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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

Anthony Gikas – Piper Jaffray

John Baugh – Stifel Nicolaus & Company, Inc.

Joseph Altobello – Oppenheimer & Co.

Laura Champine – Morgan Keegan

Albert T. Kabili – Goldman Sachs

Mark Rupe – Longbow Research

Keith Hughes – Sun Trust Robinson Humphrey

Budd Bugatch - Raymond James

Joel Havard – Hilliard Lyons

Analyst for Robert H. Ribble – Lehman Brothers

Robert Straus – Merriman Curhan Ford & Co.

Tempur-Pedic International Inc. (TPX) Q1 2008 Earnings Call April 17, 2008 5:00 PM ET

Operator

Welcome to the Tempur-Pedic first quarter earnings results conference call. (Operator Instructions) I would like to turn the conference over to Mr. Barry Hytinen, Vice President, Investor Relations.

Barry Hytinen

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 statements speak 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.

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

H. Thomas Bryant

In total, Tempur-Pedic net sales declined 7% to $247 million. As we previously announced, our production plans and operating expenses were incurred assuming a much higher sales level. As a result, earnings were substantially pressured and resulted in earnings per share of $0.18.

The primary area of sales weakness was in the U.S. The U.S. microeconomic environment deteriorated during the quarter and contributed to what we believe is the slow down in the mattress industry. Additionally, based on industry data and retailer feedback, we believe average selling prices in the industry are trending lower as many premium buyers prefer high-end mattress purchases. We believe these factors are the primary reason our domestic net sales were below prior expectations.

Our U.S. direct business was more severely impacted, down 45% to $10.7 million. As we have mentioned before, the U.S. direct channel generally serves a lower consumer demographic than our core retail customer. Therefore, we believe that it is likely that this sharp drop off in sales is caused by weakening consumer confidence and corresponding lower spending by DR consumers. While we planned for this channel to be down, it was worse than expected, resulting in gross margin deterioration, which Dale will speak to shortly.

The U.S. retail channel, while down less than direct, was also much weaker than planned. It was a decline of 14% to $129 million. Retailers reported much slower traffic trends throughout the quarter as consumer confidence weakened. In the U.S. we opened approximately 100 net new furniture and bedding doors in the quarter. This brings the U.S. furniture and bedding door count to 6,450 versus our long-term goal of 7,000-8,000.

Our medical business was up, reflecting continued progress with our partners, especially Hillrock.

Lastly, our U.S. third party channel delivered $4.3 million of net sales, an increase of $1.3 million, but that was coming off of a weak comparison in the first quarter of 2007. At this point it appears U.S. sales trends may have stabilized. However, we are mindful that the environment is unstable and we are not planning for a near-term improvement.

Turning to the international business, we saw weakening trends in many of our key European markets. While reported results reflect a 10% increase in sales to $99 million. This is driven by favorable foreign exchange rates.

On a constant currency basis our international sales actually declined about 3%. International retail sales were up 14% to $79 million. We added approximately 70 net new retail doors during the quarter, bringing the international door count to 5,060. International [inaudible] plans worsened in the second half of the quarter, which we believe is consistent with weakening consumer confidence throughout many of our markets.

With lower than planned sales and inflationary cost pressures, profitability was considerably impacted. A combination of large declines in the direct business, raw material cost inflation, and lower volumes resulted in lower gross profit margin.

In addition, first quarter operating expenses were planned and incurred to support a much higher sales level, which negatively impacted operating income. I will let Dale provide an explanation in a few moments.

Going forward, we are not assuming the sales environment will improve in the near term, therefore we have taken decisive action for allaying operating expenses and production plans with revised sales expectations. We have reduced our operating expenses, allaying variable costs with sales and reduced our headcount. The headcount reductions were approximately 10% of our total U.S. workforce, which we expect will result in about $2.5 million of annualized salary and benefit savings.

We are currently committed to our business model, our advertising strategy, and our premium product focus. Our new advertising campaign is helping to drive brand awareness. Our annual study of brand awareness indicates that our U.S. total awareness has risen to 89%, reflecting success of the new ad campaign. As our brand awareness continues to grow, we plan to offer consumers more product choices.

Over the next few quarters we will begin the most extensive new product launch in the company’s history. This launch will include new mattress models, advanced technology, and new pillow concepts, as well as an upgrade to the most widely-distributed mattress model in our line up. We anticipate this launch will well received by retailers and consumers.

For competitive reasons much of the lines will remain proprietary until the July Las Vegas trade show. However, we can tell you today as part of this initiative we are adjusting our entry-level strategy, while staying well above the $1,000 price point. Leading into the formal launch, this will result in close-out activity on the Deluxe and Symphony models, as well as selected sizes of the Original. Our new models will be available in July.

In summary, while we are very disappointed in the first quarter results, we generated position cash flow and reduced our net debt position. We are right-sizing the company to see us through the current head wind and importantly, be in the right position when the market turns.

We note that independent third-party research leads us to believe that high-end U.S. mattress shoppers are more likely to defer purchases as opposed to trading down in these economic times. Therefore, we are positioning the company to capitalize on this demand as consumers return to the market when the environment improves.

At this point I will turn the call over to Dale to review the financial results in more detail.

Dale E. Williams

Let’s take a look at the quarter in a bit more detail. As Tom focused his commentary on the channels, let’s start with products. Turning to sales results by product, mattresses were down by 9% driven by a 12% decline in units. Domestic mattress sales declined 18%, on a 20% decline in units, reflecting modest ASP improvement, despite the weakness in direct, which negatively effected ASP.

International segment mattress sales were up 12% on flat units. In a weak consumer spending environment, reduced levels of retail traffic pillows were impacted. In total pillows were down 9%, driven by a 17% decline in units. We experienced pillow volumes in both segments, with a 19% decline domestically and a 15% decline internationally.

Other products, which typically go along with the pillows and mattresses, declined less than mattresses and pillows. Other products declined 4% domestically and grew 16% internationally. These results were primarily driven by our increased focus on adjustable [inaudible] and tax rates across the world, which we are improving despite the economic head wind. We are please to see progress in this area as we focus on a complete fleet system.

Gross margin for the quarter was 43.7%, well below prior year and our expectations. The gross margin was impacted by several factors. Direct sales were much weaker than planned. Sales returns increased modestly about one point. Cost for raw materials were up sharply and with lower volumes, fixed costs in our plants were spread across a smaller sales base.

Operating income was $29.3 million, or 11.9% of net sales. Operating income was negatively impacted by de-leverage of SG&A expenses. As Tom discussed, our SG&A expenses were planned under the assumption of a much higher sales level. When sales trends deteriorated much of our cost structure was in place and we were unable to take action to mitigate de-leverage in the first quarter. For example, advertising spend is typically committed for at least two months in advance. Despite this we still managed to reduce some of our advertising expense in the quarter and in total ad spending was about 12% of sales, or 200 basis points higher than we had planned. Operating expenses also include a $600,000 charge for restructuring the latest in the headcount reduction on the staff.

As a result of the de-leveraging in P&L, diluted earnings per share was $0.18 compared to $0.35 for the first quarter of 2007.

Turning to the balance sheet, we are very focused on improving cash flow and working capital. We generated $25 million of cash flow from operations and reduced debt, net of cash, by $18 million from year end. I would like to point out that our revolving credit facility matures in 2012 and requires no mandatory principle payments until that time. We are executing on a comprehensive plan to improve cash flow and substantially reduce inventories.

Inventories were high at year end, as we noted on our last call. Our plan was to reduce them in the first quarter, however, with sales trends deteriorating, inventories grew modestly. Going forward, our operating plan anticipates a large reduction in inventory levels.

We have reduced labor in our plants and have decreased the manufacturing plans. We are also working to improve day sales outstanding and payable days to drive working capital. In addition, we have reduced our capital expenditure plan to approximately $14 million for the year versus our $20 million prior forecast. In the first quarter we spent $2.8 million on capex.

Now I would like to address our revised guidance for the full year 2008. For sales the company currently expects full year net sales to range from $1,010,000,000-$1,000,000,079, a decrease of between 9% and 3% from 2007. For earnings the company currently expects diluted earnings per share for 2008 to range from $1.20-$1.45, a decrease of 31%-17% compared to 2007. From a net sales perspective, at the low end, we are assuming U.S. sales trends to not materially change from what we experienced in the first quarter, while allowing for the potential that the international segment deteriorates modestly.

I would like to take this opportunity to note that based on our model, even at the low end of our guidance, we expect to be in full compliance with our debt covenant for the entire year. We are using a share count of 76 million shares and a full year tax rate of 34.5%. As has been our custom, this guidance does not assume the benefit of share repurchases. We remain focused on improving operating performance and maximizing share holder value. We are carefully monitoring business conditions and will be prepared to take additional action to protect profitability if necessary. 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 of the company’s control.

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

Question-and-Answer Session

Operator

(Operator Instructions) First up we’ll take a question from Piper Jaffray’s Tony Gikas.

Anthony Gikas - Piper Jaffray

Maybe you could just start out with has there been any change with April sales trends following the quarter? Also, maybe just a little bit more color on the entry level strategy. How many new products are coming there and maybe just a little bit about pricing. And then two questions on competition. Is the competition getting better in this category, with the physical product? Are they taking share due to their lower price points and do you see the competition taking more pricing action that might also be benefiting their business?

Dale E. Williams

In terms of the business trends, what we have seen in April is that the business needs to stabilize. Now it’s only about half way through the month but the trends in the business overall, as we look at the average for the first quarter, seems to have stabilized in April.

H. Thomas Bryant

In answer to our second question, in terms of the new products we’re not going to be in a position to give a lot of details, including how many models we plan to introduce in July. I would say that you can tell from our close out announcement that we are closing out two complete models and a couple of sizes in the Original. And then in July we will see a somewhat new strategy as it relates to the entry level price point for the company, but at the same time I would emphasize that we will continue to focus our attention on the $1,000 and above price point for the premium category.

I think your last question had to do with the competition and first of all, all of our testing that we do—extensive testing—you may recall about a year ago we invested a considerable amount of money in building a new test facility, not only for our products but for the competitors product. We haven’t seen any significant improvements in the competition. I think that most of our competitors are buying their Memory Foam, as they call it, from the same suppliers. We haven’t seen a lot of investment in new facilities or R&D.

As to what’s happening out there at retail, we have seen an increase in activity at the retail level in terms of incentives and what we have seen in the past is temporary and other types of discounts are going on. But from we’ve been able to tell, and our best indicator has traditionally been in looking at our own account base—those accounts with competing compared to accounts where we still have an exclusive footprint in the stores, and we still haven’t seen any type of change from the performance of those stores. That’s not to say that they’re not having some success out there, but we don’t know at this time and won’t know until we have better data later in the year as exactly how much calendarization is taking place within a lot of the inner spring brands themselves.

Anthony Gikas - Piper Jaffray

You talked about headcount reductions—approximately 10% of the work force. Could you characterize the headcount reductions in the production facilities?

H. Thomas Bryant

Yes. I don’t think we broke that out specifically. I think what we said was that we sort of did this across the board. About the only two departments that we didn’t touch were the sales group and our research and development organization, in terms of continuing to develop these new products. So I would say virtually every other department, and certainly the production, were impacted by this but I don’t think we broke out any specific numbers around that.

Operator

Next up we’ll take a question from John Baugh - Stifel Nicolaus.

John Baugh - Stifel Nicolaus & Company, Inc.

Can you discuss the sort of productivity run rate in the first quarter and what you see for the second quarter and the rest of the year as it relates to trying to bring inventory down, and I guess the offset would be either reducing ad spend or other corporate spending. But I’m just kind of interested in the interplay there, how that affects operating margins going forward.

Dale E. Williams

In terms of what we’re doing to get inventories down, we have significantly cut back production. We took out a shift in one of the factories, so we’re trying to get inventory right-sized for the business run rates that we have and it will probably take a couple of quarters to get it completely to where it needs to be but we’re trying to take a pretty good whack at it right now. And those actions, in terms of cutting back production levels, started in the first quarter. But that will give us some negative impact in terms of fixed cost leverage on the flow through—that’s built into our guidance expectations.

In terms of other costs, you know, we cut costs across the business. Discretionary costs, we have cut back advertising, we’ve cut back general marketing, we’ve cut back in terms of other corporate spending, we took out headcount out of the SG&A areas, so we’re trying to curtail costs and get costs in line with the profitability level that we feel is minimally acceptable to our standards at our lower volume level.

John Baugh - Stifel Nicolaus & Company, Inc.

And as a follow up on inventory: is there any breakout between the width and raw unfinished?

Dale E. Williams

I don’t have those right in front of me. The unfinished width tends to be higher than we would like.

John Baugh - Stifel Nicolaus & Company, Inc.

You said with the new product roll outs—and without talking about any specifics—would the plan be essentially a similar targeted gross margin, maybe at an average lower price, the two that you’re dropping and whatever Originals you’re replacing, or is there any color on the sort of expected profit margin of the new products?

H. Thomas Bryant

One of our goals has been, and continues to be, any time we introduce a new product, is to have equal or better or margin on that product. And that will be the direct that we go in with these new products.

Operator

Next up we have a question from Joe Altobello - Oppenheimer.

Joseph Altobello - Oppenheimer & Co.

First question is on the gross margin side. There’s a couple of different sort of cross ones here. You’ve got raw materials going up and I imagine in the peak now a lot of variable costs in your cost of goods, so in terms of the gross margin decline in the first quarter, would you expect the declines going forward to be greater or lesser than what we saw in Q1?

Dale E. Williams

Well, the anticipation that we have is that the gross margin impact that we saw in Q1, which was so severe, would be a little bit less as the year goes on, but we’re going to be taking—certainly cutting production does impact the fixed cost portion, from a fuel surcharge standpoint and fuel costs are through the roof right now so we’re paying heavy fuel surcharge on freight. You know, the chemical costs are in, so we’ve seen that, we’ve currently experienced it now. We would expect, as the year progresses, the productivity initiatives that we have in the business this year to gain more traction and to deliver more results. So we would, at this point, think that we would see some modest improvement in gross margins as the year progresses.

Joseph Altobello - Oppenheimer & Co.

And retailers, are they at sort of a disadvantage with your product, given that consumers are obviously moving down a little price points, or the retailer can offer your competitors’ products with a promotion whereas they sort of have their hands tied behind their back with your product so they can’t promote on that. Have they given you any push-back on that no promotion sort of dictum?

H. Thomas Bryant

No, they haven’t. I mean, obviously our partners—our retail partners—continue to promote and advertise in the local markets Tempur-Pedic and tying in with our extensive national campaign. But in terms of push-back or—for example, allowing them to discount the products the way they do competitors, we really haven’t had any push-back there.

Joseph Altobello - Oppenheimer & Co.

And then lastly, the international business, you know, ex-foreign exchange, it looked like it was not as weak as the U.S. but still relatively weak. Are the issues internationally similar to the ones you see in the U.S., where you’ve got just low consumer sentiment and a slowing economy?

Dale E. Williams

Yes. And as the quarter progressed and really in March we saw the international business weaken, you know, the UK, as a country—not that we’re going to get into details about individual country performance—but the UK has been the first economy in Europe to react or to share in the U.S. economic weakness and that really started last year. But as the quarter progressed we saw other markets in England/Europe start to have some impact as the economic weakness spread a little bit. We think that we have a good view of where it’s at and where it’s going, in terms of our business in Europe, but you know part of the reason why we are a little bit broader-ranged is at the low end, as we said, the low end of our range that we’ve now put out there does not assumed, certainly in the U.S. and all through Europe, to get a little bit tougher.

Joseph Altobello - Oppenheimer & Co.

And then last, if I could, two quick ones. Do you have plans for any share buy-backs, and progress on the new CEO search.

Dale E. Williams

I’ll take the first one. In terms of the share buy-backs, we have the credit facility and any share buy-backs we would do are somewhat limited by the current credit facility in terms of available capacity. In times of economic weakness and uncertain business environment I think the most prudent thing to do, not that we would rule out buying shares at any time, but at this point I think the most prudent thing to do is to make sure that we’re monitoring and completely confident in the liquidity of the business—which we are today. But it’s something we have to make sure is there. So share buy-backs would be a lower priority than they’ve been at other times in our history.

H. Thomas Bryant

And as far as your second question on the search, without giving out any details, I would just say the search is on schedule and progressing. And about where we expected it to be at this point in time.

Operator

Question now from Morgan Keegan’s Laura Champine.

Laura Champine - Morgan Keegan

Could you give a little more clarity on what is driving the 51% year-over-year increase in inventory, but also it’s a sequential increase. Can you give us what of that is attributable to higher raw materials prices, differences in your purchasing, lead times, and what just because of the sales declines.

Dale E. Williams

In terms of year-over-year, we were still trying to build inventory last year and we built inventory through the first—actually, we built it all year. We ended up ending the year with more inventory than we had planned and expected to have as business started to soften in the fourth quarter. We talked about that at length, the call discussing the fourth quarter results. Our plan at that time was to try to impact inventories in the first quarter, but as the business continues to deteriorate it’s hard to catch a rock rolling downhill.

So, the key thing in terms of looking at inventory is sequential. We were able to keep inventories-- with the revenue in the first quarter being down significantly from fourth quarter, we were able to keep it only a modest increase. As the business softened it was difficult to catch up to that but we feel that we’re now in a position to catch up and get inventories turned back the right direction this quarter. We’ve taken pretty drastic action there and we will get that corrected. On a year-over-year basis, it’s really not a reasonable compare with last year. We had shortages, we were trying to ramp up a new factory, we were trying to get inventories built to a higher level because they were too low.

Laura Champine - Morgan Keegan

Okay, so can you give us an idea of where we ought to see inventory levels at year end?

Dale E. Williams

Well, that partly depends on where the business volumes are running at that point in time and how that plays on a go-forward basis. We typically try to have roughly about 30 days forward of finished goods and a little bit more of raw and width on top of that. That we would expect our inventories to be potentially lower than they are now and more in line with where they were running throughout the year and the second and third quarter of last year.

Laura Champine - Morgan Keegan

And then just to get to your earnings guidance, because I’ve got to make pretty aggressive assumptions about margins improving from their depressed level in Q1, and you mentioned sales and marketing as an area of savings. How can you execute savings in sales and marketing at the same time you’ve got a major product launch coming in the back half of this year?

H. Thomas Bryant

Well, one of the things that we’ve said is we’ve always tried to do, is align our marketing with our revenue and growth. And we’ve talked extensively about trying to use media at around a 9%-10% of revenue as an investment. That still gives us substantial capital to put behind our brand and also I would remind the listeners that we don’t necessarily do product-specific advertising, so when we launch new products it’s not like we’re launching a new campaign. We have a branded strategy in terms of our advertising our message and that umbrella brand basically drives the overall model without having to stand specifically behind an existing product or a new product. So our plan is to continue to invest, still be the leader in the industry in terms of consumer advertising by taking it in the long-range. So we’ll continue that strategy.

Operator

We will move on to Al Kabili - Goldman Sachs.

Albert T. Kabili - Goldman Sachs

I guess the first question on the gross margins, if you could perhaps break down for us how much of the decrease was raw materials versus fixed cost absorption during the quarter.

Dale E. Williams

Well, there are a number of factors that impacted gross margins, not just those two. A variety of things that more or less—channel mix, you know, direct was down dramatically on a year-over-year basis, our U.S. direct business was down 45%, our global direct was down 41%. That’s by far the highest margin channel. Certainly we expected direct to be down but nowhere near those kinds of magnitudes and so direct was a very significant factor in the gross margins leverage.

Certainly factory fixed costs was a factor. The chemical costs were up double digits. We were expecting chemical cost increases, the increases came in a little bit higher than what we were expecting but we think that we can offset some of that as we go forward.

Sales returns were up about a percent, and as I said on the prepared remarks, and that’s a big factor in gross margins. Trying to understand why is the primary thing as we believe as the economy weakens and consumers had bought recently saw it as an opportunity to claw back some money. So all those factors contributed mightily to the gross margin erosion that we saw.

Albert T. Kabili - Goldman Sachs

And if I got that right, the chemical costs were up double-digits. And if you don’t assume that sales trends improve and you’re going to take down your production levels to get your inventory down below where you want it, what’s the offset on it to get the margins improved from the first quarter?

Dale E. Williams

Well, we have a number of productivity projects that are underway, things we are working on that we believe we’ll be able to use to improve our cost of production and offset some of these factors that will give us some margin improvement as we go forward.

Albert T. Kabili - Goldman Sachs

So this $2.5 million run rate savings from the work force reduction, that doesn’t sound like that would be enough to do it.

Dale E. Williams

That’s an opex, in fact. That’s not the savings related to labor. We didn’t separately quantify the labor costs, but certainly that’s a very small component of our costs of goods and variable costs. The $2.5 million is SG&A related cost savings for the people that were taken out of SG&A.

Albert T. Kabili - Goldman Sachs

And any way to quantify in terms of on the cost of goods on the production side of what the opportunity is on the cost savings, incremental to the first quarter?

Dale E. Williams

Basically what we’ve said already, we have a number of productivity projects that are underway, that are being worked, and we believe that the first quarter gross margins will be the worst margins that we have and we will see improvement from here.

Albert T. Kabili - Goldman Sachs

And then if you could just talk about the sales trends you saw throughout the first quarter. Did it continue to decrease throughout the quarter, can you just kind of give us a sense on the sales progression throughout the quarter?

Dale E. Williams

We don’t give a lot of color on quarterly progression of sales trends. We said on the call talking about the fourth quarter results that the first quarter did not start the way that we were expecting so it started weak and it continued to slow down--that we saw late in the year and things got a little bit worse, and then they seem to have been stabilizing now. From a stability standpoint it’s over the average of the quarter.

Albert T. Kabili - Goldman Sachs

Got it. So when you’re talking about stabilization in April you’re talking about from the average of the quarter, not necessarily from the low point, say in March?

Dale E. Williams

Correct.

Albert T. Kabili - Goldman Sachs

And then the final question is on the cash flow statement. I see there is a small $1.5 million acquisition, it looks like. I assume it’s an international distributor.

Dale E. Williams

Yes, we bought New Zealand. You know last September we bought Australia. We went ahead and bought a distributor in New Zealand to fold basically as a branch under the Australia business.

Albert T. Kabili - Goldman Sachs

It sounds small? Any quantification in terms of revenues?

Dale E. Williams

We did about $300,000 in the first quarter in New Zealand, up a little bit from prior years. But it is a small business; at that kind of price it’s not going to be a big business.

Albert T. Kabili - Goldman Sachs

Any pressure that you’re seeing from your retail customers in terms of pricing? As we’re going into a weaker environment, are you seeing pressure for increased expenses and volume discounts, anything like that?

H. Thomas Bryant

No, we’re definitely not. And I think probably the reason for that is that the majority of our retailers that we’ve been doing business with for a while, they understand our approach to the business and they understand that we are going to continue to invest capital behind the brand and driving consumers into the store, compared to discounting and looking at short-term initiatives that will damage the brand in the long term.

Operator

Moving on now to a question from Mark Rupe, Longbow Research.

Mark Rupe - Longbow Research

On the entry level strategy, just going back to that real fast. Outside of the fact that people are trading down and the economy’s kind of in the tank, is there any changes that you’ve seen in that market opportunity over the past three years since you’ve kind of entered it with the Original. Is there anything different that you’ve seen?

H. Thomas Bryant

No, I think that the—you know, the thing in market overall, just as a reminder, that the queen size mattress selling at retail for $1,000 and above, that that premium market has been the key driver of the industry for a number of years. It’s still a relatively small percentage, if you will, of the install base out there. And we think that there’s a lot of upside within that premium market. As a matter of fact, the research that we recently saw indicated that while the premium sector is about 25% of the install base, 46% of consumers surveyed, who intend to buy a mattress over the next five years, indicate that they will be buying a premium mattress.

Mark Rupe - Longbow Research

Right.

H. Thomas Bryant

So I think that a lot of the consumers’ perception around mattresses and price points and better night’s sleep and all of those factors will continue to drive the premium market. But as we said, we also believe that the consumers are deferring—the premium buyers are deferring compared to saving down, necessarily.

Mark Rupe - Longbow Research

Right. I didn’t know if there was a demographic issue going on at all. But, as it relates to retailers, the last time that the industry probably went through something this bad, the retail landscape was a lot more fragmented but yet a handful of power retailers kind of selling mattresses. Curious to see if there’s any kind of differentiation on the performance at retail right now between your furniture stores and you kind of your specialty bedding stores?

Dale E. Williams

Generally I think the bedding guys are not being impacted as bad, but from what we hear they’re all having difficulty. The business is down but the bigger bedding guys are probably, compared to the masses, performing a little better.

Operator

From Sun Trust, this is Keith Hughes.

Keith Hughes - Sun Trust Robinson Humphrey

You talked a lot about raw materials but as we head into the second quarter are you seeing more signs of potential raw material increases as you talk to your suppliers?

Dale E. Williams

Not at this time. Certainly it is something that we’re mindful of and watching and working, but we think right now we’ve got what we’re going to get. It doesn’t mean it can’t change but there’s no pressure as of the moment.

Keith Hughes - Sun Trust Robinson Humphrey

No pending increase is what you’re saying.

Dale E. Williams

Correct.

Keith Hughes - Sun Trust Robinson Humphrey

And if you do see more will there be an attempt to try to raise price on existing models or would you try to efficiency your way through it, as you discussed earlier?

Dale E. Williams

Well, I guess that would depend on how things are going. But ideally—we are not happy with the first quarter business results, it’s not what we’re accustomed to, it’s not how we want to run the business, and we’re going to—as we said, we’ve taken action to right-size the business, to get cost structure back in line, to improve the profitability and we’re going to be prepared to take additional actions if we need to. But we’re going to try, for the time we’re going to try to improve where we’re at based on the actions that we’ve already taken, and continue the efficiency improvements.

Keith Hughes - Sun Trust Robinson Humphrey

Dale, can you give us the units in pillows—international versus U.S.?

Dale E. Williams

Let’s see here. U.S. pillows were down 19% and international pillows were down 15%.

Operator

You have a question now from Budd Bugatch - Raymond James.

Budd Bugatch - Raymond James

Just as you reflect on the first quarter—and I know you don’t like giving any granularity as to how it progressed during the quarter—but as you reflect now, based upon the way the quarter wound up, is there any likelihood that the price increase for January 2, how much volume that might have pulled forward and so that the off 14% of domestic retail is really higher than the market was off because you guys had too much inventory going into the quarter?

H. Thomas Bryant

Well, based on our internal data and looking at the queues and the various models that we took price on, we really couldn’t draw any conclusions at all along the lines of the question that you were asking. So we really didn’t see any significant pull forward, from that standpoint.

Budd Bugatch - Raymond James

And with the large product launch coming forward, how do you plan to help your retailers clear their floor inventory? Aren’t there going to be—do you have to give them mark-down money and where does that get accounted for and can you kind of size what you think that will be?

H. Thomas Bryant

Part of our close out—and we’ve done this in the past when we’ve had close outs—we do offer some help to the retailers to help them push the product out the door. In this particular case it will amount to approximately about a 3% impact on those models that I mentioned that we were closing out. And that’s accounted for in the guidance that we’ve given and will obviously run through on the margin line in terms of product and discounts.

Budd Bugatch - Raymond James

I’m confused a bit on that, Tom. Is that on new product that you ship to them so your existing inventory, or is that on inventory that’s on their floor to help them move goods?

H. Thomas Bryant

That’s on the product that we are shipping to them, in terms of new orders.

Budd Bugatch - Raymond James

So that will therefore come off your sales line and therefore impact the gross margin line.

Dale E. Williams

That’s correct.

H. Thomas Bryant

Yes.

Budd Bugatch - Raymond James

So my question then is, Dale had promised or insighted that into increasing gross margins, which that’s another thing you have to overcome during the next couple of quarters, how will you be able to do that?

H. Thomas Bryant

And we obviously factored that into our guidance. As I said, if you look at it in terms of the percentage and the impact, it’s not a major discrepancy from our normal margin and that we have a pretty good handle on it in terms of what we expect and built that in.

Budd Bugatch - Raymond James

So it’s 300 basis points on what you ship to do that. Is there a dollar number you could elucidate on that?

Dale E. Williams

It’s 30% off wholesale price.

Budd Bugatch - Raymond James

30% off the wholesale price that you ship to them. That’s your sales dollar, on the items that you’re going to ship to them. Right, Dale?

Dale E. Williams

Right.

Budd Bugatch - Raymond James

And is there a dollar amount that you could—and when would we see that? Second or third quarter, or both?

Dale E. Williams

You’ll see some of the impact of that in the second quarter and some clean up in the early third quarter.

Budd Bugatch - Raymond James

So 80/20? 80% in the second?

Dale E. Williams

It’s hard to gauge, but probably. And certainly there’s a couple of months left in the second quarter and the new product should be out there by late July, so the bulk of that impact would be in the second quarter, yeah.

Budd Bugatch - Raymond James

So you will have the product in place to the retailers by late July? You will introduce it in Vegas and have it to the retailers by late July?

Dale E. Williams

We will start shipping it right away, when as it’s introduced to retailers.

Budd Bugatch - Raymond James

But you’ve got 6,400 doors you’ve got to get it to. Can you get it all done in latter July?

Dale E. Williams

With new products there will be a transition from July through the third quarter, but we plan to have them replaced fairly quickly.

Budd Bugatch - Raymond James

Okay. Just another quick question. Do you usually break out R&D on the income statement? Is there a reason why you haven’t?

Dale E. Williams

It will be in the queue and we didn’t just to try to clean it up a little bit as most people don’t break it out. In the first quarter R&D was $1.8 million.

Budd Bugatch - Raymond James

Okay. And my last question. I just want to make sure I understand the inventory—two more questions, I apologize. The inventory bogey—you said it’s 30 days forward sales or cost of sales for the finished goods—is that right? Plus width and raw materials?

Dale E. Williams

That’s what we typically try to run.

Budd Bugatch - Raymond James

So it’s 30 forward days cost of sales—because that’s your wholesale price, right?

Dale E. Williams

Right.

Budd Bugatch - Raymond James

How would you characterize that? 30 days cost of sales or 30 days forward sales?

Dale E. Williams

30 days on cost.

Budd Bugatch - Raymond James

30 days on your cost. And you did say you don’t believe you’ll trip to covenant and I can see in your guidance where you don’t trip the free times debt to EBIDTA covenant but on even the high end guys it looks like you do trip to 2 ½ times, at least at the current debt level, which would raise your borrowing cost from that point forward I think by about 30 basis points.

Dale E. Williams

Right.

Budd Bugatch - Raymond James

But does that mean you’re going to pay the debt down to avoid that or should we expect an increase in borrowing costs in the out years?

Dale E. Williams

Well, I mean, we expect to pay the debt down some as the year progresses, with capital. And it’s possible that we’ll see a 30 bip increase in borrowing power.

Operator

Next up from Hilliard Lyons this is Joe Havard.

Joel Havard - Hilliard Lyons

I’m piling on the gross margin questions, too. If I’m getting this right, the product is in development; it’ll be shown at market, shipped over the course of Q3. Where does the close out windows affect us?

H. Thomas Bryant

Starting with the quarters . . .

Joel Havard - Hilliard Lyons

I’m sorry, Q2 and Q3 or kind of over the rest of the year? How does that typically work?

H. Thomas Bryant

. . . Q2 and Q3. I mean, once we start shipping the new product in July that transition will go through the system. Between now and July we will be closing out the existing products and that margin impact that we talked about—3% off the wholesale price—it will start impacting us in the second quarter and we’ll run some of that through the third quarter.

Joel Havard - Hilliard Lyons

And not to get too particular on the product itself, but did you say in your prepared remarks that there are three that are essentially being replaced and the total new one or two, as well?

H. Thomas Bryant

Just to clarify. What we said was we were closing out specific models . . .

Joel Havard - Hilliard Lyons

Deluxe, Symphony and the Original if I got it.

H. Thomas Bryant

The Deluxe, the Symphony. The Original, we’re only closing out a couple of skews in terms of sizes. The majority of the product that we sell on the Originals is being utilized with what we call the youth market—the kids--and so we’re going to have a plan to capitalize on that going forward so we’re not going to close out the total line on the Original, but only the large sizes—the queens, the kings. So it’s two models and some sizes on one of the third models, the Original.

Joel Havard - Hilliard Lyons

And there was or was not a totally new product platform in addition?

H. Thomas Bryant

Yeah, we talked about we would be launching new products in July but we didn’t elaborate on . . .

Joel Havard - Hilliard Lyons

I’m sorry, okay.

H. Thomas Bryant

. . . what those products were going to be.

Joel Havard - Hilliard Lyons

All right. Good. Thanks. One other for Dale. Dale, when you mentioned that returns were up a percent, that’s to say that they were kind of double last year’s rate?

Dale E. Williams

No. Last year returns were . . .

Joel Havard - Hilliard Lyons

I’ve got a note in my model it was kind of running about a percent a year ago. Did you mean it was running at 2% of sales right now, on an annualized basis, or it was up just incrementally?

Dale E. Williams

Up incremental. Last year--it was running about 4.3% last year and it’s running in the first quarter about 5 points.

Joel Havard - Hilliard Lyons

4% versus 5%.

Dale E. Williams

5.1%.

H. Thomas Bryant

I wanted to make just one clarifying item the close out. Now keep in mind that that nine model we’re closing out on two of the nine models in terms of full impact on the close out, so it’s not every product we sell is suddenly going to be impacted by the close out. It’s only a couple of nine models.

Operator

Moving on to the next question, this is Bob Ribble at Lehman Brothers.

Analyst for Robert H. Ribble - Lehman Brothers

I’m actually filling in for Bob. Good evening. Just a quick question. I just want to get an understanding on your thoughts on how you’re going to manage production levels between Albuquerque and Virginia, given the slow down; how do you think about that? And are you still shipping units from Virginia to California?

H. Thomas Bryant

You may recall when we opened the new facility we talked about how the demand for the product was pretty well split geographically in the West Coast/East Coast and that the savings that we would get on the freight side from shipping out of Albuquerque to the Western and Northwestern part of the country—and that still holds. It will still apply and if you think about it it’s almost split down the middle of the country in terms of East and West.

Analyst for Robert H. Ribble - Lehman Brothers

Okay, so you plan to do the production from the West Coast from Albuquerque still? And are you actually still shipping units from Virginia?

H. Thomas Bryant

Yes.

Analyst for Robert H. Ribble - Lehman Brothers

Okay. Thanks.

H. Thomas Bryant

Not to the West Coast, though.

Analyst for Robert H. Ribble - Lehman Brothers

Not to the West Coast.

H. Thomas Bryant

Virginia, as I said, would be supplying more the East Coast.

Operator

Next up from Merriman Curhan Ford, this is Robert Straus.

Robert Straus – Merriman Curhan Ford & Co.

Hi, guys. How are you? Just really one quick question. At retail, for both existing stores as well as new stores, what kind of trends have you seen as it relates to the slots that you have or the slots that you are looking to acquire?

H. Thomas Bryant

We have continued to see our average slot per store go up and as we prepare to launch the new initiative in July our expectations are that we will be successful at continuing to gain incremental slots around some of those new products.

Operator

We will conclude the question and answer session.

H. Thomas Bryant

I just wanted to thank you for joining us this evening. We look forward to talking to you again in July when we will review the second quarter. Thank you.

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Source: Tempur-Pedic International Inc. Q1 2008 Earnings Call Transcript
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