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Executives

Barry Hytinen - Senior Vice President of Financial Planning & Analysis, Investor & Media Relations & Competitive Intelligence

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

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

Analysts

Jason Campbell - KeyBanc Capital Markets Inc., Research Division

Mark Rupe - Longbow Research LLC

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Jessica Schoen - Barclays Capital, Research Division

Chad Bolen - Raymond James

Peter J. Keith - Piper Jaffray Companies, Research Division

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

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

Eric Hollowaty - Stephens Inc., Research Division

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

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

Tempur Pedic International (TPX) Q3 2011 Earnings Call October 20, 2011 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to Tempur-Pedic Third Quarter 2011 Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. Now I'll turn the call over to Barry Hytinen, Senior Vice President. Please begin.

Barry Hytinen

Thanks, Tyrone, and thank you to everyone joining us on today's call. Joining me in our Lexington headquarters are Mark Sarvary, President and CEO; and Dale Williams, Executive Vice President and 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 statement speaks only as of the date on which it is made. The company undertakes no obligation to update any forward-looking statements.

The press release, which contains 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 A. Sarvary

Thanks, Barry. Good evening, everybody, and thanks for joining us. Today, I'll provide an overview of our performance in the third quarter and an update on our strategic focus areas. Dale will then provide a detailed review of the financial results as well as our updated financial guidance.

We're pleased with our third quarter performance globally. Sales were up 30% from last year, and earnings per share were up 45%. Tempur continues to gain market share both in the U.S. and internationally, primarily as a result of our strategic investments in new products and brand advertising.

Gross margin improved 140 basis points year-over-year, a result of our productivity programs, favorable mix and fixed cost leverage. And the improvement in gross margin allowed us to maintain our commitment to significantly invest in marketing, while still expanding operating margin 220 basis points to 25.2%. Having said that, our gross margin in the third quarter was lower than in the second quarter, and Dale will provide more details on that when he talks about our financial results.

Now, I'd like to provide an update on our strategic initiative. Firstly, our commitment to ensure that there is a TEMPUR mattress and pillow that appeals to everyone. In our international markets, the Cloud launch is progressing very well. The line is now in distribution in all markets, with the U.K. being the last major geography to start shipping. Retailer and consumer feedback remain very positive, and we believe the Cloud Collection is highly incremental. We anticipate that our Cloud business will be an important contributor to our international markets' overall growth during 2012.

In the U.S., our rollout of the Contour Collection was completed on schedule, in advance of the Labor Day shopping period. This line is designed for those consumers with a preference for the original TEMPUR feel and offers an improved product with a broader differentiation within the line compared to the products it replaces. Again, we're very pleased with the response that this line has received both from retailers and consumers.

Additionally, in the U.S., we showcased our new Traditional Pillow line in August at the Las Vegas Bedding Show and began shipping this quarter. These new pillows supplement the very popular iconic TEMPUR-molded pillows. These are filled pillows, designed to appeal to consumers who prefer a more traditional pillow, one that is more huggable. A broader range is a key component of our strategy to ensure greater distribution for our pillow products.

Lastly, from a new product perspective, as I mentioned on our second quarter call, we have several new product concepts in various stages of development. Over the coming 12 to 24 months, we will introduce exciting new products that we anticipate will drive considerable growth and market share gains in the premium space by meeting the needs of large consumer segments that we currently do not address. These new products cut across all of our lines and geographies.

We're in the final stage of development for a new line we expect to introduce in January, at the Las Vegas show, that we're very excited about, and we look forward to showing it to many of you in person. As our investors understand, due to the competitive nature of future product introductions, we'll make no further comments on this topic during the call.

The next strategic imperative is making sure that everyone knows that they will sleep better on a TEMPUR. In the third quarter, we increased our marketing by over 55% to nearly $40 million, enabling us to build the TEMPUR brand and increase awareness of the breadth of our product range. In the U.S., our investment in marketing is paying off well. The Ask Me campaign continues to expand, most recently with the message that a Tempur-Pedic is available for a range of consumer preferences, from soft to firm and everything in-between.

We tested increased levels of advertising in 29 of our key markets, and there we saw an appreciable step up in sale in those markets. And we expect this -- we expect to expand this test during 2012. The North America business as a whole experienced 19% growth in mattress units, which we are confident is largely due to the effectiveness of our advertising.

We're also pleased with the return on marketing investment in our international markets. As a reminder, in 2011, we're implementing a strategic investment in advertising to raise awareness in several of our largest international markets, concentrated in the U.K., Germany and France, with additional investments in several smaller markets. We have seen an unambiguous lift in sales volume in those markets, and our retailers are enthusiastic about the consumer response. In addition, we're able to monitor the effectiveness of advertising by tracking web traffic during periods that we are on the air and again, we have seen a significant lift as a result of the investment.

Last, I would like to update investors on our goal of making sure that TEMPUR is available to everyone. This quarter, we opened approximately 150 doors, of which roughly half were in the U.S. And throughout 2011, we have gained spots with both the Cloud rollout in our international markets and with the Contour rollout in the U.S.

So in closing, we had a strong third quarter in a macro environment that remains challenging, both in the U.S. and internationally. The mattress industry as a whole is significantly below historic norms, is growing very slowly in most geographies and not at all in others. Nonetheless, we project significant growth for Tempur-Pedic in the fourth quarter and in the years ahead. We will continue to invest in technology, in product innovations and in building consumer awareness of the TEMPUR brand. We remain committed to becoming the world's favorite mattress and pillow brand.

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

Dale E. Williams

Thanks, Mark. I'll focus my commentary on the third quarter financial results.

In total, third quarter net sales were $383 million, an increase of 30%. On a constant-currency basis, sales were up 26%. North American sales increased 30%, and international sales were up 28%. On a constant-currency basis, our international sales increased 15%, reflecting the positive response to investments in marketing and new products. By channel, in North American retail, net sales were $257 million, an increase of 30%. Internationally, retail sales were up 37% to $86 million.

On a product basis, total mattress sales were up 28%, driven by an 18% increase in units. North American mattress sales increased 28% on a 19% increase in units. The increased average unit selling price reflects favorable price and mix, partially offset by increased floor model discounts. In the International segment, mattress sales increased 31%. On a constant-currency basis, international mattress sales were up 18%, and mattress units increased 16%.

In total, pillows were up 12% driven by a 3% increase in units. North American pillow sales increased 5% on a unit growth of 2%. International pillow sales were up 21% on a 5% volume increase. On a constant-currency basis, international pillow sales increased by 9%. Sales of our other product category, which includes items that are normally sold along with the mattress, were up 42%, reflecting continued improvements on Ergo attach rates in the U.S.

Gross margins for the quarter was 52.4%, up 140 basis points year-on-year, but down 50 basis points sequentially. I am disappointed the margin rate was not up more. However, the reasons behind this are mostly transitory. While the underlying trends in our margin continue to be strong, in the third quarter we made some strategic investments, which lowered our overall gross margin. These investments include an IT system upgrade at our European manufacturing facility, new product launches, and a program that provides an opportunity for sales associates to purchase their own TEMPUR sleep system. All of these are supportive of long-term growth plans and provide a foundation for future growth.

At the same time, we are experiencing unprecedented levels of demand for our new product launches internationally. This demand, in combination with some productivity issues arising from the upgrade, resulted in unacceptably low levels of inventories in some international markets. So rather than risk extensive back orders and further impact to customer service, we began shipping products from the U.S. to Europe and incurred incremental shipping costs.

Despite this support from the U.S. plants and a significant improvement in productivity by the end of the quarter, our international business ended the third quarter with a record backlog. So to ensure the best possible levels of customer service, we will continue shipping to Europe in the fourth quarter.

Now let me give you a breakdown of the key drivers of our gross margin. On a year-over-year basis, gross margin improvement related to our ongoing productivity programs generating improved efficiencies in manufacturing and distribution, favorable mix and fixed cost leverage related to higher production volumes. Partially offsetting these benefits were higher commodity costs and floor model discounts related to new product introductions.

On a sequential basis, the modest decline in gross margin resulted from the impact of productivity issues related to the Danish manufacturing facility, higher commodity costs, floor model discounts related to new product launches and the retail sales associate program. Partially offsetting these items were improvements related to our ongoing productivity programs and fixed cost leverage.

Looking at operating expenses, we increased our advertising investment by 170 basis points, reflecting our commitment to ensure everyone knows they would sleep better on TEMPUR. On our sales growth, we do have 80 basis points of operating expense leverage despite our increased investment in brand awareness. Our operating margins expanded by 220 basis points to 25.2%. Interest expense was $3.3 million. Net income was $61.9 million, up from $44.2 million last year. EPS was $0.90, up from $0.62 last year.

Now I'll turn to the balance sheet for a brief review. We generated $75 million of operating cash flow and have $103 million of cash on our balance sheet. The majority of our cash balance is in our international markets. Receivables were up reflecting higher sales, while our DSOs were down approximately 3 days from the third quarter of last year and flat sequentially. Inventory decreased 3 days sequentially, principally reflecting the completion of the initial distribution of the Contour line in the U.S. Our inventory days were down considerably more in the international markets, especially so for our new products.

Turning to our share repurchase program. Through open market purchases, we bought 1.34 million shares during the quarter at a total cost of $80 million. During the first 3 quarters of 2011, we bought back 4.25 million shares for a total cost of $240 million. Our funded debt-to-EBITDA ratio decreased modestly to 1.36x, despite an increase in debt outstanding deployed to purchase stock. As we said before, our target leverage ratio is 1.5 to 2x versus our debt covenant of 3x.

We continue to view the share repurchase program as an excellent means to return value to shareholders over the long term. So we are pleased to announce that our board has expanded our share repurchase authorization by $80 million. Reflecting the shares we purchased in the third quarter, we currently have $200 million available under this authorization.

Now I'd like to address our updated guidance for the full year. With our new outlook, we are balancing strong results through the first 3 quarters of 2011, while continuing to acknowledge the macroeconomic environment remains unclear. Industry conditions are volatile, and retail customers report that traffic is variable. Therefore, we are projecting the end of the year in a manner reflecting this uncertainty.

We currently expect net sales to range from $1,405,000,000 to $1,425,000,000, and we currently expect EPS to range from $3.12 to $3.17 per diluted share. Regarding our outlook for gross margins, in the fourth quarter we anticipate a modest increase on a sequential basis, as margins will remain challenged by incremental shipping costs related to rebuilding international inventories and a conservative commodity outlook. We expect interest expense for the full year to be $13 million. We anticipate the full year tax rate to be 33.5%.

We are lowering our share count projection to 69.5 million shares for the full year, which includes the net benefit from our repurchase activity through the third quarter. However, it does not assume benefit from the potential for a further reduction in shares outstanding. 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 companies 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] Our first question is from Mark Rupe of Longbow Research.

Mark Rupe - Longbow Research LLC

Dale, on the gross margin, I know you cited the 3 things but obviously, there's the one thing that's slowing into the fourth quarter as well. Is there any kind of framework you can give us that would provide the magnitude of what you were expecting in the third quarter and what this did to the gross margin in the third quarter, and then kind of the thought process in the fourth quarter? And then, I guess, then lastly on that, does it get resolved by the end of the fourth quarter?

Dale E. Williams

Just to be clear, you're talking about the productivity and shipping...

Mark Rupe - Longbow Research LLC

The Danish, yes, exactly.

Dale E. Williams

Yes, let me just put a little context on that. We upgraded our IT system in Dan-Foam, our Danish manufacturing facility. Our system there was old. It was several generations behind, so it was a major upgrade. With any major upgrade, you have occasionally some hiccups at the start, and quite honestly, we were very pleased with the new system. There was absolutely no issues around the new system. What we saw was the old system had several thousand customizations to it, which the new system did not have. And it primarily affected one element of the manufacturing operation, which was the cutting operation. So that operation became a bottleneck in the factory, which impeded the ability, temporarily, of the factory to produce at a normal rate. By the end of the quarter, that productivity was improved. We are producing more in the Dan-Foam factory than we'd ever produced before. We're also, because of the growing demand internationally, because of the advertising and because of the Cloud, though requiring more than we've ever produced in Denmark. And so we got into a situation of being short on inventories. We leave the quarter still well short on where we should be from an inventory standpoint to support the customer service levels that our customers have come to expect from us. So in the third quarter, the cost of the temporary productivity shortage in Dan-Foam and the cost of shipping product from the U.S. to Europe cost us approximately $2 million. In the fourth quarter, we're actually expecting that to cost us between $3 million and $4 million. Now we do, sitting here today, think everything's going to be back to normal by the end of the quarter. In fact, as I said, Dan-Foam today is producing at record levels. But we need to still ship from the U.S. and actually ship a little bit more from the U.S. than we did in the third quarter to be able to fulfill the backlog and to get the inventories to where we can have the proper service levels with our customers.

Mark Rupe - Longbow Research LLC

Okay. Very helpful. Okay. So the other puts and take on the margin from 3Q to 4Q, the product rollout stuff, is that by and large behind us with the exception of maybe the U.K.?

Dale E. Williams

Yes.

Operator

Our next question is from Brad Thomas of KeyBanc Capital.

Jason Campbell - KeyBanc Capital Markets Inc., Research Division

This is actually Jason Campbell filling in for Brad this evening. You mentioned some nice doors, door growth and slots growth. I was wondering, you guys have obviously been pretty popular lately. Is there anything you've done to change maybe your training or how you're really gaining a lot of these slots or the salesperson awareness of your mattresses?

Mark A. Sarvary

Well, the slot gains have been both in the U.S. and in international. And they have been -- you're correct, we have had solid growth in the U.S. We've had particularly good growth in international. And that's because, as we roll out the Cloud, a lot of our customers are moving from carrying essentially just the Traditional line of mattresses to carrying the Traditional and the Cloud and the Sensation, what we call the Collections. And this has given really quite a significant increase in slots. We've said before that we expect, over the full rollout of the Cloud, to gain a net of about 2 slots in international. So it really is, it is quite important. From a training point of view or training of the people selling in the stores, it's obviously crucial for people who are in stores, the RSAs, representing our products to know the product well. And Dale referred to the RSA program where we get people to buy the discounted rate, our products, so that they can sleep on them because we know that there's no better advocate than somebody who actually own a TEMPUR bed. And on top of that, we're putting a lot of extra emphasis on training and calling on stores. We continue to invest in people, what we call feet on the street, because again, there's no replacement for having somebody call on our store and talk to the people there and get to know them and explain how our beds differ and how they work and how people prefer them. And that's true in the U.S., and it's true in the major countries in the rest of the world.

Jason Campbell - KeyBanc Capital Markets Inc., Research Division

And just a quick follow-up, have you guys updated any of your longer term door slot goals?

Dale E. Williams

No, not from the last time that we published those. I would expect you may have an update on that in mid-February when we have our Investor Day.

Operator

Our next question is from Budd Bugatch of Raymond James.

Chad Bolen - Raymond James

This is actually Chad filling in for Budd who's traveling tonight. Question, I guess, kind of following up on the Danish production issue. Your international growth in local currency was very solid again this quarter at 15%, but it did moderate a bit versus the 18% that you put up last quarter. And I think if I remember correctly, the comp was a little bit easier. How much was there -- was the loss revenue impact from the production bottleneck? I mean, can you quantify how much it impacted reported sales for the quarter?

Dale E. Williams

So we certainly would have had better revenue internationally without the significant increase in backlog. We have -- you can see internationally that if you look at the pieces, retail did very well, direct did very well. The part that -- the one part of the business that was down, and down quite a bit sequentially, was third party. Now third party was related to really 2 things. One, the conversion of CRE [ph] from a third party to a subsidiary. It was a small impact. But really, the primary impact was as we were -- if you're familiar with Europe and the way Europe -- particularly the Europe side of the business works, July and August, during those months, one of -- there's always some country that's on vacation for the month. So third quarter internationally is heavily determined by September. That's the big quarter internationally, particularly in Europe in the third quarter. So as we got into September and demand was increasing significantly, what we would prioritize was the shorter lead time shipments, trying to make sure that we had all of our customer service levels covered. And so third party tends to be a little bit longer lead time, so it was -- we emphasized on the shorter lead time customer service items that we needed to protect the retailers on. So there was an impact. Like I said earlier, we had record backlog going into the fourth quarter. I don't want to quantify exactly how much revenue may have slipped from 3Q to 4Q because of that, but it was a fair bit.

Chad Bolen - Raymond James

Okay. Fair enough. And I guess you gave -- I believe you gave the door number consolidated, 150 door increase. Was it 75 and 75 -- international and domestic?

Barry Hytinen

Roughly correct, Chad. About half of it was in the U.S.

Chad Bolen - Raymond James

And then just one more housekeeping for me and I'll defer to others. U.S. furniture and bedding sales in the quarter?

Dale E. Williams

U.S. furniture and bedding sales, $242 million.

Barry Hytinen

Yes, $242 million.

Operator

[Operator Instructions] Our next question is from Keith Hughes of SunTrust.

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

As you look at the Cloud rollout in Europe, will we start hitting the kind of run rate pace you think you'll get too early in '12? Or will it take as the year goes along to get there?

Mark A. Sarvary

We think it will take -- it will take the year. In fact, ultimately, it will take more than a year. It takes time because not only does it takes time to rollout, it takes time for it to roll out to every -- as many stores in any given chain, and also for people to get used to it. But we'll see probably a faster rollout that we did in the U.S. because we're rolling all the models together. So it will be faster than the U.S. but it won't -- it's not going to be -- we have our expectation and the normal experience is that it will build over time. So it will build over next year.

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

Okay. And the product you're shipping from the United States to Europe to make up for the production issues you've had, is that primarily the Cloud or that include other models as well?

Dale E. Williams

It's primarily the Cloud, but there are a few other of the traditional TEMPUR products that are being shipped. But it is predominantly the Cloud.

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

And you do that out of Virginia?

Dale E. Williams

Actually, a lot of that production is coming out of Albuquerque.

Operator

Our next question is from Eric Hollowaty of Stephens.

Eric Hollowaty - Stephens Inc., Research Division

Just a real quick question on the remainder of the European rollout. Could you just refresh us on the -- what remains to be done? I believe you said the U.K. Has that started already? Or when do you anticipate that will be completed? If we could just revisit the update on that, that'd be great.

Mark A. Sarvary

The U.K. has literally started in the last few weeks, so it's just rolling, literally rolling out as we speak. And the availability -- it's now available pretty much everywhere. It's all intents and purposes everywhere, but it's rolling out. I mean, it still takes time for it to get to all the different customers.

Eric Hollowaty - Stephens Inc., Research Division

Right. And Mark, could you remind us on how large that market is vis-à-vis your other international markets?

Mark A. Sarvary

We haven't done that in the past, Eric.

Eric Hollowaty - Stephens Inc., Research Division

Okay. Not even on a relative basis?

Dale E. Williams

Well, certainly, the U.K. is a important market for us. It's one of the larger economies in Europe. It's also -- and we believe that the Cloud will do very well there. But in terms of breaking down, we don't break down our international business by country.

Operator

Our next question is from John Baugh of Stifel, Nicolaus.

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

Real quick on the gross margin guidance for Q4. Did I hear you right you said it was going to be up sequentially from Q3?

Dale E. Williams

Yes.

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

Okay. And yet you're going to incur more gross margin hit relating to the shipping costs and productivity there. So I'm curious, so even if I throw in, say, $3 million of costs for those items, $3 million to $4 million, the flow-through number I get on your guidance is about 25% to EBIT from the increased sales and you've been running closer to 30%, 35% for the year. You mentioned higher raw materials, higher ap. I don't know. Just put some color on what else maybe going on in there.

Dale E. Williams

Well, chemical costs are up, and we -- it would be nice to see some relief in chemicals. But until we see it, we're not going to count on it. So obviously, as we talked all year, chemicals costs are up this year. They went up at the end of the second quarter, so they're at a higher run rate than they were -- significantly higher run rate year-over-year than they were even in the first half, and sequentially, they're higher. We do have some additional step up in marketing planned for the business. And while we do expect those margins to improve from 3Q to 4Q, the improvement is going to be muted a little bit by increasing the transatlantic shipping of product to support rebuilding the inventory levels internationally. And we think that, we'll get through that as we get through the balance of this quarter.

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

Dale, where would that step up in marketing occur? Both here and international markets?

Dale E. Williams

Yes, predominantly internationally as we -- the fourth quarter is internationally the peak quarter for the year, which is different than here. Here, the fourth quarter is a little bit softer seasonally. But fourth quarter internationally is higher, so we'll be ramping up that spend internationally.

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

And I know you're not guiding anything on '12 yet, but is there any way to tip your hand about how you're thinking about marketing spend in '12?

Dale E. Williams

Well, we stepped up our marketing spend this year almost 200 basis points. As we get into '12, like we said, we're not providing guidance at this stage. We're just still in the planning process. From a marketing standpoint, you would think that we would at least maintain the percentage marketing rate that we're using this year.

Mark A. Sarvary

Yes, that's right.

Operator

[Operator Instructions] Our next question is from Joshua Pollard of Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

First, I want to ask a housekeeping question around how you guys are calculating the sales when they show up in North America versus international? The sales that were actually shipped from North America but were sold in Europe, did those show up in North America sales or international sales?

Dale E. Williams

International.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Could you say that again?

Dale E. Williams

International.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Okay. Great. My second question was, you also talked about the Danish issue. I'm trying to understand, and it wasn't clear to me, whether or not that will creep into 2012 and whether or not that changed your long term -- whether or not 2012 would be an anomaly to your -- some of your long-term goals of cutting additional costs out of the COGS line?

Dale E. Williams

Yes, sitting here today, we don't expect it to continue into 2012. Like we said, the thing that the U.S. is doing is trying to help support rebuilding the inventory levels internationally. Fourth quarter is, as I said just a minute ago, is the peak quarter in the year internationally. So at a time of record revenues and getting behind the eight ball, if you will, getting behind the curve, the U.S. is helping the Denmark plant get caught back up from a service level standpoint. We expect everything to be back to normal, Denmark able to support the international business as we go into next year. Though it might be a positive thing if it can't, because that would mean that demand further exceeds our expectations, because from a production standpoint, it is coming up to speed very quickly. And as I said, every week it's doing record production levels.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

So where's your capacity utilization in Denmark? And is there something that you guys are going to need to address as you think about capital expenditure for '12 and/or '13?

Dale E. Williams

Yes, right now our capacity utilization in Denmark is about 50%. Now you may say well why are you having trouble producing? Like I said, the system change caused one operation to become a bottleneck, so we're working to change the process around that one system to make it more efficient. And actually, we believe, once we get through this transition, it will actually be even much more efficient than it used to be. The other thing though is that capacity is a -- machine capacity of the overall plant, with the growth in demand, we're having to add shifts in Denmark. To add people requires finding people, the right kind of people that you want to hire, getting them on board, getting them trained and then getting them productive. So in a growth scenario, once you hit a point where you need to add a shift, you actually take a temporary backward step from the overall productivity standpoint as the new people come on and get trained and become productive themselves, and then you start to see the productivity go back up. But from an absolute capacity standpoint, we have sufficient capacity in Denmark as we ramp up employment to support the international business and international growth plans for many years.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

And if I could sneak one last one in there on your new product introduction and the effect that it had on gross margin. Could you quantify that? And also, give us a framework for thinking about how new products should consistently affect your gross margin? Mark called out 2012 in a year where you guys expect to have, even starting in January, another rollout. I'm trying to understand, as I think about the 2012 numbers, how I should expect that, obviously, to impact revenue but also the gross margin.

Dale E. Williams

Yes, the thing that -- I think the important thing to keep in mind is generally, because of the timeframe of how we introduce products, or have historically introduced products, there's usually always something that's rolling out. The thing that was unique this year was on the Contour rollout. It was an extraordinarily compressed -- word was escaping -- extraordinarily compressed timeframe. Because it was -- it wasn't a new product line addressing a new need. It was a product line replacing an existing product line. So therefore, the timeframe -- we rolled out to all the stores in basically 3 months. And so it was a very compressed floor model rollout, which was why we expected to have more than usual impact of floor model discounts in the third quarter. And we did have the floor model discount impact that we were expecting. That's a little bit of an unusual situation like the Cloud rollout internationally. You're seeing floor model discounts flow throughout the year as we roll out market-by-market. When we did the Cloud in the U.S., the floor model discounts were spread over approximately 18 months. Where here, we took roughly the same number of floor models and put them out in 3 months. So it was a very concentrated thing. As we get into next year, we have new product -- the next new product rollout. It likely would not be so concentrated because it would be a new platform as opposed to existing -- replacing an existing platform. Does that help?

Operator

Our next question is from Joe Altobello of Oppenheimer.

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

Just a couple of questions here. First, in terms of competition, did you guys see any impact from iComfort at all in the quarter? It doesn't seem like that was the case given the strength in North America, but wanted to see if that was -- if you were seeing any there. And then secondly, on that same front, what kind of distribution has that product gotten? I mean, has it overlapped with yours at all?

Mark A. Sarvary

So we're not going to talk specifics about a specific competitor. As we normally don't. But obviously, we -- there is always competition in the industry, and there are a series of competitors all of whom have over time introduced products that are comparable to ours. We've had a growth rate of 30% in the U.S. this last quarter, so we're quite pleased with how it's going. We anticipate -- one of the things that's happening that we see is that the growth of the specialty market is very significant. Obviously, we're very -- we're pleased with our role in helping it grow. The specialty market is very, very significant, and all indications are that it will continue to do so. So we're not surprised to see other people come in, but we see enormous potential for growth. We see enormous potential for growth, but kind of the big driver of that is the proportion of the market, the proportion of the users. That will be specialty in general, and TEMPUR in particular, consumers. We see growing for some time.

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

Okay. That's actually helpful. Then secondly, in terms of new products, you mentioned earlier we're going to see a number of them over the next 12 to 24 months. Is there a particular price point that you feel is an opportunity? And on that same front, would you consider an entry-level price point below Contour? Or are you guys committed right now to the premium end?

Mark A. Sarvary

I'm not going to talk about specific products, but I will say this. As I said in the prepared comments, I really don't want to talk in specifics about new products because we're going to talk in great detail in just -- in January about it. The thing I'd say though is that we have taken the position that -- we have a product plan that literally goes out for 3 years, 3.5 years. And we have product launches scheduled out for 3.5 years, in the U.S. and internationally. And what's quite exciting is that each of these areas are -- or each of these product platforms are ones that address consumer needs that we have been able to identify that are materially incremental to what we already supply. And so we're quite excited about it. And we see this as something that -- one of the things that we have continually done as well as investing in advertising is invest in product development. And invest not just in product development, as much as material and technology development, so that we're in a position to make products that meet different consumer needs. And so it's really quite an exciting time right now, and you will see the first wave of that in a couple of months.

Operator

Our next question is from Peter Keith of Piper Jaffray.

Peter J. Keith - Piper Jaffray Companies, Research Division

I want to just get a little more color on the mix benefit that you highlighted that impacted gross margin. If we look back to Q2, I think that was highlighted as the #1 gross margin driver. Here, it looks like it was a little bit behind the manufacturing efficiencies. I was wondering, was there a slight deceleration in the overall positive impact? And could you just provide a little more color on what drove the overall benefit?

Dale E. Williams

The mix continues to be very good, but we also started lapping when we started rolling out the Luxe last year. So through -- we started shipping the Luxe in the third quarter, second half of the third quarter last year. So it was providing significant positive mix, uncontested, if you will, throughout the year. And then in the third quarter, it started lapping itself. So you get a little less mix from the Luxe, but the Luxe continues to perform extraordinarily well. We also expect from a mix standpoint, and whether you want to call it price or mix, it's actually a combination of the 2. The Contour versus the TEMPUR Original line -- 3 products replacing 3 products, a little bit higher price for the new Contour line than what it was replacing. That's a combination of mix and pricing going on, but you don't see the full impact of that in the quarter because of the floor models -- significant floor models going out on the Contour.

Peter J. Keith - Piper Jaffray Companies, Research Division

Okay. That's helpful, Dale. There's a gross margin-related question on the commodity costs. I'm guessing there's been some step down in your overall chemical costs over the last 3 months since you last spoke to us. I guess, could you help us think about how that might look over the coming quarters? And when, if the current prices were to hold, when we actually might see commodity cost headwinds go away and maybe potentially turn into a -- even a slight tailwind?

Dale E. Williams

Well, our commodity costs are up in the third quarter from what they were in the second quarter, which is what we expected. But with a little moderating and staying moderated for a while. The upward pressure on our commodity costs seems to have eased, but we're not seeing reductions yet. Hopefully, those will come. And it's hard -- it's something that's hard to predict because it's not just related to what's the price of oil. The price of the commodity chemicals that we buy is -- can be related to the percentage mix of if it's produced by oil or natural gas. But it's really heavily influenced by supply and demand, and there are a lot of things that factor into supply and demand. And we would be hopeful to -- if oil stays at a moderated level, to ultimately see some give back on the commodity increases that were driven by oil running up earlier in the year. But until it happens, we can't predict it.

Operator

Our next question is from Jon Andersen of William Blair.

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

Europe is a bit of a blind spot, I think, for U.S. investors -- for us clearly, and you had good organic growth there in the quarter. But the growth did decelerate sequentially on a somewhat easier comp. And I guess taking out the impact of the productivity issue in Denmark, we would have expected, I guess, some acceleration there. And I'm just wondering if you could talk a little bit about bigger picture what you're seeing in Europe in terms of industry trends, and if you're seeing trends fairly stable or deteriorating, and any commentary in the premium segment would be helpful.

Mark A. Sarvary

Well, I mean, firstly, I mean, I think there are 2 big messages now, a bit of detail. The first message is our business in international is going quite nicely and in Europe in particular, where we're investing in advertising. We're quite pleased with those results. The second big message is the market. In those 3 -- the mattress market in the big geographies where we're investing is not good. There has been quite -- I mean, obviously, the macro environment is not good and the industry is not good. So we're growing despite a significant headwind. And it continues to respond well. We -- this investment in advertising was predicated on the fact that we have very good distribution in many of the largest geographies, but relatively low awareness. And the hypothesis that we -- the fact that supported our investment, our decision to invest in Europe was that if we could raise awareness, then we should be able to lift sales levels. And we can now say that, that really does work and has worked and will continue to work, and we'll continue to invest behind it. So this quarter was impacted to some extent by delivery constraints. But overall in a difficult environment, we're doing quite well. Now from a macro point of view, you read the same newspapers that I do. It's -- every day, we wonder what's going to happen in Germany and in France and the U.K. and Spain and so on, with what's going on. So there's bound to be some macro effects, but the fundamental and long-term opportunity we're very confident about.

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

That's helpful. One last question on gross margin. I think you cited kind of mix is a positive, I believe, in terms of its influence on gross margin year-over-year and sequentially. I kind of thought that you had a very strong organic growth rate, obviously, in North America in the third quarter and so much lower internationally. And I guess I was under the assumption that the international business tended to be higher margin for you. So would that not have been a headwind perhaps? Just more clarity on that would be helpful.

Dale E. Williams

Yes, mix can cover a number of things. It can cover the mix of the products. It also is a factor of geography mix. And yes, the growth in the U.S. versus the growth rate internationally gives you a negative geographic mix. You also have very -- we have very strong growth in direct, which gives us a positive channel mix. So mix covers a lot of different things. Absolutely, geography mix was a negative, but we look at mix across a number of different categories.

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

Okay. Got it. Actually one more if I could squeak it in. The acquisition that you made, I think it was a little under $5 million in the quarter. Was that buying in the Korean operation?

Dale E. Williams

Yes. We announced that as a subsequent event in our Q -- well, I think we announced it on the July call. So yes, that was buying in the Korean operation.

Operator

Our next question is from Jessica Schoen of Barclays Capital.

Jessica Schoen - Barclays Capital, Research Division

I was wondering if you guys could talk about the attached rates for the Ergo adjustable products for a minute? I know you said the attached rates did improve. I was wondering if you're still seeing a large difference between the U.S. and internationally and what you think accounts for that.

Mark A. Sarvary

Well, we don't give the exact number, but I will say that the Ergo rate continues to improve significantly in the U.S. And quite honestly, no sign of slowing in that. That's a very positive thing. It's something we're putting a lot of emphasis on. We've got advertising that's running specifically associated with it. We've got training specifically associated with it, but it's no doubt it continues to grow. And we really are getting -- but internationally, it's growing too, and we believe that we can get a very significant growth rate there too.

Jessica Schoen - Barclays Capital, Research Division

Okay. But it's still -- in the U.S., would you say it's still lagging or...

Mark A. Sarvary

You can't overwrite international as a whole -- I see what you are saying. Sorry, I misunderstood the question. There are parts in -- there are some countries in Europe where attached rates are very high. But on average, it's still higher for us. The attached rate is higher for us in the U.S. then it is on average in international.

Jessica Schoen - Barclays Capital, Research Division

Okay. And then my second question was about the improved efficiencies of the manufacturing and the impact on gross margin. And how much longer you think those could still continue to positively impact it, if there was still a long ways to go or if most of the improvements were in place.

Mark A. Sarvary

Well, that's certainly not the way we're planning. No, I think we do believe there is efficient -- we -- sort of fundamental to our plan is that we build in an expectation of efficiency improvements every year, and we have a 5-year plan that we've been working on and which every year we update. So no. We believe there are productivity improvements that we can see for a long way to come.

Operator

Our next question is from Mark Rupe of Longbow Research.

Mark Rupe - Longbow Research LLC

Just one follow-up here. I know it's a small piece of the business, but the U.S. Pillow business, is there anything funky going on in the quarter? I know you guys have a new rollout coming, but it looks like it didn't grow nearly as fast. I know the comp was hard from last year. But is there anything going on there with the new rollout, maybe people waiting for that or anything?

Mark A. Sarvary

I mean, it is a slower growth. If you look at it on an absolute level, it still was a record sales of pillows this past quarter. But it's compared to a big rollout last year of one big customer that we had. So we're up against what you would call a funky comp. Having said that, we believe that the growth of pillows is a big area of focus, which is why we are putting emphasis behind it. Why these new products are just rolling out now are very important. We believe there is potential growth beyond what we've been getting.

Mark Rupe - Longbow Research LLC

Okay. And then -- just real fast on the kind of the 29 markets that you cited that you tested some heavier spend. Was the duration of that during, I guess, 2011, how significant it was? And then is 29 the number? Is there a potential to do more than that in '12 and beyond?

Mark A. Sarvary

That was an extended experiment -- no, not experiment -- an extended monitor test. And through the bulk of the year, it was very good, very conclusive and we will definitely expand it. We're going to do it thoughtfully, and we're picking our markets one by one, but there'll definitely be more than 29 next year.

Operator

Ladies and gentlemen, this ends the Q&A portion of today's conference. I'd like to turn the call over to management for any closing remarks.

Mark A. Sarvary

Well, thanks again, everybody, and we look forward to talking with you again in January when we review the fourth quarter and the full year. Thanks for joining us this evening.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect, and have a wonderful day.

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