good quarters. Third quarter it was joint channel that showed growth. Here in the fourth quarter, the direct channel had a very significant growth, which is very positive that we have been able to thin the tide and turn it. The direct business got hurt sooner and harder than the rest of the business did in the recession, ultimately the rest of the business caught up to it, but it's good to see that turning and coming back. But on a go-forward basis, we recognized the bulk of the growth is going to come from retail.

And we would be thrilled to see direct have a growth rate similar to the retail growth rate, but by and large the consumer research that we have done throughout the years let's say 80% of consumers won't even consider buying direct. We still feel is valid, so, retail is the key growth driver of the business, and will continue to be, but we just want to make sure that the direct business is healthy, and is as the business starts to grow again, that the direct business you don’t gets a piece of it.

Jack Murphy – William Blair & Company

Great. Thanks.

Mark Sarvary

Thanks.

Operator

Our next question comes from Bob Drbul with Barclays Capital.

Matt McClintock – Barclays Capital

This is actually Matt McClintock filling in for Bob. Good evening, everyone.

Mark Sarvary

Hey, Matt.

Matt McClintock – Barclays Capital

Just one quick question. Dale, as sales have recovered has the variance widened regarding the performance among the different price point ranges that's of your products?

Dale Williams

No, actually, as we said throughout the downturn, we saw the downturn pretty much affect all of our product range about the same from our lowest-priced product to our highest-priced product and as sales have started to turn, we're talking about one quarter here, at least where it was positive on a V. But we have seen three quarters of kind of successive improvement, and we have seen the business pretty much come back across the board as well.

Matt McClintock – Barclays Capital

Perfect. Thanks, guys.

Mark Sarvary

Thanks, Matt.

Operator

And that’s all the questions that we do have today. I would like to turn the conference back over to our host for any additional or closing remarks.

Mark Sarvary

Thanks a lot. Well thank you, everybody, and we look forward to talking with you again in April when we will review the first quarter. Thanks for joining us this evening.

Operator

That does conclude today’s conference. We thank you for your participation.

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Source: Tempur-Pedic International Inc. Q4 2009 Earnings Call Transcript
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