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Executives

Barry Hytinen – Senior Vice President

Mark A. Sarvary – President, Chief Executive Officer & Director

Dale E. Williams – Chief Executive Officer, Executive Vice President & Secretary

Analysts

Mark Rupe – Longbow Research

Bob Drbul – Barclays Capital

Analyst for Budd Bugatch – Raymond James & Associates, Inc.

Keith Hughes – SunTrust Robinson Humphrey

John Baugh – Stifel Nicolaus & Company

Jack Murphy – William Blair & Company

Henry Capellan – Oppenheimer

Brad Thomas – Keybanc Capital Markets

Tempur-Pedic International, Inc. (TPX) Q1 2010 Earnings Call April 20, 2010 5:00 PM ET

Operator

Welcome to the Tempur-Pedic first quarter 2010 earnings conference call. Today’s conference is being recorded. At this time I’d like to turn the Barry Hytinen, Senior Vice President.

Barry Hytinen

Joining me in our Lexington headquarters are Mark Sarvary, President and CEO and Dale Williams, CFO. After prepared remarks we will open the call for Q&A. Forward-looking statements that we make during this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements including the company’s expectations regarding sales and earnings involve uncertainties.

Actual results may differ due to a variety of factors that could adversely affect the company’s business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating and other factors discussed in the press release issued today. These factors are also discussed in the company’s SEC filings including the company’s annual report on Form 10K under the headings special note regarding forward-looking statements and risk factors.

Any forward-looking statement speaks only as of the date on which it is made. The company undertakes no obligations to update any forward-looking statements. The press release which contains a reconciliation of non-GAAP 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’s my pleasure to turn the call over to Mark.

Mark A. Sarvary

Today I’ll provide a brief overview of our performance in the first quarter and then an update on some of our strategic focus areas and then a commentary on our outlook. Dale will then provide a detailed review of the first quarter financial results and will discuss our revised guidance. We’re really pleased with our first quarter results. We’ve increased sales and grown our market share while improving both our gross and operating margins. Our investments in marketing and research and development are driving our sales momentum and we believe they will continue to do so in the future.

Sales were up 43% from last year and earnings per share were up 144%. Fixed cost leverage in our productivity program helped increase gross margin by 300 basis points year-over-year to 49.2% and we were able to increase our operating margin by 600 basis points year-over-year to 20.6%. Overall, a very good start to the year.

During the earnings call three months ago I outlined our strategic focus areas for 2010 and beyond to drive growth and I said that from time-to-time this year we would update the investment community on our progress. Today, I’ll talk about three of them: our commitment to makes sure that there’s a Tempur mattress for everyone; our commitment to ensure that they would sleep better on Tempur; and finally, our commitment to ensure that Tempur is available to everyone.

Firstly, I’m very pleased with the progress we made this quarter to ensure there is a Tempur mattress and a pillow that appeals to everyone. Our new cloud and sensational lines both experienced strong growth. We designed these products to address specific holes in our existing product line and they are doing what we hoped, expanding our addressable market and growing share.

The Tempur Cloud Supreme which we only launched in November has already completed its roll out in the US. The performance of this new product has been exceptional and importantly, it appears to be very largely incremental to our business. We began shifting the entry level Cloud mattress in mid February. It has gained significant new floor space and is performing well and its roll out will continue through the second quarter. Earlier this year at the Vegas market we showed our top of the line Cloud mattress, the Cloud Luxe and in response to retailer enthusiasm, we’ve accelerated our launch plan for the Luxe and expect to start shipping in August. In the second quarter we will begin distributing the Cloud line in Canada.

Internationally, our Sensation mattress line continues its roll out across Europe. We’ve been very impressed with the lines sales per slot and distribution gain. Also, last quarter we introduced the [Promesa] mattress in Europe. It’s a completely unique mattress, extraordinarily soft and comfortable and with a sleeping surface that is contoured like a wave. You have to see it to believe it and it’s priced higher. The queen size mattress equivalent of about $7,000 which means this is our highest priced mattress anywhere in the world and it certainly has been catching the attention of retailers across Europe.

It’s a busy new product year for us and we’ve got interest in concepts under development which should provide us with compelling offerings in the years to follow. The second strategic focus area that I want to discuss is our commitment to ensuring everyone knows they would sleep better on a Tempur mattress and pillow and here too we’ve made good progress.

We sharply increased our advertising spending up 53% and most of our $22 million advertising was focused on our ask me marketing campaign. This campaign focuses on one of our brand’s greatest aspect, the extremely positive referrals we get from existing owners. The ask me campaign is fully integrated in to all our US consumer communications and in February, we launched our first product specific TV ad focused on the Cloud line.

We’re also working with many of our retail partners to incorporate our marketing message directly in to their ad campaign and we’re seeing strong uptick from those retailers who see the benefit of being seen as the destination for Tempur-Pedic in their area and thus leverage the investment we are making on advertising.

Finally, the third strategic area is our commitment to ensure that Tempur is available to everyone. In both the US and internationally the continued slot growth related to our roll out of the Cloud and Sensational lines, expanded our square footage at retail considerably and for the first time since the recession began, we added to our international door count and see opportunities for considerable additional door growth.

In addition, we’ve expanded our distribution by establishing a joint venture in China and completing the acquisition of our Canadian distributor. We see opportunities for significant long term growth in both markets and so we’ll be increasing our marketing investments in both those geographies.

Now, before I hand it over to Dale, I’ll comment on our near term outlook. During the macroeconomic downturn when business visibility was low, we were projecting sales and earnings based on our most recent quarterly sales volumes. Today, the macro environment appears to be gradually recovering and recent results indicate the start of a recovery is underway in the mattress category too. Retailers tell us that they’ve seen stabilization in customer traffic.

Also, over the next few years we believe the mattress market will experience a benefit from the pent up demand of deferred purchases and at the same time our investments in marketing and new products are gaining traction and as a result we’re gaining market share. So, we feel it is now appropriate to evolve our methodology for financial projections. I’ll let Dale discuss the numbers in detail but at a high level we’re projecting sales in 2010 based on the assumptions that number one, the mattress market is recovering; number two, that normal seasonality is returning; and number three, that we grow our market share for the full year.

These assumptions have caused us to raise our projected sales and with the resulting cost leverage we are projecting to grow earnings materially higher than we had previously projected. In summary, we’ve had a very good quarter and we’re expecting that we will have a good year overall. In the longer term, we remain confident that there is enormous potential for Tempur-Pedic and we are executing effectively on our plan to capitalize on that opportunity.

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

Dale E. Williams

I’ll focus my commentary on the financials and our 2010 guidance. In total first quarter net sales were $254 million, an increase of 43% over the same period last year. As we projected on our last call, foreign exchange rates were modestly favorable during the quarter and on a constant currency basis net sales increased 40%. Domestic sales were up 57% and international sales were up 24%. On a constant currency basis our international sales were up 15%.

By channel in domestic retail net sales were $143 million an increase of 53%. Our domestic direct channel was up over $6 million or 72%. Internationally, retail sales were up 22% to $70 million. On a product basis, mattress were up 42% driven by a 41% increase in units. Domestic mattress sales increased 55% on a 67% increase in units. The 7% decline in average price reflects the impact of deeply discounted floor models related to our product roll out and the very positive trends we are seeing in the sales per slot of our new Cloud line which is currently priced below our US average.

As we have previously announced, effective in May, we’re raising the price of the Tempur Cloud Supreme which will bring the pricing of that model to slightly above our US average. If we adjust our first quarter sales to remove the impact of floor models and add the benefit of price increases for the Cloud and Advantage models, we estimate US average selling price would have been flat to slightly up on a year-over-year basis. For the second quarter with pricing and fewer floor models, we would expect to see average US price grow sequentially.

In the international segment, mattress sales increased 19%. On a constant currency basis, international mattress sales were up 10%. International mattress units increased 13%. In total, pillows were up 33% driven by a 35% increase in units. Domestic pillow sales increased 44% on unit growth of 54%. International pillow sales were up 26% on an 18% increase in volumes.

Sales of our other product line which includes items that are normally sold along with a mattress were up 55%. This product line grew faster than mattress driven largely by the pricing action we took last year when we upgraded our foundation and improved attach rates of our adjustable beds.

Gross margin for the quarter was 49.2% up 300 basis points year-on-year and 70 basis points sequentially. On a year-over-year basis, the gross margin improved principally related to increased production volumes to support higher sales resulting in fixed cost leverage and our ongoing productivity program generated improve efficiencies in manufacturing and distribution. Partially offsetting these benefits were unfavorable geographic mix, new product introductions and higher commodity costs.

With significant sales growth, we drove over 300 basis points of operating expense leverage. This despite having ramped advertising spend as a percentage of revenue up 60 basis points. While our G&A expense was up year-on-year, this primarily reflects a significant increase in bonus accruals. Last year during the first half, we were under running our financial targets and therefore accruing bonus below our target rate. However, for 2010 in light of our increased outlook, we are accruing bonus at maximum levels for our financial targets.

Interest expense was $3 million, down $1.4 million year-on-year reflecting lower debt levels. Our tax rate was 32.5% reflecting favorable geographic mix. Net income was $33.1 million, up from $13.3 million. Investors will note a new line on our income statement, net income attributable to non-controlling interest. This line reflects our minority partner share of income in our Chinese joint venture.

Given our improved profitability, EPS was $0.44 up from $0.18 last year. On a year-over-year basis, despite repurchases our share count is up due to more in the money stock options affecting the diluted share count. Now, I’ll turn to the balance sheet for a brief review. Our accounts receivable balance was up reflecting improved sales level however, DSOs were down four days from the fourth quarter of last year. Inventories were up $7 million year-on-year consistent with our projections on our last call when we highlighted that our inventory levels would likely grow with new production launches and our positive outlook for sales.

We generated $23 million of operating cash flow during the quarter and capital expenditures were $3 million. As we previously disclosed, effective April 1st we acquired our Canadian distributor. Our cash and debt balances as of March 31st reflect the timing of the purchase. Our funded debt to adjusted EBITDA ratio was 1.9 times, far below our debt covenant of three times.

Now, I would like to make a few comments about our share repurchase program. Through open market purchases, we bought back 3.7 million shares during the quarter fully utilizing the $100 million repurchase authorization we announced in January. Consistent with our increased outlook for 2010 and our long term goals, we believe we are well positioned for substantial growth in sales earnings and cash flow with limited capital expenditures over the next several years.

As we have said, we have enough manufacturing capacity to nearly triple our 2009 sales and our financial projections assume fully funding our key initiatives such as marketing and research and development. Even with these investments we project we will generate substantial excess cash. After considerable evaluation of our capital structure and potential uses of cash such as paying down our revolver and instituting a dividend among other options, we continue to view share repurchases as an excellent means to return value to shareholders over the long term.

We are currently targeting the debt to EBITDA ratio to be between 1.5 and 2 times. We are pleased to announce our board of directions have authorized the repurchase of another $100 million of the company’s common stock pursuant to the program described in our press release.

Now, I would like to address our updated guidance for full year 2010. We currently expect net sales to range from $1.02 billion to $1.06 billion and we currently expect EPS to range from $1.70 to $1.85 per diluted share. We expect our gross margin to be up 200 basis points or more for the full year driven by fixed cost leverage in our ongoing productivity plan. We are planning for commodity cost to rise throughout the remainder of the year and we are assuming unfavorable geographic mix related to the faster growth from our US business.

Regarding the second quarter, we expect sales in our international segment will be down from the first quarter which is consistent with normal seasonality and will result in negative geographic mix as it relates to gross profit. Also, late in the first quarter we have absorbed some commodity price increases. While we see opportunities to largely offset these factors, we expect second quarter gross margin to be flattish as compared to the first quarter.

Consistent with our long term plans, we are planning to advertise at a rate at just over 9% of sales for the year. We expect interest expense for the full year to be approximately $13.5 million which includes the impact of our $100 million repurchase in the first quarter as well as interest rate swaps and facility fees. We anticipate the full year tax rate to be generally in line with our first quarter run rate at 32.5%.

We are using a share count of just over $75 million for the full year. This assumption includes the benefit from our repurchase activity in the first quarter coupled with more options being in the money given the appreciation of our stock. However, our updated guidance does not assume benefit from the potential reductions in shares outstanding relating to today’s new repurchase announcement.

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

Question-and-Answer Session

Operator

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

Mark Rupe – Longbow Research

Could you provide any more color on kind of how the Cloud performed? I know in the last quarter you broke it out kind of as a percentage of sales, any chance you can do that again?

Mark A. Sarvary

We aren’t going to break it out in detail Mark. As you know, we don’t break out products one-by-one. We’ll say that the Cloud obviously has done very well, it’s contributed very significantly to our growth this quarter and obviously we’re pleased with it and assumptions about it like both its size and its level of cannibalization appear to be certainly within on the good side of what we had hoped for.

The other thing to say is overall the rest of our business, if you took the Cloud out that’s growing. That has been growing. So overall we see good performance in the rest of the business and then Cloud on top of that.

Mark Rupe – Longbow Research

Inherent in kind of your new formulation for the guidance, you had mentioned kind of an industry recovery, normalcy now, that you need to grow market share, are there any numbers that you can kind of throw out kind of what your assumptions are for the market?

Dale E. Williams

As we look at the situation, if we talk about our guidance in a little bit more detail we had been using during the recession four times our last quarter. At the low end of our guidance that basically reflects four times the first quarter so that’s kind of a low end. But then what we’ve tried to do is take the first quarter as a base line and look at historically, taking out some abnormal years, but historically what is the seasonal pattern of the business based on the projections or the experience that we’ve been seeing here over the last couple of quarters and that’s how we get to the top end of the guidance.

The data through the first two months of the year would indicate that the markets growing somewhere in the 7% to 8% range. The projections that we’ve seen from Furniture Today, [inaudible] indicate that the general expectation is that the market will grow fairly consistently with what we saw on average off the first two months of about that 7% to 8% range so that’s kind of built in there.

Mark Rupe – Longbow Research

On the gross margin outlook, I know that obviously you commented 200 basis points or more on the last call, I believe it was 100 basis points or more. Is there anything specifically or is it just leverage that’s the big difference kind of between the delta of the two? Then secondly Dale, on the late Q1 commodity price increase, any kind of color on that would be great too in magnitude.

Dale E. Williams

As we look at our outlook for gross profit you’re right on the last call we thought gross profits would be up about 100 basis points this year, we’re now expecting it to be up 200 basis points or more this year. Obviously, we had a very good performance in the first quarter on that front. What we’re expecting in that is the big driver, certainly volume leverage is a factor but really the biggest driver is the productivity initiatives continuing to deliver results and we had a relatively small commodity price increase late in the quarter which will give us full affect in the next quarter but we’re also expecting some additional commodity price increases as the year progresses.

Oil has been a little bit erratic but generally on a little bit of an upward trend. So we’re trying to build that in to our expectations. The big drivers here obviously are continued volume leverage, continued productivity. Obviously we have some price increases going in to effect in May that will give us some benefit as well.

Mark Rupe – Longbow Research

Then just lastly, on the new product over in Europe can you remind me what that was again? Was it [Promesa]?

Mark A. Sarvary

The key product over in Europe is the Sensation which is the product that’s rolling out. The [Promesa] is an idea creator, it’s almost like a concept car. It’s a beautiful thing, it’s really comfortable. The next time you’re in Europe you should really see it but it’s expensive. So, it’s not going to sell a great deal but what it is, is it’s sort of setting the high level for which we will then cascade. The learnings that we’ll get from that we’re going to cascade through the rest of the line.

Operator

Your next question comes from Bob Drbul – Barclays Capital.

Bob Drbul – Barclays Capital

I guess the first question is on the business itself domestically versus internationally if you back out Cloud how are the numbers ex Cloud?

Dale E. Williams

As Mark said earlier Bob, we gave some specific information about Cloud in the fourth quarter because it was brand new. It’s not our practice to give product specific or product line specific information primarily for competitive reasons. But, as Mark mentioned, our US business ex Cloud is doing well, our core business is doing well it showed good growth in the first quarter and that’s why we believe the Cloud is largely incremental. So in combination it is doing very well.

Certainly the Cloud is a key driver of the outsized performance of the US business and internationally, what we’re seeing there is very pleased with the progress of the international business but I would just remind people that the international market got in to the recession later than the US market did. We would expect it to come out later than it did and it’s tracked roughly a quarter or so behind the US business on its recovery.

But, I would also say that we don’t expect it to rebound quite as sharply as the US initially just because it is a much more complicated and diverse market and there are some countries in Europe specifically that are really struggling. We have some countries that have recovered very nicely, other countries are still struggling. It’s more of a mixed bag internationally but we’re very pleased to see 15% constant dollar growth over there.

Bob Drbul – Barclays Capital

On the industry itself, is there any way to quantify just how long you believe the consumers have pushed out the replacement cycle? Sort of how much of this is pent up demand and sort of how much of it was sort of just pushed out demand?

Mark A. Sarvary

Frankly, the answer is not really. The thing I think that is going to happen is that there is some proportion of the lift that we’re seeing now in the industry as a whole is the pent up demand coming back. My personal belief is that this pent up demand is not going to be like a switch going back on. I don’t think there’s going to be a step function change. I think it’s going to be a gradual overlay on top of the fundamental recovery. So we’ll see the normal recovery and so we’ll see the normal return to mid single digit growth and on top of that will be an overlay of pent up demand which I think is going to last a couple of years. I don’t think it’s going to be a blip. But, to be honest with you I don’t know how to split it more exactly than that.

Bob Drbul – Barclays Capital

Then just one last question is in the release you talked about how your investments in marketing and R&D are driving the sales but given the strong gross margin results this quarter, your approaching your long range target of 50%. How should we begin to think about potential upside to the target and how that could be used to reinvest in to actual product?

Mark A. Sarvary

As you said, the 50% was our long range target and I should reiterate it still is our long range target. When we set it we did not anticipate quite the speed of the growth in the last couple of quarters and also some of the things that we projected about commodity prices are coming a little bit more kindly so far. We still think 50% is the right long term target. The way we think about the structure is as time goes on we’re going to move the functionality from our top line products down to the lower line products while maintaining the margins thereby making available greater functionality to the middle and lower end of our product range which is why some of the more expensive products that we’re doing like the Cloud Luxe and [Promesa] are ones that we’re using as sort of experimentation to learn and develop technologies that we will then roll down.

The place that we’re going to continue to invest though is in marketing and advertising. We’ve said this year we’re shooting at 9%. Obviously, this is below the gross margin line but it’s a big area and the other one is R&D. We spend a material amount on that and it does pay dividends and we will continue to do so.

Operator

Your next question comes from Analyst for Budd Bugatch – Raymond James & Associates, Inc.

Analyst for Budd Bugatch – Raymond James & Associates, Inc.

Dale, in your commentary regarding the outlook you mentioned that you expected international sales to be down sequentially in Q2 kind of consistent with typical seasonality. You didn’t mention expectation for the domestic business. I think normal seasonality there would suggest lower sequentially as well but with the continued success of Cloud and maybe benefits from the May price increase, should we expect domestic sales to be flat, up, down? How do you look at Q2?

Dale E. Williams

I think that’s a good thought there. Specifically I would mention international because obviously international is more marked seasonality from 1Q to 2Q. Traditionally the US business has a very modest seasonality. I think with the price increase and the continued roll out of the Cloud I think flattish is probably a more reasonable expectation there.

Analyst for Budd Bugatch – Raymond James & Associates, Inc.

I know it’s early but is there any way for you to sort of compare the pace of the roll out of the new entry level Cloud product, what we’ve seen since February with the early weeks and months of the Cloud Supreme, is it a similar trajectory, slower, faster, any color you can give us there?

Mark A. Sarvary

It’s going very well. It’s going as well, maybe a little bit better than we thought but we think of it a bit differently than the Cloud Supreme which is sort of the absolute center point of the product line, it is the sweet spot. We think of the Cloud entry level and the Cloud Luxe together and the way we think about it is that over – by the end of this year and maybe just in to the first quarter of next year, the combination of those two will have collectively gained us an extra slot so that essentially we’ll have two slots from Cloud, one for the Cloud Supreme and another one from the combination of these two. So the roll out is going quite quickly by comparison to previous roll outs but we never expected it to go as fast as the Supreme in the first place.

Analyst for Budd Bugatch – Raymond James & Associates, Inc.

The last question maybe if you could just comment a little bit about the opportunity that you see in Canada in terms of maybe either market share or opportunities with key retailers there. What are you expectations for that business and what sort of time frame should we expect before we see some real contribution there?

Mark A. Sarvary

We obviously are pleased to have acquired what was a subsidiary because it’s a good business, it’s a good opportunity and we think there’s potential growth there. We think that by investing in marketing we can build on what is there already and grow the business over time. In the short term we think it’s going to be this year mildly accretive but in the long term, in the two to three year time frame we think there is quite a nice opportunity there. But, it’s too early to put an absolute number on it.

Operator

Your next question comes from Keith Hughes – SunTrust Robinson Humphrey.

Keith Hughes – SunTrust Robinson Humphrey

You said several times on the incremental nature of the Cloud. How do you measure that out in the business? How do you look at it?

Mark A. Sarvary

As you also notice we never put a specific number on it because it’s hard to be absolute about it. But, fundamentally what we do is we can watch the trajectory of the other products in the portfolio and see how they’re affected by the introduction of the Cloud. So what we can tell is we can project what the sales would have been without it and what they are now and we can deduce by making corrections what we think the underlying growth of the industry and so on is.

Keith Hughes – SunTrust Robinson Humphrey

So there’s no incremental change with the products around the price points?

Dale E. Williams

Just looking at the change in directionality or absolute volumes of those products.

Keith Hughes – SunTrust Robinson Humphrey

Final question on the debt targets data, you mentioned one to two times, is that a number, debt to EBTIDA, is that a number that you’re going to hold fast to, is that something you could go above if business continues to do well? Just what kind of sensitivity do you have on that?

Dale E. Williams

Well certainly in the short term it’s possible that we could go above it on a temporary basis. Right now, that 1.5 to two times is kind of the zone that we feel like is a good place to be. Our credit facility has a three times limit, our credit facility goes until July of 2012 so we’ve got a fair amount of time left on that facility and we’ve never come close to any issues with that credit facility.

But given there’s still some global uncertainty we think it’s still a fair thing to keep a substantial cushion on that. We’d hate to see a double dip come and have gotten ourselves a little bit over exposed so we’re going to stay a little bit conservative there. As time goes on we could see a change in what that target level should be and certainly on a short term basis we could see it go up a little bit over to – for example we ended the year at 1.7 so we ended the first quarter at 1.9. we would expect that with this additional share repurchase and the projections that we just gave and what that means from a cash flow standpoint even if we spent the whole $100 million authorization in the next three quarters by the end of the year we’d still be comfortably in that 1.5 to two times range.

Operator

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

John Baugh – Stifel Nicolaus & Company

Two questions, first on the guidance methodology, you mentioned some changes and if you took the low end just annualized in the first quarter, if you did that you wouldn’t have the price increase coming on Cloud Supreme, you wouldn’t have obviously the Luxe introduction or the full roll out even of Cloud in Q1 I guess as marginal. So is your new methodology on the high end incorporating some of these assumptions or how do I think about the new methodology as it relates to these specific items?

Dale E. Williams

Basically the high end of the range that we have right now is assuming a return to somewhat normal seasonality. We don’t know that we’ll see the full brunt of seasonality yet but our expectation is that we’ll be getting close to normal seasonality. It has built in to it some general macro recovery. As we mentioned earlier, the industry data says at least for the first two months of the year on average it was up about 7% to 8% so we would expect that to continue.

It takes in to consideration what we’re spending on marketing and new products and their impact on the business. So that’s a pretty wide range now from 120 to 160 so we are trying to build some of those assumptions in to our forecasting model like we use to before the recession.

John Baugh – Stifel Nicolaus & Company

My second question is how do we think about the direct business? You’ve touched on that in the past of some of the things you’ve done and follow up on leads is having phenomenal results. What is sort of the run rate of that business annualized going forward or how should we think about it?

Mark A. Sarvary

We’ll look up the specific number but let me just comment on the direct business. First of all, it is up very nicely and it’s a function of a variety of things. We’ve obviously put a focus on it for some time now. Using the web, not just by itself but as a tool to help people prepare before they call in to speak to our reps on the phone has been incredibly affective. Then also by kind of tying in together some of the communication from the TV advertising on to the web has also been very effective.

But, kind of the most important thing to think about when you look at these direct numbers is that it’s increasingly obvious and important to understand that there really aren’t two different types of consumer, they really are the same person. So almost everybody who buys in a store has been on the web and most of those will have gotten a catalog at one time or another. Everybody who buys online is very likely to have been to a store.

The large majority of people with whom we communicate and get leads in our direct business, the majority of those people go and buy in a store. So it is growing, we’re very pleased with it but it’s important to recognize that it’s part of – you have to think of all the channels working together.

John Baugh – Stifel Nicolaus & Company

So Mark do you think it’s sustainable, and you’ve done it two quarters in a row with a seasonally strong fourth quarter close to $15, $14.5 million per quarter, is that sustainable as you look out?

Mark A. Sarvary

I would put the same exact assumptions that Dale said a little bit earlier when we were thinking about the high end of the guidance. The low end of the guidance assumes, as we have been for the last I don’t know six quarters, that the most recent quarter will repeat four times. The high end assumes number one, that seasonality returns which means that – first of all it assumes that this level, the level that we’re at will continue and won’t decline and that level has an implicit 7% to 8% industry growth in it.

It also implies that there will be seasonality coming back and it implies that our market share will be held through this level. But, those same things can be said of direct and frankly, I have the same level of confidence in that as I do in the overall business. I think there’s nothing in it which is a onetime event assuming that we’re returning to some sort of normalcy.

Operator

Your next question comes from Jack Murphy – William Blair & Company.

Jack Murphy – William Blair & Company

Just a few follow ups here, first on the cannibalization on the Cloud lines, what are your thought son the cannibalization on the second and third units? And, I think you mentioned earlier that you still believe that most retailers will carry two but in terms of the cannibalization versus the rest of the product architecture do you think there is much difference between the second and third versus what you’re experiencing with the first?

Mark A. Sarvary

Obviously we don’t know and obviously one would think just logically that having three products with this new unique material on top would have some degree of internal cannibalization. But, remember how we’ve designed these products, how the architecture in which the products fit. We have the three different lines for the three different ways that people feel which is the traditional Tempur, the HD Tempur and then this ES, the new soft material lines.

Within that we have the high priced, the entry priced and the middle priced. The idea very specifically is to aim at different consumer groups with each of the different products. So we believe that a entry level consumer will have a choice of a Tempur and a Cloud and a premium person will have a choice of a Tempur and a Cloud and they’ll choose which feel they like best. Our feeling is that it should be largely not cannibalistic.

Of course there is some cannibalism both with the existing line and with the Cloud lines but our belief is obviously in aggregate it will be incremental but so far we don’t see it. I don’t want to miss state this, of course there is some cannibalization, there’s bound to be. The issue is whether overall it’s incremental and so far we believe that it is.

Jack Murphy – William Blair & Company

Then just a follow up on advertising plans, could you talk about the kind of trajectory in terms of the year-over-year growth and advertising for the balance of the year? Then also, any comments on how you feel about how this product specific advertising went for you? Is that something that you’ll be looking to repeat and expand in the future?

Dale E. Williams

Let me answer the first part of that question and then I’ll let Mark answer on the advertising strategy. But from a spend standpoint, as Mark mentioned in this prepared remarks he said we spent about $22 million the first quarter which represents about 8.5% of the top line which is a little less than what our target was and that’s principally because the business was performing well and we couldn’t catch up which is a nice problem to have. But, we are really trying to get back to our 9% number this year.

Our plan over the next three quarters is to spend a little bit above 9% to get the full year to that 9% level. We have these projections so we’ll plan the advertising around the projections that we have. You will see an increase in the operating expenses of the business on a go forward basis related to upping that advertising spend rate to get back to the 9% for the year. You’ll also see an increase in operating expenses related to the Canada acquisition, just to throw that one in. we said that it’s going to be marginally accretive this year but there is a step up with taking on that acquisition here in the second quarter from an operating standpoint to go with that business.

The spend rates in Canada right now are at a little bit of a higher rate at each of the line items than what we spend in the US because they don’t have the leverage level that we have in the US. That’s one of the goals, to grow that business to get it to the US type level of spend. Mark, if you want to talk about the product specific advertising?

Mark A. Sarvary

We obviously track every ad that we have in terms of leads that are generated and lifts that we can measure. The bottom line is that the Cloud advertising has been quite effective and we’re pleased to say that the best and easiest measure of how it works is how we see spikes in people coming to the web which is what we believe the first step in people starting this process of getting to know the product and then going to a store and then ultimately buying. We see that it works quite well. We will continue to create new versions of this ad but frankly the original and the new Cloud one are both certainly working quite well right now.

Operator

Your next question comes from Henry Capellan – Oppenheimer.

Henry Capellan – Oppenheimer

I guess the first question was around the sales guidance I understand that it incorporates market growth of 7% to 8%, kind of consistent with the first two months of the year? Can you kind of walk me through what the other elements are to get to that kind of 23% to 28% growth? You said your market share you held it steady but I thought typically that the [inaudible] category was growing faster than the traditional inner spring business so I just kind of wanted to get a sense of what the drivers were there?

Mark A. Sarvary

One thing, I just want to frame this a bit as you’re thinking about it is one of the challenges has been throughout literally since the recession began that using percentages on a year-over-year basis is very difficult because when you compare this quarter of 2010 with the first quarter of 2009 it’s a very different comparison, a very different comp than the second quarter and the third quarter and the fourth quarter. So annualized percentages are very misleading which is why we have until recently been using just simply the last quarter in absolute terms and multiplying that.

That still is the fundamental way we’re operating. But, if you think about it, if you take that fourth quarter and say let’s assume that rate will continue, that’s going to be a modest decline in terms of rate for the industry for the whole year because the industry grew a little better at the end of the year last year. But, I think that it’s hard to think in rates. We certainly think in absolute terms. What we do is we’ve taken that and then applied seasonality to that and as we said market share.

Dale E. Williams

Let me just clarify the market share thing. What Mark said was maintaining the kind of market share that we’ve seen in the first quarter. Obviously with mattress growth in the first quarter of 55%, we don’t have the full quarter data yet but in the first two months the industry was up 8% so obviously we gained a lot of share in the first quarter. So Mark saying holding the share means the share that we have gained here in the first quarter, holding that through the year.

Henry Capellan – Oppenheimer

Then just in terms of you talked about increased traffic at the furniture retailers, to what degree is kind of sell through matching up with sell in? So are consumers taking away or purchasing the mattress just as quickly as you’re bringing them in or is there some level of kind of pipeline fill for the Cloud Supreme in the quarter that still needs to work itself through I guess?

Mark A. Sarvary

In general there’s very limited sort of channel holding of the inventory. But, the one thing that you do need to take in to account is there is a sell in of the floor models which is a onetime event which happens. There’s one per store basically so it’s not a vast number. But beyond that there’s no filling up of the industry or filling up of the channel that’s going on here. One thing I did say was I did say that retailers are seeing a stabilization of customers. I haven’t heard yet from most of our partners anything they would say is back to how it should be. It just a period of continuous decline and now that has seem to arrested and now it’s sort of stable is how I’m hearing it described.

Henry Capellan – Oppenheimer

Then you talked about commodity cost increase earlier this year. I was wondering if you had quantified that at all? And, what are your expectations for kind of that headwind through the remainder of the year?

Dale E. Williams

What we said is we saw commodity price increase in the fourth quarter in the high single digit range. We had a price increase here late in the quarter in the low single digit range, low to mid.

Henry Capellan – Oppenheimer

This is in addition to the first one?

Dale E. Williams

In addition to what we had in December. Our expectation is that we’ll probably see one or two more depending on what happens with oil and intermediate chemicals and overall demand for these types of chemicals. Certainly there’s a strong supply demand relationship in there also, it’s not just tied to oil. But, our expectation at this stage is that we’ll see some additional price increases, again still in the single digit levels but as the year progresses.

Operator

Your next question comes from Brad Thomas – Keybanc Capital Markets.

Brad Thomas – Keybanc Capital Markets

I wanted to just dig in a little bit more in terms of the Cloud line and how you’re thinking about the longer term opportunity in this softer line of products. Mark I believe you had previously cited saying that the consumer is about 50% of them prefer a softer mattress. At the same time when we look at your product segmentation now you have three buckets of three different firmness levels. How are you thinking about this longer term potential of this softer category? Should we think about it as potentially representing a third of your business or could it be greater than that?

Mark A. Sarvary

I don’t know if a simple a third is right but I know that a lot of people, as fact as many as half of people prefer soft beds, particularly people who like premium beds prefer a soft bed. So I think it is a very material group of people and I think that the way that we’re looking at all three of our current architecture lines is that we’re very specifically trying to create and make sure that our products, our mattresses meet the needs of a specific consumer. So that each one essentially earns its right to be in the portfolio.

Clearly, this addition of the soft line was a very big un met need within our portfolio. It was an opportunity for us which was quite bit. We believe that these first three products are going to capitalize on that and I am confident that over time we will continue to evolve and even more fully meet the needs of consumers and even grow it still further. I think there may be other opportunities like this but it’s not easy for us to big up an immediate one as big as this. But this is not the end of the game.

But, I think the important thing to recognize too though is that this is one of our four strategic objectives and the other ones are to make sure that people know about Tempur and the other one is to make sure that they’ve tried it and that it is available. It’s not a one dimensional approach. It was important to fill this need but it’s also important to make sure that everybody knows about it which is why we’re spending money on what otherwise seem as a new strategy which is to advertise a single line of products because it’s so important for people to realize not just that we make soft beds but that we make a variety of beds. Then, to make sure that we’re available in as many and as good a manner as the stores as we should be.

Brad Thomas – Keybanc Capital Markets

Then just a follow up from a practical standpoint as you speak about this roll out of the Cloud line, I believe that you mentioned that the Supreme is essentially fully rolled out. Should we think about that as being in essentially all doors as of the end of the first quarter? Then, how are you thinking about the door penetration on the entry level Cloud relative to the Supreme?

Mark A. Sarvary

We think for all intents and purposes the Cloud Supreme is in all the doors. I’m sure it’s not in every single one but for all intents and purposes it’s in all the stores. The way we think about the Cloud and the Luxe is that by the end of this year we expect one additional slot to be in every store. It might not be just at the end of this year just looking at we’ve brought forward the roll out of the Luxe a month so that gives us a bit more time. But, in the next 12 months shall we say we expect over that period to have one additional slot in every store. It may be a little faster and maybe a little bias towards the first six months of that period but that’s the way I would think about it, I would spread it over that period.

Operator

At this time there are no further questions. I’d like to turn the conference back over to today’s speakers for any additional or closing remarks.

Mark A. Sarvary

Thank you. We look forward to talking to everybody again in July when we’ll review the second quarter. Thanks for joining us again this evening.

Operator

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

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Source: Tempur-Pedic International, Inc. Q1 2010 Earnings Call Transcript
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