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Tempur-Pedic International Inc. (NYSE:TPX)

Q4 2007 Earnings Call

January 24, 2008 5:00 pm ET

Executives

Barry Hytinen, Vice President, Investor Relations and Financial Planning & Analysis

H. Thomas Bryant, President and Chief Executive Officer

Dale E. Williams, Executive Vice President, Chief Financial Officer and Secretary

Analysts

Edward Yruma - JP Morgan

John Baugh - Stifel Nicolaus

Albert Kabili - Goldman Sachs

Joe Altobello - Oppenheimer

Bob Drbul - Lehman Brothers

Robert Straus - Merriman Curhan Ford

Budd Bugatch - Raymond James

Laura Champine - Morgan Keegan

Joel Havard - Hilliard Lyons

Tony Gikas - Piper Jaffray

Keith Hughes - SunTrust

Jack Murphy - William Blair

Operator

Good day, everyone and welcome to the Tempur-Pedic Fourth Quarter 2007 Earnings Results Conference Call. As a reminder, today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Barry Hytinen, Vice President, Investor Relations.

Barry Hytinen

Thank you for participating in today’s call. Joining me in our Lexington headquarters are Tom Bryant, President and CEO; and Dale Williams, CFO. After prepared remarks, we will open the call for Q&A.

Forward-looking statements that we make during this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements, including the company’s expectations regarding sales and earnings involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company’s business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating and other factors discussed in the press release issued today.

These factors are also discussed in the company’s SEC filings, including the company’s annual report on Form 10-K under the headings, Special Note Regarding Forward-Looking Statements and Risk Factors. Any forward-looking 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 is posted on the company’s website at tempurpedic.com and filed with the SEC.

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

H. Thomas Bryant

Thanks, Barry. And to our listeners, thank you for joining us this evening. Tempur Pedic delivered an outstanding year with sales up 17% to $1.1 billion and EPS up 36% to $1.74 per share. By executing our business strategy throughout 2007, we were able to achieve the goals established at the beginning of the year. The company delivered growth across all product lines, both domestically and abroad.

In the retail channel, we substantially improved account productivity while expanding floor space. We introduced several new products around the world, which have been received well. And most important to our long-term objectives, we improved brand awareness, increased market share, and expanded capacity by opening the world’s largest mattress factory.

In addition, we maintained the profitability of the business while absorbing the increased cost of starting up the Albuquerque plant. In the fourth quarter, despite a slowing US economy, Tempur Pedic delivered a solid quarter with sales up 13% and EPS up 44% to $0.52 per share.

During the quarter, we gained market share reflected by mattress sales and unit growth. Gross profit margin ascended to the highest quarterly levels of the year, although modestly below our prior expectation due to channel and product mix.

Turning to channels, our worldwide retail business was up a strong 17% in the quarter. Our retail business growth was driven primarily by increasing brand awareness, established account productivity, and slot expansion. Reflecting our market share gains, sales in the US furniture and bedding channel were up 17% in the quarter, while doors in this channel were up only 5% year-on-year.

In the US, we opened approximately 80 net new furniture and bedding stores in the quarter. This brings the US furniture and bedding door count to 6,350 versus our long-term goal of 7 to 8,000. The other part of our US retail business is what we refer to as specialty retail, which includes pillow-only stores and the US department store channel among others.

Specialty was down slightly in total and impacted by disappointing pillow sales during Christmas. As we have discussed, pillows are sold at a higher gross profit margin. As pillows did not meet prior expectations, gross profit margin was impacted.

Turning to direct channels, sales in our US direct-to-consumer business did not meet our expectations. As we have discussed before, the direct business skews to a less affluent consumer demographic than our retail business. As a result, we believe the macro environment had a more pronounced impact on this business.

Internationally, retail was also the key driver of the business. We added approximately 70 net new retail doors during the quarter, bringing the international door count to 4,990. We are also pleased with the modest gains in our international third party business, given the conversion of Australia and Austria from third party distributors to subsidiary markets within the last 12 months.

While retail was strong in the quarter, we also saw nice growth from our healthcare channel. Reflecting continued success from our strategy within this channel, US healthcare was up 39%. While the base is still small, we believe there’s significant long-term opportunity in this channel.

Turning to 2008, we entered the year with confidence and a degree of caution as a result of the uncertainty in the US economy. In 2008, our aim is to build on the progress we made in 2007. We will continue our effort to expand market share driven by growing brand awareness. Expanding floor space will also be an important focus as this is a key driver of market share.

Our new advertising campaign will continue to be implemented in the US and rolled out across many of the international markets. Based on our analysis of the best ways to reach our target demographic market, we are pleased to announce that beginning next week consumers will see Tempur Pedic advertising on national network television during times when our best potential customers are tuned in.

We will be expanding the Welcome to Bed campaign to high rated primetime shows, network news, daytime and late night talks. We expect this to nicely complement our existing short form, national cable, and long form advertising. In addition, we believe expanding product offerings will help Tempur Pedic continue to substantially outperform the industry.

We plan to unveil several new mattress and pillow models around the world during 2008. For example, next week we will introduce a new mattress model in the US, the AlluraBed by Tempur Pedic. This model, featuring our world renowned Tempur-HD will have a suggested retail price point of $3,999 for a queen size mattress.

Internationally, during first quarter our high end mattress models the Royale and the Scandinavian Supreme will be expanded into the majority of our major markets. These products were well received in their pilot launches. These exciting product positions and upgrades are only the start. We have several concepts under development in our R&D labs. We are committed to bringing more high quality products to the market faster, which is reflected in the 60% increase in our R&D spend over the last year. We are confident in our ability to design compelling products for the unique consumer preference that exists around the globe and view this as a key competitive advantage.

From an operational perspective, we have had several initiatives underway to improve productivity and drive margin gain. These initiatives cut across all the areas of our company, including manufacturing, distribution, and sourcing, as well as staying lean in terms of operational expenses. We have experienced strong productivity improvement in our factories and see more opportunities for continuing this improvement. As a result, we anticipate expanding operating leverage will help drive earnings per share growth.

Speaking of productivity improvements and projects to improve operational excellence, I’d like to provide you with an update on the progress we have seen at our Albuquerque facility during its initial year of operation.

We are very pleased with the output and productivity of our newest plant. In the past, we have suggested that the capacity at Albuquerque would need to be expanded in three or four years to meet our $2 billion net sales goal. As we have said before, we expect this to be our most productive plant. After one full year of production, capacity at Albuquerque is higher than previously estimated, and in fact we no longer anticipate requiring significant additional capital for plant expansion to meet our $2 billion net sales goal.

We enter 2008 with a solid operating and financial position. We have a diverse business model and a growing assortment of compelling products. Because our products are sold in over 70 countries, our financial performance is geographically diverse. Our go-to-market strategy of building brand awareness and focusing on premium price points has proven to be a competitive advantage. We are focused on the long-term growth opportunities and will continue to invest in new products, marketing, and research and development.

In summary, we are very confident in the long-term prospects and look forward to what we expect will be a very successful new year. At this point, I will turn the call over to Dale to review the financial results in more detail. Dale?

Dale E. Williams

Thanks, Tom. Let’s take a look at the quarter in a bit more detail. Since Tom focused his commentary on the channels, let’s start with products.

Mattress sales grew 14% in total, which is quite strong, especially considering the 21% mattress sales comp last year. Worldwide mattress unit growth was 6%. Domestic mattress sales were up 11.4% and units were up 9%.

As Tom discussed, direct sales were down which has the effect of muting our blended average unit selling price. Despite this headwind, we are pleased to see average selling price up, both sequentially and year-over-year, which is consistent with the pricing actions we have taken this year.

Pillow sales were up 6% in total, 3% in the US and 8% internationally. Other products, which typically accompany a mattress sale, grew 14% in the quarter. The international business continues to do a great job selling complete sleep systems, which is driving this product segment.

Gross margin for the quarter was 48.8%. That is down 60 basis points compared to the prior year, but it was our best quarter of the year in terms of gross margin performance. On a year-over-year comparison, this includes approximately $2.5 million of depreciation cost related to Albuquerque. As Tom mentioned, gross margin was modestly impacted compared to our prior expectations due to channel and product mix.

Operating income was $67.7 million, or 23.4% of net sales. Operating income was positively impacted by leverage of SG&A expenses despite continued expansion of our investment in R&D. Fully diluted earnings per share was $0.52, compared to $0.36.

EPS in the fourth quarter of 2007 was positively impacted by a one-time favorable tax rate reduction. This related to the elimination of valuation allowances or net operating loss carry-forwards in two foreign tax jurisdictions.

In these two cases, the subsidiaries have demonstrated an ability to generate positive taxable income over a sustained period of time. Accordingly, the company is no longer reserving for the tax net operating losses. This change resulted in slightly less than a 1% reduction in the company’s full year effective tax rate as compared to the company’s third quarter year-to-date effective tax rate. EPS in the fourth quarter of 2006 was reduced by a $10.7 million pre-tax charge to income for a loss on debt extinguishment.

During the quarter, we purchased 700,000 shares of common stock at an average price of $30.18. Under its existing share repurchase authorization, the company has $280.1 million available for repurchase.

Speaking of repurchases, let me pause for a moment and highlight the amount of capital the company has returned to shareholders during the year. As we have said many times before, we are focused on maximizing shareholder value. During 2007, we repurchased $320 million of stock and paid dividends of $24 million.

Recapping the year from a sales perspective, we delivered strong performance, up 17%. It was a balanced year with US up 17% and the international business up 18%. From a channel perspective, retail was up 21% worldwide. Though a small base, our medical business was up 12%, driven by 25% growth in the US.

From a product perspective, mattress sales were up 18% driven by 12% unit growth. Unit growth was very strong in the US, up 15% with 18% sales growth. Total sales were up 12% in total, 14% in the US and 11% internationally.

Now, I would like to address our guidance for full year 2008. And as Tom mentioned, we are mindful of the uncertainty related to the US economy. In addition, we recognize that the most recent industry projection for total mattress growth in 2008 is for flat to slightly down unit volume with approximately 3% sales growth.

That said, we are building the company for the long term. We have invested substantial capital to expand our capacity. We are building brand awareness. We’ve extended our global footprint. And we have invested in research and development to be the leader in innovation. These reasons are why we believe we are well positioned to capture market share even in challenging times.

For sales, the company currently expects full year net sales to range from $1.195 billion to $1.250 billion, an increase of between 8 and 13%. For earnings, the company currently expects diluted earnings per share for 2008 to range from $2.03 to $2.20, an increase of 17 to 26% compared to 2007.

We are using a share count of 77 million shares and a full year tax rate of 34.5%. As has been our custom, this guidance does not assume the benefit from additional share repurchases. Regarding the repurchase authorization, if the company decided to be more active in the market than free cash flow would allow, the company would need to raise debt as the company’s U.S. revolver is largely utilized as of year end.

Turning to operational performance, as Tom mentioned, we are working on numerous opportunities to drive margin expansion. In total for the full year, if we achieve the low end of our sales guidance, we currently anticipate operating margins to be up at least 50 basis points.

At the high end of our sales guidance with incremental volume, capacity utilization, and more SG&A leverage, we currently anticipate an opportunity to see operating margins improve by as much as 100 basis points. This outlook includes the negative impact of up to $4 million more stock-based compensation expense related to FAS 123R.

Regarding interest expense, our average interest rate is variable at approximately LIBOR plus 125 basis points. Internationally, the company is out of debt. The company’s EPS guidance does not assume we would repatriate cash from our international subsidiaries to repay U.S. debt.

The company would like the investment community to be mindful of this factor as it relates to interest expense. With approximately $600 million of variable rate US debt, we will continue to monitor developments on the rate curve. It is conceivable that we may choose to fix a portion of this debt sometime in 2008, depending on how rates trend.

Regarding CapEx, the company expects full year CapEx of $20 million, consistent with our prior projection. It is the company’s practice to only provide annual guidance and we are not deviating from that practice. However, we remind the investment community that it is the company’s traditional practice of incurring heavier marketing expenditures as a percentage of sales in the first quarter of each year.

While things can always change, I would like to spend just a moment reiterating our long-term goals, which we currently measure through 2012. We expect the business to be $2 billion in net sales by then, and we anticipate operating margins of 25% or more. We remain very focused on improving operating performance and maximizing shareholder value.

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 for questions.

Question-and-Answer Session

Operator

We will take our first question from Edward Yruma with JP Morgan.

Edward Yruma - JP Morgan

Hi guys. Thanks for taking my question and congratulations on a good performance in a tough environment. I know you try to shy away from it, but could you talk a little bit about your intra-quarter trend? Did you see a more pronounced macro impact toward the back half of the quarter?

H. Thomas Bryant

This is Tom. We saw a definite slowdown, and this was reflected in our retail accounts feedback that we received as well in terms of traffic. But from Black Friday on, throughout December and the Christmas season, there was definitely a slowdown in comparison to the early part of the quarter.

Edward Yruma - JP Morgan

Did you see any trade down in terms of your mix, or was there more weakness in the higher end lines or was it kind of broadly distributed as the macro pressures intensified?

Dale E. Williams

Yeah, this is Dale. No, we did not see a trade down. If anything, we might have seen a little trade up. But essentially, we saw business just kind of slowdown a little bit at the back half of the quarter. And we had the top end of the business continue to do fairly well. The lower end of the business did fine. But if anything, there may have been a little trade up.

Edward Yruma - JP Morgan

Got you. And then, one follow-up if I may, and I’m sorry if you’ve already touched upon this. But have you seen any material impact on your raw material pricing? And do you have any of that expectation embedded in your ‘08 estimate? Thank you.

H. Thomas Bryant

The answer is that we are anticipating commodity prices will go up and we have some early indicators of that for this year. And we factored that into the guidance.

Operator

We’ll take our next question from John Baugh - Stifel Nicolaus.

John Baugh - Stifel Nicolaus

Good afternoon. The inventory number looked a little high. Could you discuss that and whether the timing of the price increase on the three SKUs had anything to do with that?

Dale E. Williams

There were actually four factors that drove inventory being a little bit high and we, I would agree that inventory is a little bit high. When you get the K, you’ll see in the inventory data that raw and in process inventory was up about $6 million from the prior quarter.

We made a decision as a company during the quarter to increase the amount of raw and in process materials we have related to covers and things that caused the shortages in the third quarter. And it took us until essentially the end of October to get caught up on the backorders.

So we consciously raised the level of raw goods, particularly related around covers and netting that we hold, because of the shortage issues that we had. That was about $6 million of the roughly $25 million increase from the third quarter.

On top of that, the second item, we had about $7 million of higher inventory related to our new adjustable bed system. We’re transitioning our adjustable. We’ve got a new supplier, a higher quality product at a better price. But the source of the product is coming from Asia, so we have a longer supply chain.

We had to bring in quantity to fill out our warehouses, to get the product in a position where we could start selling it in the market. And that caused us to increase inventory on our new adjustable system. So, that’s over half of the increase from quarter-to-quarter.

We did have a plan to increase modestly our inventory going into the first quarter. We look at our inventory on a day’s forward basis. The first quarter we usually see an increase in volume, so there was a little bit of a planned inventory there. But then, when business slowed down a little bit in the back half of the quarter that caused us to end up with a little bit extra inventory than we had planned.

John Baugh - Stifel Nicolaus

Okay. And then, your comment about the extra capacity that you seemingly have at Albuquerque. I guess there’s some implied CapEx ceiling for the next, what now, four or five years, what should I read into that statement?

Dale E. Williams

Yeah, basically, John. Again, this is Dale. We’ve been saying that we expect to spend on a CapEx basis roughly $20 million, give, or take a little bit, year-to-year in maintenance and general growth capital. What we had said is that at some point in the next three years or so we might have to spend an additional $20 to fit out another line in Albuquerque.

What Tom was saying earlier was based on a year’s worth of production, and the way we always said that we thought Albuquerque would be our most productive and most efficient facility. And based on what we’ve seen in year one of operation of Albuquerque, we believe that the inherent productivity and capacity level of Albuquerque will be sufficient, that we will need to even put that additional line into Albuquerque before 2012.

John Baugh - Stifel Nicolaus

And then quickly, what would be, the stock a lot lower than the average price you bought it in at, any commentary on the desire to add additional leverage to buy in stock, assuming it stays in the low 20s?

Dale E. Williams

Well, that’s a Board decision. We’re not here to speak for the Board tonight. Obviously, we’ve bought a lot of stock over the last couple of years. We’ve said that our intention is to continue to return value to shareholders. This repurchase, when we announced it was intended to be a cash flow based repurchase. That’s the marching direction that we have at this time.

Operator

Your next question is from Albert Kabili with Goldman Sachs.

Albert Kabili - Goldman Sachs

Dale, just a quick question on the sales trends. You mentioned the weakness going on through the back half of the fourth quarter. Can you give us an update on January and how that’s progressed so far?

Dale E. Williams

Yes, January as you know we’re seeing ongoing business levels that are decent. It’s not the big surge of demand that we saw last year going into January, but we’re seeing decent levels of business and all that’s been factored into our guidance ranges.

Albert Kabili - Goldman Sachs

Can you give us a sense of door count growth in ‘08? How you are thinking about that?

Dale E. Williams

Yes, we don’t give specific plans in terms of door count, now we ended the year at right about 6350. Our plan is still to get somewhere between 7 and 8,000 doors. The only color we’ll give there is, we expect to add some doors in 2008, just like we added some doors in 2007. It’s at a slower pace, but we’ll continue to add doors and it’s just not something we want to give a specific number on, because it’s going to be as 2007 was, little bit more sporadic.

Albert Kabili - Goldman Sachs

Would a 4% to 5% growth number be in the ballpark at least?

Dale E. Williams

That could be a reasonable expectation.

Albert Kabili - Goldman Sachs

Okay. And then on the advertising cost, you mentioned the national advertising. Is that change, how we should be thinking about advertising cost as a percentage of sales this year? Is that going to go up or trend about where we’ve been seeing it?

H. Thomas Bryant

No, our objective, this is Tom. Our objective has been for number of years that to maintain about a 10% media cost to revenue, and that’s the thinking that we built into our guidance that will allow us to continue to invest in marketing, while we’re growing our topline.

The other thing, I would point out is that we also feel that this particular advert, the ads that we will be running in the outlets, the networks, specifically in primetime TV, will be much more productive use of the dollars as well, but that’s an important piece.

Albert Kabili - Goldman Sachs

You highlighted the opportunity of productivity savings and just wondered if you could give us a little bit more color on where we’re going to see those and maybe an absolute dollar target ballpark that we could be thinking about.

H. Thomas Bryant

Well, I can give you a little bit more color around where we expect to continue to see those improvements. And a lot of them are around our manufacturing facilities. Dale mentioned Albuquerque becoming much more efficient and productive, but all of our facilities have been showing improvement in terms of our yields, our productivity, which obviously helps some of the absorption and takes the cost down on each mattress that we put through those facilities.

From a sourcing standpoint, our sourcing department, they have particular challenges that they will be implementing throughout the year. They’ve done a great job of taking costs down in a lot of areas and in some areas just maintaining the costs when we’ve seen commodities go up in certain areas.

So, if you look at it from an operational standpoint, it’s really across the board and as we’ve mentioned on our overall expenses, we’ll continue to operate a very lean operation.

Operator

We’ll take our next question from Joe Altobello with Oppenheimer.

Joe Altobello - Oppenheimer

Hey, guys. Good afternoon. The first question in terms of inventory levels, obviously, you guys have touched on your inventory levels, but can you give us a little bit of insight into where you feel like your retailers are? I mean, how many weeks do they typically hold and where are they at this point?

Dale E. Williams

The retailers, they operate pretty much on a JIT system. A lot of them don’t have a great deal of storage space. And so, what they like to do is to have the product come in on a weekly basis, and we have most of our retailers set up, so we can ship to them once or twice a week. So there’s just not a lot of inventory in the pipeline at any given time.

Joe Altobello - Oppenheimer

Okay. So it sounds like, there’s not a big concern about any inventory glut at this point, given obviously the slowdown you’ve seen since Black Friday?

Dale E. Williams

No.

Joe Altobello - Oppenheimer

Okay. And secondly, in terms of your guidance for next year, the sales guidance, I just want to make sure, how conservative you guys are being. The 8% low end of that range, does that assume a U.S. recession, or if we do go into a recession, would you expect sales to fall below that level?

Dale E. Williams

Well, I mean, that’s hard to say. When you look at revenue guidance, we have a lot of different models. Certainly, we took into account a slower economy. I suppose, I’m not an economist, but I hear debate on the nightly news about whether we’re in a recession now or not.

But there are many factors that we consider. What’s the general economy doing? What’s the industry saying it expects to do? What do we think the high end consumer is doing? What’s the level of penetration of new products, new store adds? We continue to gain market share as the market transitions to the new technology. What’s the pace of that change? All of those things are factors that are a lot of times independent variables that can give us wide ranges of outcomes.

We just felt like in this economy, who knows if the stimulus package that was announced at 4 o’clock today or whenever it was announced will have some impact. So it’s hard to say that we’re assuming a recession or we’re not assuming a recession, because there are so many independent variables that you could have high growth in a weak economy just if the transition or the pace of a shift from springs to visco speeds up.

Joe Altobello - Oppenheimer

Okay. So it sounds like the low end of your guidance assumes things sort of stay at current levels at this point.

Dale E. Williams

The low end of our guidance assumes a lot of different variables, but, yes, we’re assuming a generally weak economy.

Joe Altobello - Oppenheimer

Okay. And then, lastly, I’m not sure if you talked on this specifically, but in the past you’ve talked about ‘07 being trough for gross margin. Given what’s gone on, obviously, the macro side plus the mix shift that you’ve seen, is that still the case, or could we see gross margin dip a little bit again in ‘08?

Dale E. Williams

Now we would expect gross margins to improve. I said in my comments that at the low end of the guidance, we’d be looking to get 50 basis points of operating margin improvement. At the higher end of the guidance, as much as 100 points of operating margin improvement. That’s going to be largely attributed to gross profit.

Operator

We’ll hear next from Bob Drbul with Lehman Brothers.

Bob Drbul - Lehman Brothers

As you look to 2008, you seem like you have several new mattress and pillow launches scheduled. And I guess historically you had talked about one new pillow and one new mattress launch. Is your thought process changing around the product launches as we look at this environment at all?

H. Thomas Bryant

I wouldn’t say that the environment was a factor in terms of the launching of the product. I think there are a couple of things. One is that we’ve in the past, to your point, we’ve indicated that our objective is to introduce one per year. But, from time to time we have introduced more. So, it’s not first time that we’ve introduced the couple.

Also, if you look at the sheer number of products, the larger number of new products we’re launching in the international market, the only one that we’ve announced here in the U.S. is the one that we’re launching next week that we mentioned in the prepared remarks.

So, the other products that we have unique demands in different geographic areas of the world. For example, in the Scandinavian countries the product that we are selling there is unique to that area. But then, if that product does well, we may launch it into other countries. So, some of the products we’ve had in limited distribution as sort of a pilot test in Europe, and now we’re expanding into some of the other larger countries.

Bob Drbul - Lehman Brothers

Okay. And then, the next question I have is you talked about the slowdown before Black Friday and after Black Friday. Can you maybe give us an idea, like the rate of change from the first part of the quarter and versus the second half of the quarter? And just how dramatic the slowdown was from like a percentage basis on the run rate of the business?

H. Thomas Bryant

I think all that we would say about that is that we saw a slowdown and that it was definitely a pre and post, if you will, Thanksgiving. And that seems to be pretty prevalent throughout the retail sector. So, I don’t think it certainly didn’t seem to be just related to furniture and bedding stores. It seems to following Black Friday a lot of the retail traffic, mall traffic, slowed.

Bob Drbul - Lehman Brothers

And then, another question on the inventory. As you work through the higher than optimal inventory levels, is it to the standpoint that you’ll need to stop some of the production to get this better aligned or like, how will you, from a manufacturing standpoint, really adjust the levels to get them to sort of the current run rate of the business?

Dale E. Williams

Well, Bob, we won’t have to stop production or anything. Basically, we’ll just trim back the rate of production or not expand production as quickly as we had planned.

Bob Drbul - Lehman Brothers

And then, just my last question is on the entry into the department stores. Can you maybe just give us an update now that you’re into it for some time in terms of the learnings that you’ve had as you’ve gone into that channel?

Dale E. Williams

We are actually still evaluating it. As we said I think on our last call, we were going to take this initiative very slowly in terms of any additional expansion. We’re still at this point in the evaluation mode. And we’ll see exactly how well the department store channel will do with our products and some of the unique issues surrounding the individual stores and how they sell the product.

So at this point, there is no change in terms of our go-forward strategy. We’ll continue to watch it closely and at some point in the future we’ll make a final decision. But, I don’t think anything has really changed since our last call there.

Operator

We’ll take our next question from Robert Straus with Merriman Curhan Ford.

Robert Straus - Merriman Curhan Ford

Hi, guys. Nice quarter given the environment that we have here. On the international front, Tom, could you just remind me, which are the mattresses that are currently in a rollout phase?

H. Thomas Bryant

We have one that’s called the Royale, which is a product that we’ve had in pilot tests in a couple of markets. We also have the Scandinavian bed system, and this is a product that is a little different than our typical mattress. This is also with a bed as well as the mattress and foundation, so the bed, it sort of substitutes the foundation. And that’s the product that we’ve had in a couple of the Scandinavian countries. So, those are products that we’ve gotten some pretty good feedback and read on in terms of consumer acceptance and are moving those into other markets.

Robert Straus - Merriman Curhan Ford

So the Scandinavian product is just in a couple of countries, correct?

H. Thomas Bryant

It has in the past, but now we’re rolling into all the primary markets and the same thing with the other one that we mentioned in the prepared remarks was the Deluxe HD.

Robert Straus - Merriman Curhan Ford

And how many countries is the Royale in currently?

H. Thomas Bryant

We just added it. It was more of a pilot in a few countries but this quarter we will be rolling it in and introducing into the other markets.

Robert Straus - Merriman Curhan Ford

Okay, and for both of these mattresses, how many countries do you think there will be in by the end of 2008, for example?

H. Thomas Bryant

Well, I don’t think we’ve given a specific target out. We don’t plan to give a specific target out, but the objective is to launch it into all of the subs. So, if you look at that outside the US now we have 17 countries that we have our own subsidiary. So, those operations will be charged with introducing and getting distribution in all of those countries.

Robert Straus - Merriman Curhan Ford

Okay, thank you for that.

H. Thomas Bryant

Absolutely.

Robert Straus - Merriman Curhan Ford

Last question, I think that your comments regarding macro trends really were on the domestic markets and if I am mistaken please correct me, but I was curious to know whether or not you saw certain macro trends in the international markets?

Dale E. Williams

In general, we had a strong quarter internationally. Certainly, it’s a diverse set of countries. You have some countries that are doing better than others at various stages of time and this quarter was no different. We had some countries that were stronger than others, but not any country that was having major issues or problems. Some had some tough comps, but we saw very good performance internationally.

Operator

We’ll take our next question from Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James

Good afternoon, and thanks for taking my questions. Dale, I think you mentioned three, you mentioned there were four reasons why inventory was up and I heard three of them. Well, you had the raw materials, the reverie issue, some additional inventory, but that’s $12 million at additional finished goods inventory, if I calculated it right, after you account for the adjustable units. What was the fourth bucket?

Dale E. Williams

You had $6 million of raw and in process around covers and netting, having extra of that because of the shortage issues that we had. You had $7 million in the new adjustable base. So, that’s $13 of the $24 million increase from Q3. The rest was really split between production plans to build, we look at inventory on a day’s forward basis. The first quarter, we usually see an increase in demand, so the production plans were to build up a little extra inventory on a day’s forward basis. And then, the fourth piece was the business softened after Black Friday and so we didn’t sell as much as we expected to sell.

Budd Bugatch - Raymond James

Got you. Okay. When I look at the $7 million of the adjustable basis, if I remember right that’s something I think for you all about a $30 million business, somewhere, a $25, $30 million business. What kind of turn are you looking for? Are they yet out at your dealers at this point in time, or what kind of inventory do you think you’ll keep on that going forward?

Dale E. Williams

It started to roll into, a few dealers had it in the fourth quarter, but not many. And really, the first quarter is where we’ll start getting that new base out into more and more dealers.

Budd Bugatch - Raymond James

Okay. And your basic inventory on that will be for what do you think is the run rate of inventory you’ll keep on that? What kind of turn do you think you can get on that?

Dale E. Williams

Well, given that we, it’s got to be on a boat for a while, and while it’s on the boat it’s in our inventory.

Budd Bugatch - Raymond James

Correct.

Dale E. Williams

So, you’re going to have roughly somewhere in the neighborhood of, something like that that we are having to ship from overseas. We would look to get four to five turns on at a start until we get a better gauge of volumes.

Budd Bugatch - Raymond James

Okay. Can you give us a characterization perhaps of the manufacturing profitability between Virginia and Denmark and New Mexico and maybe give us some, if there’s some way to quantify that, at least in this quarter?

Dale E. Williams

No, I mean, the structure of the plants are all very similar, a little bit different. The wage rates are pretty similar, at least in the U.S. plants, a little bit more expensive in Denmark. The biggest factor right now is the exchange difference. The Denmark currency is a lot more expensive than it used to be, but the productivity of the plants are very good and very strong and the...

Budd Bugatch - Raymond James

So, in local currency, they’re all running at about the same manufacturing profitability rate, or are, I would have thought that Duffield would be much more profitable than Albuquerque?

Dale E. Williams

Albuquerque had a very good year. Certainly, it started much less profitable than Duffield, but by the end of the year was right on its heels. And they both operate a little bit more efficiently than Denmark, but they’re both newer facilities.

Budd Bugatch - Raymond James

And on the overall financials, what was currency’s impact on sales and profits in the quarter?

Dale E. Williams

Pretty consistent with what it’s been all year. For the whole year currency was about 3% and we saw roughly that amount in the fourth quarter.

Budd Bugatch - Raymond James

And in your guidance, what are you looking for going forward on currency? Any major change? I mean, we’ve had…

Dale E. Williams

We’re not looking for any major change in currency. Our expectation, we looked at what currency did all throughout the year last year. In putting our guidance together, we assumed a similar currency situation this year.

Budd Bugatch - Raymond James

Okay. And finally for me, did you give pillow units percentage change? Did I miss that or don’t you normally do that?

Dale E. Williams

Yes. Pillows were up 9%. No, I’m sorry, that’s a year. I’m looking at the wrong piece of paper. Pillows were up 3% in the U.S.

Budd Bugatch - Raymond James

And overseas?

Dale E. Williams

They were down a couple percent.

Budd Bugatch - Raymond James

A couple being 2, 3, 4?

Dale E. Williams

The pillows internationally were down 4%.

Operator

We’ll take our next question from Laura Champine with Morgan Keegan.

Laura Champine - Morgan Keegan

Good afternoon. I’ve just got a few housekeeping things as well. The units for mattresses, did I hear for the quarter that they were up 9% domestically? And I didn’t catch the international units.

Dale E. Williams

Yes, they were up 1%.

Laura Champine - Morgan Keegan

Up 1% international and up 9% US. And then, did you give explicit guidance for CapEx in 2008?

Dale E. Williams

I said that I was expecting to spend about $20.

Laura Champine - Morgan Keegan

Okay. And in the, I know you’ve broken out the inventory increase in a number of ways because it was so big year-over-year. Can you give us an absolute dollar amount of the inventory that’s related to sales coming in weaker than expected in the fourth quarter?

Dale E. Williams

It was about $6 on a year-over-year basis, I know you weren’t with us a year ago. Fourth quarter of 2006 our inventories were about $20 million too low because we were out of inventory and out of capacity.

Laura Champine - Morgan Keegan

Can you talk about, you did mention switching to an overseas source for the adjustable foundations and what implications that has for inventory turns. What’s the cost implication as a percentage on those items?

H. Thomas Bryant

Well, we don’t give out that type of detail. But what I can tell you is that when we made the decision to change suppliers it was made for a couple of key reasons. One was we felt that we were getting a better product, a higher quality product, with some unique features that would help us increase the sales of the adjustable bases. And also, from a cost standpoint, the cost is substantially less. Our margins will improve on the new product, even taking in the cost of capital for the increase in the inventory.

Operator

We’ll take our next question from Joel Havard with Hilliard Lyons.

Joel Havard - Hilliard Lyons

Thank you. Good afternoon, guys. The comments, Tom, you made earlier about advertising, I went back and reviewed what you had said in the press release. You said something about sort of staying in that 10% of sales range, if I caught the comment right. With it being an election year, is that more TV oriented in the first half than in the second? Can you talk to us a little bit about what that would look like from a selling cost standpoint?

H. Thomas Bryant

Well, certainly, if the past is any indicator, the television time will get tight around the election this year. But what we’ve done in the past is that we simply changed some of the timing and also shifted some of our dollars into other outlets that we have also been productive, such as print, for example.

And of course, the internet has become a much more important piece of our overall marketing strategy as well. So I wouldn’t expect in terms of our objective of spending about 10% that that would be impacted by the election. It may be skewed a little bit in terms of timing, but not significantly enough where we would need to give additional color outside of the fact that we do expect to spend more in the first quarter of the year.

Joel Havard - Hilliard Lyons

I’m budgeting a little higher than that in our model here. I guess what I’m trying to get that to jive is that you’re going to push advertising a little bit more internationally, too. Is that really new dollars, or is the same as you’re talking about here where you’re kind of shifting the nature of the dollars around?

H. Thomas Bryant

There it’s simply the new advertising campaign.

Joel Havard - Hilliard Lyons

Is that the TV and print that you all unveiled a few months ago?

H. Thomas Bryant

Exactly, the Back to Bed campaign.

Joel Havard - Hilliard Lyons

Yes.

H. Thomas Bryant

So that campaign will just shift over into the international market, but the dollars that they were spending won’t change.

Joel Havard - Hilliard Lyons

Okay. So you’re just translating that campaign to the other languages?

H. Thomas Bryant

Right.

Operator

We will take our next question from Tony Gikas with Piper Jaffray.

Tony Gikas - Piper Jaffray

Hey, good afternoon, guys. My congratulations on the year as well. Most of my questions were answered, but maybe a few follow-up sort of housekeeping questions. I know you talked about ASP increases. I think you said 3% for ‘08. Could you talk about increase in number of doors and number of slots?

Second question, could you maybe just talk a little bit about the reasons for moving media to primetime advertising and maybe a little of the, I don’t know, research behind that decision to move? And does that affect TV ads later in the evening that you’ve seen historically?

And then, even as recently as last quarter you were still experiencing some shortages on a few SKUs. Have you alleviated those issues throughout the fourth quarter moving into the New Year?

Dale E. Williams

A number of questions there. I’ll hit a couple of them and I’ll let Tom hit a couple. In terms of doors and slots, Tony, we don’t give specific guidance on those, as we talked earlier. We do expect to add some doors, but not a significant part of the business anymore. We add a few doors here and there over time. In the fourth quarter, we added about 80 doors. So it’s a much more modest rate and it’s much more tactical and strategic in terms of where we’re adding doors.

From a slot standpoint, we don’t specifically comment on slots, but anytime we introduce a new bed we want to get in another slot. Certainly, depending on the pricing of the bed, et cetera, you may not get them in all stores, but over time our slots per door has increased and we expect it to continue to increase as we continue to gain more market share.

H. Thomas Bryant

And in terms of the advertising, just to pick up that from Dale, last year during 2007 we did extensive research projects throughout the country, a lot of focus group testing and target market analysis. And we determined that our advertising, specifically our long form advertising, for example, was not working very well towards the key demographic group that we wanted to reach.

So we looked at ways of better penetrating that target consumer and determined that the best way for us to do that besides changing our advertising campaign, which we’ve already done to the new Welcome to Bed campaign, was to go primetime network television. And that our research shows that the approach to reach those consumers will be very effective because we have a high percentage of our target market that we determined had never seen one of our ads, simply because they didn’t watch the infomercial. So that type of analysis led us to change the strategy.

And then, your other question was that we did get caught up, I think, Dale mentioned something about getting caught up towards the end of October on the shortages. And so, we’re in pretty good shape at this point and aren’t experiencing any backorders.

Operator

We’ll move on to Jack Murphy with William Blair.

Jack Murphy - William Blair

Thanks. Just wondering, if you could give a little more insight into your competitive position specifically in a slowing environment. When you look at the lower cost, but cheaper specialty manufacturers, do you see the lower relative pricing having any impact on you in a slower environment, maybe with rising unemployment? Or do you think people will gravitate more to the brand? And I’m wondering if even since Thanksgiving you’ve had any sort of insights around that relative behavior?

H. Thomas Bryant

We do believe that people will migrate to the brand and the quality of our product over the knockoffs. And one of the things that we’ve mentioned in the past that we continue to track, that there are a number of retail stores out in the market where we have exclusive distribution and we don’t have any of the knockoffs on those floors.

And then, obviously, there are a lot of stores out there that are carrying competing types of products. And we continue to do better where we have competition. So, I think, that certainly speaks well of when the consumer has an opportunity to compare, because there’s certainly a significant difference there.

Operator

Thank you. Ladies and gentlemen, we have exceeded the time limit for today’s call. I will now turn the conference back over to the company for any closing comments.

H. Thomas Bryant

Well, we would like to certainly thank you for joining us this evening. We look forward to talking with you again in April when we’ll review the first quarter. Have a nice evening.

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Source: Tempur-Pedic International Q4 2007 Earnings Call Transcript
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