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Tempur-Pedic International, Inc. (NYSE:TPX)

Q2 2008 Earnings Call

July 17, 2008 5:00 PM ET

Executives

H. Thomas Bryant - President, Chief Executive Officer

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

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

Barry Hytinen - Vice President of Investor Relations and Financial Planning & Analysis

Analysts

Mark Rupe - Longbow Research

Bob Drbul - Lehman Brothers

Joseph Altobello - Oppenheimer & Co.

John Baugh - Stifel, Nicolaus & Company

Keith Hughes - Sun Trust Robinson Humphrey

Laura Champine - Morgan Keegan & Co.

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

Robert Straus - Merriman Curhan Ford & Co.

Pete Walsh - Goldman Sachs

Anthony Gikas - Piper Jaffray

Joel Havard - Hilliard Lyons

Joan Storms - Wedbush Morgan

Operator

Welcome to the Tempur-Pedic second quarter 2008 earnings results conference call. (Operator Instructions) At this time I would like to turn the conference over to Vice President of Investor Relations, Barry Hytinen.

Barry Hytinen

Joining me in our Lexington headquarters are Tom Bryant, President and CEO, Mark Sarvary, Incoming President and CEO, and Dale Williams, CFO. After prepared remarks we will open the call for Q&A.

Forward-looking statements that we make during this call are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements including the company’s expectations regarding sales and earnings involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company’s business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating and other factors discussed in the press release issued today. These factors are also discussed in the company’s SEC filings including the company’s annual report on Form 10K under the headings special note regarding forward-looking statements and risk factors. Any forward-looking statements speak only as of the date on which it is made. The company undertakes no obligations to update any forward-looking statements. The press release is posted on the company’s web site at tempurpedic.com and filed with the SEC.

And now with that introduction I will turn the call over to Tom.

H. Thomas Bryant

In total Tempur-Pedic achieved net sales of $239 million a decline of 7% over the same period last year. As we previously announced, during the quarter we were focused on restructuring portions of our business to better align with current and expected sales levels. As a result performance has improved in a number of key areas compared to the first quarter. With second quarter EPS is $0.27. The primary area of sales weakness continues to be the US. However, we experienced a slowdown in many of our international markets specifically towards the end of the quarter. During the quarter the US microeconomic environment remained challenging for our industry. Industry trends, third party research, and retailer feedback lead us to believe that many premium buyers are deferring high-end mattress purchases. The good news for us is the premium buyers are not trading down to cheaper products.

By channel our US direct business continues to be the most severely impacted, down 38%. As we have mentioned before the US direct channel generally serves a lower consumer demographic than our retail channel and direct is more affected by economic slowdowns. The US retail channel posted net sales of $130 million, a decline of 10% but was up modestly from the first quarter. In the US we opened approximately 200 net new furniture and bedding stores in the quarter. This brings the US furniture and bedding door count to 6,650 versus our long-term goal of 7,000 to 8,000. Our medical business was up 31% to $4.5 million reflecting continued progress with our distribution partners, especially Hill-Rom in the acute care market. Lastly, our US third party channel delivered $2.6 million of net sales a decrease of $1.2 million reflecting a slowdown in the Canadian mattress market.

With respect to our international segment, some of our key European markets appear to be impacted by microeconomic factors. While our reported results reflect a 4% increase in sales to $90 million, this is driven by favorable foreign exchange rates. On a constant currency basis our international sales declined 9%. International retail sales were up 5% to $69 million. We added approximately 40 net new retail stores during the quarter bringing the international door count to 5,100. International third party sales were up fractionally by our recent conversions of Australia and New Zealand the subsidiary markets.

In light of the macroeconomic pressures, last quarter we outlined our key financial objectives for the balance of 2008. One, improving financial performance through aligning the business cost structure with our expectations for top line performance. Two, improving our financial flexibility by driving cash flow and reducing debt. In the second quarter profitability improved over the first quarter. Gross profit margin was up modestly despite substantially lower production levels resulting in fixed cost deleverage. Our focus on yield improvement, reducing fixed costs, and improving sourcing helped offset commodity cost inflation. Reflecting the operating expense cuts we discussed last quarter, expenses were down substantially which led to margin improvement.

Turning to cash flow we are pleased to report the business made excellent progress in the second quarter. During the quarter we began reducing inventory, improving collections, and lowering expenses. These activities yielded a substantial reduction in debt and an increase in cash. We see numerous opportunities in the coming quarters to generate cash flow and will continue our efforts. In light of the economic environment, maintaining financial flexibility is our primary short-term focus.

As our investors are aware we are firmly committed to our business model, advertising strategy, and premium product focus. In the second half of this year we will begin an extensive new product rollout across the globe. For competitive reasons we will not be outlining all aspects of this plan tonight. However, we will provide some commentary on the first phase of the US rollout which begins at the Las Vegas market at the end of this month.

Over the next couple of months we will begin shipping three new mattress models. One is an upgrade and two are completely new. DeluxeBed by Tempur-Pedic which has historically been one of our popular models has been upgraded. In the past we have found upgrading our older models helps refresh the sale of the product while providing consumers even more value. The new BellaSonna by Tempur-Pedic incorporates layers of Tempur material on top of our new support layer, the Tempur-Flex. Tempur-Flex provides a buoyant feeling without adding pressure to the body. The queen size mattress will retail for $2,499.00. And lastly we will introduce our new entry-level model, the Advantage by Tempur-Pedic which will retail for $1,299.00. This model offers exceptional value as an alternative to old-fashioned innerspring. Through extensive consumer testing we believe the Advantage model will expand our market share of the entry-level premium mattress market.

As we discussed last quarter the original bed will now be focused on small sizes and repositioned specifically for the youth market. In addition we will soon be rolling out new mattress models internationally, new pillow concepts on a global basis, and we have a strong pipeline of new products.

As investors are aware next month I will be retiring and Mark Sarvary will become CEO effective August 4. I would like to take a brief moment to say a few words about Tempur-Pedic and the market opportunity after reflecting upon my seven years with the company.

While the current environment is a challenge for nearly all consumer companies, we have always maintained our focus on the long term. Therefore over the years we have put in place a foundation to sustain the business over the long term. We have built a strong brand with a premium image. We have an amazing and unique material which provides every marketers dream, a real point of difference versus old-fashioned innersprings. We have highly talented and motivated employees and we have a vast market with a solid history of growth. I have no doubt about the company’s long-term success and I look forward to remaining a part of the company as a director and watching the company’s progress during my retirement.

Having said that, I would now like to publicly welcome Mark to the company. Mark has a great background and history of achievement. He is uniquely qualified to lead the company in this next chapter. Over the past few weeks Mark and I have spent our time focused on a full and orderly transition. That process is nearing completion and now I would like to turn the call over to Mark.

Mark A. Sarvary

Thanks Tom for that warm welcome and on the time that you’ve spent with me on the transition. I’d also like to thank the Board, the executive leadership team, and all the employees for their support during this transition.

Let me spend just a couple of minutes reviewing my background and what attracted me to Tempur-Pedic and I’ll save the more detailed commentary on the business for a later date. Throughout my career I have worked in companies whose primary businesses were differentiated in strongly branded products. In each company the keys to maximizing the value of these brands was very similar: Creative marketing, a strong sales team in the field, systematic and focused product innovation, a clear well-articulated strategy, and efficient operation. At Campbell Soup Company I was responsible for the $6 billion North American division. Prior to that I was President of the Pepperidge Farm division. And earlier in my career I was the CEO of J. Crew and I worked in executive roles at Nestlé, most recently as President of the Stouffers Frozen Food division.

I was attracted to Tempur-Pedic for several reasons. Firstly the Tempur-Pedic brand itself is very attractive: a genuinely global premium and differentiated billion dollar brand. Secondly Tempur-Pedic has a broad and ongoing set of unique products. And the company’s proprietary material and technology together with its industry-leading product development and R&D capabilities and being able to continue to improve its core product and introduce innovative new product. In addition the company has a strong infrastructure. It’s well positioned to take the business to the next level and beyond. The management team is well seasoned and the organization is talented and engaged and has a culture of consumer satisfaction. I’m very proud to be working with such a strong team. Finally and very importantly, the company has an outstanding network of retail partners literally across the globe.

So I’m thrilled to be a part of the Tempur-Pedic team and I would like to thank all of the employees who have given me such a warm welcome. At this point I’ll 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. Turning to sales by product, globally mattresses were down 9% driven by a 15% decline in units. Domestic mattress sales declined 15% on a 16% decline in units reflecting flat pricing. Declines in the direct business negatively impacted domestic blended selling price while retail channel ASPs continued to grow. In the international segment mattress sales were up 5% reflecting foreign exchange gains as units were down 13%. In total pillows were down 9% driven by an 18% decline in units. We experienced weak pillow volumes in both segments with a 13% decline domestically and a 21% decline internationally. Many of our pillows are sold along with the mattress and therefore with the slowdown in mattresses, pillows were impacted. Sales of other products remained flat in total with a decline of 5% domestically and growth of 8% internationally. These results are primarily driven by our increased focus on adjustable bed-based tax rates which are improving despite the economic headwinds. Incidentally we recently announced a price increase on adjustable bed bases in the US to help offset the increases costs of steel.

Gross margin for the quarter was 44.4% well below prior year but improvement over the first quarter. The gross margin continues to be impacted by several factors. Softness in the direct business which has a higher gross margin continues to be a big headwind. Costs for raw materials and transportation costs were up as compared to last year. And with lower volumes six [inaudible] plants were spread across a smaller sales space. These factors were partially offset by improved yields and other factory efficiencies.

Operating income was $36.3 million or 15.2% of net sales. While still well below prior year, operating income has improved to first quarter largely due to actions we outlined on our last call. On a sequential basis we reduced sales and marketing costs by over $8 million. G&A costs were down modestly. Second quarter results also reflect an increase bad debt reserves of approximately $1.5 million. During the quarter we further evaluated the credit quality of our accounts receivable and determined that the additional reserve was prudent in light of the current economic environment. Despite the environment and as a testament to the hard work of our AR and sales teams, we are pleased to report our receivable aging is on par with prior year. Interest expense for the period was $5.6 million down $600,000 from last year and $2 million below last quarter. On a sequential basis the reduction reflects the benefits from lower LIBOR rates instituted earlier in the year. In the first quarter due to the timing of LIBOR adjustments these benefits were not fully realized. As an update we recently swapped into a 3.75% fixed interest rate for approximately $350 million of our debt with a declining balance over a three-year period. Fully diluted earnings per share were $0.27 compared to $0.39 for the second quarter of 2007.

Turning to the balance sheet, as Tom mentioned we’re very focused on improving cash flow and working capital. During the quarter we made progress on our drives to lower inventory with an $18.5 million reduction. As a result of that progress and other working capital improvement we generated $71.7 million of cash flow from operations and reduced debt by $40.6 million from last quarter. Again I would like to point out that our revolving credit facility matures in 2012 and requires no mandatory principal payments until that time.

Now I would like to address our revised guidance for full year 2008. For sales the company currently expects full-year net sales to range from $980 million to $1,020,000 a decrease of between 11% and 8% from 2007. For earnings the company currently expects diluted earnings per share for 2008 to range from $1.05 to $1.20 a decrease of 39% to 31% compared to 2007. At the midpoint of our range we are assuming a second half sales decline of 12% versus a first half decline of 7% reflecting only modest seasonal growth in the second half. As a reminder Tempur-Pedic’s seasonality has historically resulted in the second half being larger than the first half. Further, it assumes flat gross margins from the first half with a projected productivity improvement offset by increased commodity costs. However, at this point we have not received any notifications of price increases from the first half. Great. At the high end of the range we have assumed a second half decline of 8% reflecting more normal levels of seasonality and growth from the new products Tom discussed. And at the low end we assume a sales decline of 15% which implies no benefit from seasonality or new products.

Furthermore, during the second half we anticipate substantial US debt pay down and an increase of cash balances in our international operations. And based on our model, even at the low end of our APS guidance we will be in full compliance with the financial covenants in our senior credit facility for the entire year. This includes a restricted payment test of 2.7 times at the EBITDA. We’re using a share count of 75 million shares and a full-year tax rate of 34.5%. 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

(Operator Instructions) Our first question comes from Mark Rupe - Longbow Research.

Mark Rupe - Longbow Research

On the international, you mentioned that it did kind of fall off towards the end of the quarter. How significant was that fall off and what should we expect in the coming quarters?

Dale E. Williams

We saw deterioration of the international business throughout the second quarter kind of as we expected with the economic weakness in the US moving over to Europe. Basically what I would say is our guidance expectation in terms of international is that the trends that we saw towards the end of the second quarter would continue throughout the rest of the year. At the low end of our guidance it says international will get worse.

Mark Rupe - Longbow Research

Predominantly on the European side though?

Dale E. Williams

Yes.

Mark Rupe - Longbow Research

On the inventory situation, obviously they’re down from the first quarter. Where do you think you sit on that? Obviously on a day’s basis it’s still much higher than you historically had been at. I mean how much more work do you have on that front?

Dale E. Williams

While we don’t want to give a specific dollar amount of inventory that we’re targeting, certainly we expect in the second half to continue to reduce inventory, continue to pay down debt based on the cash flow not just from that but other working capital and income generated by the business, but we think we still have fairly substantial room to go in inventory.

Mark Rupe - Longbow Research

Lastly, on the ad spender in the quarter, can you just give us an update on your advertising program and the spend rate in the quarter?

Dale E. Williams

If you look at it, we spent about $22 million and as a percentage of revenue it’s about 9%, right around what we spent last year during the quarter. And the new campaign that we launched last year continues to go well and we continue to invest in brand building even during the economic slowdown.

Operator

Our next question comes from Bob Drbul - Lehman Brothers.

Bob Drbul - Lehman Brothers

The questions I have I guess still are around the inventory side and just maybe a little bit more color. Dale, can you talk about the impact of closeouts on profitability this quarter and do you anticipate that the closeout activity this quarter will impact sales next quarter? And then the other side of it is, on the inventory side a little bit more detail. Like how much is closeouts of the total inventory and when will the inventory associated with these new product launches that you’re talking about begin to build?

Dale E. Williams

There are a number of questions nestled in there. I’ll try to piece them out and help me if I leave one out. From an overall inventory standpoint we reduced total inventory in the second quarter by $18.5 million. We believe that we still have a significant chunk of inventory to go. We still ended the quarter with our inventories sitting at about $93 million. For a good part of last year we were running in the low 80s, in 2006 we were running in the low 60s. Obviously we’ve said repeatedly 2006 we were too low but somewhere in the vicinity of where we were in the early part of last year or even better as we’ve gotten now the benefit of the two factories being able to respond faster and the distribution set up so that Virginia’s serving the East and Albuquerque’s serving the West, we feel like we can do a little bit better on inventory than we were even doing through the early part of last year.

The second part of your question was related to closeouts and impact on profitability and inventory. Certainly we are reducing the inventories associated with the closeout models but we’re reducing the inventory across the line. We will start building the new models in the third quarter in advance of the launch but we don’t expect that to cause a blip up in inventory because we will be continuing to reduce overall inventory levels.

The other part was related to closeouts and impact on profitability. Certainly the closeout process started in the May timeframe and so the discounts that we had were part of the gross profit equation of the second quarter. That will continue into the third quarter. As we stated in April when we talked about the closeouts and what we were doing there with new product launches and how we were structuring the closeout, but we don’t see that as being a big impact on the overall profitability of the business.

Bob Drbul - Lehman Brothers

One bigger picture question for you, Dale and maybe even Tom. When you look at the competitive environment out there, how much of the challenges that you’re seeing would you attribute to macro versus more aggressive and sort of more competitive Visco products from some of the other major players out there today?

H. Thomas Bryant

I think it’s more the macro and specifically how the macro environment is impacting price points within the industry. If you look at the information coming out of the Trade Association, you see the average sale price per mattress continues to go down and as we said, third party research that’s been conducted shows that a large percentage of premium buyers are deferring their purchases and that automatically will then SCU the ASPs for the industry down. So I think that if you look at a lot of the stores out there today are being more aggressive with their pricing on the very low end and advertising sub-$500 products to try and drive customers into the store. So I think it’s more that factor than competition. And one of the things that we continue to track and have been tracking since almost the time we went public is the accounts where we have competition compared to accounts where we still are the only Visco on the floor. And in the second quarter the same results that we’ve seen historically which is that we do better in stores where we have competition.

Operator

Our next question comes from Joseph Altobello - Oppenheimer & Co.

Joseph Altobello - Oppenheimer & Co.

First question is on the US business and I just want to make sure I’ve got my numbers straight here. It looks like for the second quarter US mattress units was about flat with 1Q, about $103,000. Is that correct?

Dale E. Williams

Yes.

Joseph Altobello - Oppenheimer & Co.

Is that indicative of some kind of stabilization in the US or is it still too early to sort of go that far?

Dale E. Williams

If you look at the total US results, we did actually a little bit more in total revenue in the second quarter in the US than we did in the first quarter. They were essentially flat quarter-to-quarter so that’s a little bit of a - we feel like that we see stabilization in the business. And back to the guidance ranges and the different parts of the range, what we’ve seen through the first six months is the business seems to have stabilized and the key thing for us in terms of our outlook is, Do we see the normal pattern in the second half that we have always historically seen in terms of the seasonality of the business being stronger in the second half than in the first half? And the level of seasonality we may or may not see along with the impact of the new products and the impact of additional distribution is what gives us the range. The low end of the range is kind of flat lining the business because through the first half it seems stable.

Joseph Altobello - Oppenheimer & Co.

Okay, because if you look at the numbers year-over-year obviously the units are down, sales are down in the US but sequentially the units have flattened out here and it looks like ASPs are up sequentially and year-over-year. So it seems like maybe while we haven’t quite turned the corner in the US, you could at least see a floor in terms of where the business could go.

Dale E. Williams

Hopefully. It seems to be that way but only time will tell.

Joseph Altobello - Oppenheimer & Co.

And the wild card obviously for the second half is how bad the international business gets.

Dale E. Williams

Well yes, we think that the international business what we saw in the second quarter is where it will come in but at the low side of our guidance it calls for the international business to get worse. I would also point out that all the way within the guidance ranges is we do expect in the second half the US dollar to strengthen some and certainly at least from a FX impact the dollar weakened significantly throughout the last year, so there’s much less currency impact in the back half of the year than there was in the first.

Joseph Altobello - Oppenheimer & Co.

Are you guys losing floor space within the retail channel? The reason I ask that is, it seems like consumers are obviously trading down in a lot of categories and I imagine bedding is one of those. So are retailers allocating a greater amount of floor space to that opening price point bed?

Dale E. Williams

No, we have not lost floor space. Actually we’ve continued to expand the average number of slots in the stores that we’re doing business with and as we come out with these new products we’re obviously expecting to get incremental slots as well. And I think one of the reasons for that, while the sub-$500 market has been doing better in the current economic environment that we find ourselves in, the profitability of our products are still substantial for the retailers.

Joseph Altobello - Oppenheimer & Co.

So the unit decline is purely a traffic issue and not a floor space allocation issue?

Dale E. Williams

The feedback we get from the retailers makes us really believe that traffic is down substantially versus last year and that’s what we’re hearing across the country.

Joseph Altobello - Oppenheimer & Co.

And in terms of the gross margin and commodity costs, it sounds like you haven’t seen any incremental commodity cost inflation beyond what we’ve talked about in the past. Does your guidance reflect any additional input cost increases or administration cost increases in the back half?

Dale E. Williams

Good question. We said on the April call that we saw commodity cost increase in early in the year from a chemical pricing standpoint, we saw a little bit additional chemical price increases in the second quarter, we at this point have no notification or indication of further commodity cost increases. However, our guidance does assume that there will be additional commodity cost increases in the back half. We tried to be very conservative and actually at the lower end we’re even assuming a higher level of commodity cost increases. So we’ve tried to be very conservative in our outlook in terms of where commodity costs are going and oil’s been down a little bit the last couple days. Maybe that trend will continue and things will turn. But we tried to be conservative as it relates to commodity costs and built additional commodity cost increases into the back half even though we have not received any notice of any pending or coming chemical cost increases.

Operator

Our next question comes from John Baugh - Stifel, Nicolaus & Company.

John Baugh - Stifel, Nicolaus & Company

I guess as a follow up to the raw material issue there, Dale, you’ve assumed higher raw material costs. Have you then also assumed you will not raise prices as you can’t offset any of that? What’s the assumption there?

Dale E. Williams

At this point in time we’re not assuming that we’re going to raise prices on our mattresses. As I mentioned we did raise the price on our new Ergo adjustable system because of the steel price increases, but right now we’re not assuming additional price increases on mattresses. We did have a price increase right at the start of the year on a selected group of mattresses. We’re going to try to ride that out, but we always reserve the right to change our mind also.

John Baugh - Stifel, Nicolaus & Company

I guess it’s kind of hard to play with what you do in the future but if you had a raw material price increase, say even above and beyond what you’ve assumed in your guidance, would you likely take pricing?

H. Thomas Bryant

I think we wouldn’t want to speculate on our pricing strategy but I would say that we leave that option on the table. We’ve demonstrated in the past that we can take price without having a negative impact on the demand for our products. So I would just say that that is always an option but that’s something that we don’t really discuss as to what our game plan is for price increases.

John Baugh - Stifel, Nicolaus & Company

Fair enough. And then just some clarity Dale on the 2.7 ratio. I had 3 stuck in my head. Can you give some more color on the ratio you’re talking about?

Dale E. Williams

Absolutely. And let me first clarify. I should have said 2.75. The 3 that you have stuck in your head are the real key covenants and in terms of EBITDA to interest coverage 3 times. The 2.75 is a restricted payment tab that basically sets up a protection if you will against the possibility of hitting 3 times and what it does is it limits the business. If we were to get to 2.75, we would have to discontinue restricted payments. Restricted payments are defined as things like acquisitions, dividends, payments to subordinated debt, so it’s a buffer within the bank agreement structure to protect against the 3 times.

John Baugh - Stifel, Nicolaus & Company

I can do my own math but again you said that even at the lower end of your guidance you wouldn’t violate the 2.75, is that correct?

Dale E. Williams

Correct. And John just to add some color there, at the low end of the guidance the EBITDA that implies we are also assuming as I mentioned a little bit earlier, we paid off over $40 million of debt in the second quarter. Our expectation is that we will pay down a minimum of an additional $50 million in the back half. So those two together between EBITDA and continuing to reduce debt protect us.

John Baugh - Stifel, Nicolaus & Company

What were R&D expenditures for the quarter?

Dale E. Williams

$1.5 million.

Operator

Our next question comes from Keith Hughes - Sun Trust Robinson Humphrey.

Keith Hughes - SunTrust Robinson Humphrey

On the new introductions that are coming out to Las Vegas, just to clarify the price you gave on the Advantage mattress, is that for a queen set or is that just for the queen mattress?

H. Thomas Bryant

Queen mattress $1,299.00 just for the queen.

Keith Hughes - SunTrust Robinson Humphrey

And what would a set come out?

H. Thomas Bryant

If you look at it from the standpoint of adding a set, you’re talking $1,599.00 for a queen.

Keith Hughes - SunTrust Robinson Humphrey

So this is roughly similar to what we saw from the previous lower-end SCUs?

H. Thomas Bryant

Yes, it’s right in the middle.

Keith Hughes - SunTrust Robinson Humphrey

If we look at the margins on that bed, would it be similar to products in a similar price range or is the construction different?

H. Thomas Bryant

The new products would have equal to or greater [inaudible] than our other products in terms of margin. One of the [inaudible] is that we’ve always had when introducing new products is either to maintain or improve margin.

Keith Hughes - SunTrust Robinson Humphrey

It sounds like we’re going to see a lot more from you in product. Is that going to be coming just over the next six months? Is that a year-long program? What kind of timeframe are we looking at?

H. Thomas Bryant

Obviously these products that we just discussed will be launching at the end of this month in the US. We have two upgrades and one new product on the international front that we will be launching in Europe in the third quarter. But beyond that the only thing that we have said consistently is our objective is to introduce a minimum of one mattress and one pillow each year.

Keith Hughes - SunTrust Robinson Humphrey

Given the economic climate particularly for mattresses, one thing that you’ve always been known for is key pricing, no discounting on the mattresses retail and that’s always been something I know you’ve stuck to and had to police. Have you found more violations of that of late, things you’ve had to address with retailers or is that situation been roughly the same?

H. Thomas Bryant

It’s been the same. We haven’t seen an increase in any violations.

Operator

Our next question comes from Laura Champine - Morgan Keegan & Co.

Laura Champine - Morgan Keegan & Co.

My question is a follow up on the raw materials issue. You mentioned chemicals cost increases and I think I heard you say passing on some steel cost increases. My guess is that all your input costs are up. Can you quantify in 2008 guidance as a whole either on a percentage or an absolute basis what you’re looking for in terms of raw material and component cost increases?

Dale E. Williams

Well we said earlier in the first quarter at the beginning of the year we had seen a high single digit, low double digit increase in chemical costs. We saw a little bit additional increase in the second quarter relatively small. I won’t quantify for you what we’re expecting in the second half because I don’t want to tell our suppliers what we’re expecting and give them an idea of what they could tack on to us because we’re going to fight them on any additional pricing as we do on product price increase from a supplier. But yes we did see in the second quarter an increase on the Ergo system because of the global an increase in steel price. It was a modest from an overall standpoint price increase on that new product of ours and we did pass that on as a price increase on our unit and felt very good about doing that given the success of that unit as well as almost anything out there that is heavily steel has seen significant price hikes in the last three or four months.

Laura Champine - Morgan Keegan & Co.

Lastly, obviously you’ve got thousands of small independent stores that are seeing terrible traffic trends in customers. What’s the trend in your accounts receivables, your reserves there, and how comfortable do you feel with the quality of your receivables at this time?

Dale E. Williams

What we have seen from the accounts receivable standpoint is our accounts receivable aging overall is the same as or actually slightly better than it was a year ago. We have been all over this, we’ve been working very proactively with our accounts, we have certainly in the last nine months there’s been a handful of bankruptcies within the industry that not any one of them collectively or individually have been of any significance to us; however, because it’s a difficult environment, because the longer the difficult environment occurs you run a higher risk of having more people go under, that’s why in the second quarter we increased our receivable reserves by $1.5 million even though our agings and our experience didn’t say we had to. It’s something that we wanted to do from just trying to be more conservative as we look out front. We’ve always felt like our receivable reserves were conservative but we wanted to be even more prudent in this type of environment.

Operator

Our next question comes from Analyst for Budd Bugatch - Raymond James & Associates, Inc.

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

Could you tell me what US furniture and bedding sales were during the quarter?

Dale E. Williams

US furniture and bedding was $115 million.

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

I hate to keep piling on the chemical price questions, but just a clarification. Dale I know you guys have had I think it was a low double-digit price increase in January and then you mentioned there was an additional price increase in Q2. Was that incremental to that?

Dale E. Williams

Yes.

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

Could you quantify for us the amount of that at all?

Dale E. Williams

It was in the single-digit range.

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

And earlier on the call you mentioned that retail ASP increased. Could you give us any sense of how much of that you would attribute to the actual price increases versus say product mix? Was product mix a positive contributor to that or did you just see a little bit of a downshift?

Dale E. Williams

No, actually our retail ASP was up pretty much in line with the impact of the price increase.

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

So call it pretty stable in terms of product mix?

Dale E. Williams

Yes. And from a product mix standpoint, we’re not seeing a shift in product mix, we’re just seeing generally an across the board softness.

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

And domestic direct obviously was down pretty sharply but it did modestly improve versus the decline we saw in Q1. If I’m correct, I think you guys were running some more aggressive promotions in terms of financing and you did have some of the closeout models which might have maybe attracted some more of those customers. Could you care to comment at all on maybe the impact? Are you seeing more consumers in that segment taking advantage of those financing offers?

H. Thomas Bryant

Just to clarify. The finance offers that we’ve run are very similar to what we’ve run in the past. We haven’t added anything new to the rotation cycle of our promotional orders. And if we look at the percentage of consumers who are taking advantage of that third-party financing, we have seen an increase there during this year.

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

And last question, how long will the closeouts on the three models last?

H. Thomas Bryant

It comes down to a little bit of sizes because you get down to mix where the twins and twin longs for example you can end up with some inventory on the different sizes as compared to the more popular Queens and Kings but our plan right now is still to have that transition till we run out of inventory on the Deluxe for example around the time that we start shipping the new. And as I said we’re introducing the new one at the end of this month.

Operator

Our next question comes from Robert Straus - Merriman Curhan Ford & Co.

Robert Straus - Merriman Curhan Ford & Co.

As I think of the SG&A on a go-forward basis for the back half of the year, could you give us any more color on the opportunities that you continue to see and if it’s from a quantitative standpoint that would be much appreciated?

Dale E. Williams

We took some cost actions in March and April that we talked about quite a bit on our last call. You can see that sales and marketing costs were down $8 million quarter-to-quarter, however advertising spend ratio was essentially the same as what it was a year ago. We would expect to see that spend ratio drop a little bit in the second half because we’re still going to be making up for a little bit of overspend in the first quarter. We want for the year to get it back in line with our historic ratios. So you’ll continue to see some impact there. Obviously from a G&A standpoint it looked like a very marginal reduction quarter-to-quarter but we did take a large hopefully one-time increase in our bad debt reserve and we think that is something that our normal flow of bad debt should cover us. But we felt like we needed in this environment to set up a little extra protection so we should see a little bit of additional improvement in terms of the G&A rate that we’re spending at also.

Robert Straus - Merriman Curhan Ford & Co.

On the Deluxe bed I know that it used to be in virtually all of the stores domestically. Is that still the case?

Dale E. Williams

Yes.

Operator

Our next question comes from Pete Walsh - Goldman Sachs.

Pete Walsh - Goldman Sachs

I know that you’re hesitant to provide specific details on the raw materials piece but from a guidance perspective would you be able to quantify or just help us think about which has a greater impact on the gross margin? Is it going to be that raw material piece or is it more pronounced that the volume decline and fixed cost absorption has a greater impact?

Dale E. Williams

We have raw material costs going up in every scenario within the range. We actually tweak a little bit harder at the low end but our outlook is at the high end of the range versus the gross margin that we saw in the first half, we will see a little bit of improvement in gross margin even with some potential additional commodity costs as we continue to work productivity in the factories. At the midpoint we would expect gross margins to be roughly about flat because we would get a little bit less volume, and at the low end we’ve assumed a little bit higher commodity cost as well as some additional factory deleverage on lower volumes. So it’s something that we have built in, some significant additional costs in the back half related to the potential of additional commodity costs. But as I said earlier we don’t have, have not been notified of any additional increases to come yet.

Pete Walsh - Goldman Sachs

And certainly solid working capital in the quarter and the comments regarding inventory notwithstanding, do you expect to really keep this flat in the back half of the year? Is this type of working capital sustainable effectively?

Dale E. Williams

Well, working capital will further improve in the back half?

Pete Walsh - Goldman Sachs

The last question for you is, in the revised outlook it certainly implies the double-digit decline below the market trends and you noted that third-party research suggested that high-end consumers are tending to defer or delay their purchases rather than trade down. Is there any sense of timing as to when these high-end consumers typically will return to the market or how long they remain on the sidelines?

H. Thomas Bryant

No. I think it all comes down to consumer confidence and the economy. We’ll start seeing those buyers come back into the market when they are feeling better about their personal finances and at this point it’s very difficult to project when that will happen.

Operator

Our next question comes from Anthony Gikas - Piper Jaffray.

Anthony Gikas - Piper Jaffray

You talked about some potential changes to the sales team. Could you talk a little bit about any structural changes, compensation, number of people, efforts, that sort of thing? Second question, Dale maybe you could just give us an update - if you said this, I apologize if I missed it - but where you’re at with capacity utilization today? And the last question would be on consumer credit. Are you hearing from your retailers that this is really becoming a real issue?

H. Thomas Bryant

I’ll take the first one only from the standpoint that Mark won’t officially be taking over until the first, but I will say that we have been committed during these trying times to continue to invest in the business in certain key areas and our sales organization and sales trainers has been one of those. As you’ll recall when we did the restructuring and we had to lay off, we did not take any personnel out of R&D or out of our sales organization.

Dale E. Williams

First, you may have misheard something. I don’t think Mark said anything about doing anything with sales but Tom just explained what we have done in terms of or haven’t done because we’ve maintained our sales organization when we were going through the reductions.

Related to capacity, certainly we’ve got ample capacity right now. We’d love to get some more orders. We’ve got a lot of room to build a lot of mattresses. We have as we mentioned in the April call taken a shift out of each factory to downsize the production volumes. We didn’t want to go in and just close down a factory for an extended month or so to have a very sharp quick correction in inventory. We wanted to just ratchet back production so that we were gradually reducing inventory but maintaining our skilled and qualified workforce and not having to have significant disruptions. We made good progress on that in the second quarter. We will continue to progress that in the third quarter and in the fourth quarter.

The other part of your question about consumer credit. What we have seen in a consumer credit standpoint both within our own [DR] business as well as feedback from retailers is credit is available. The credit companies that provide this type of credit, the credit is available. I think in general the consumer FICA scores are dropping a little bit so the credit companies have not changed their standards around FICA scores from what they have been for the last couple of years but you’re seeing some consumers no longer qualify just because their own scores have dropped.

Operator

Our next question comes from Joel Havard - Hilliard Lyons.

Joel Havard - Hilliard Lyons

Tom for you, this is probably a terrible time to be trying to figure it out, but how would you characterize the performance or however it is you measure the new marketing campaign again granting that this is probably a really tough time to be trying to figure that out? Anything that you want to tweak yet as far as the message or the media?

H. Thomas Bryant

It is. To your point about the current environment makes it difficult, but based on all the research that we’ve done before we launched the new campaign and are continuing to do our research, we are still very pleased and at this point do not see any need to make any tweaks. So we are going to stay the course for the foreseeable future.

Joel Havard - Hilliard Lyons

Dale given that there’s probably a little bit higher working capital needs on a sequential basis in Q4, you ought to still be free cash flow positive in the second half overall. Is there room for further debt reduction or how do you see handling the opportunity?

Dale E. Williams

Joel I stated it earlier, so I’ll reiterate. We reduced debt of a little over $40 million in the second quarter. In the back half we expect to further reduce debt a minimum of $50 million. But we will continue to see working capital improvement particularly around inventory. We’re going to keep dropping the inventories. We feel like we’ve still got a lot of room to go there.

Joel Havard - Hilliard Lyons

Any thought that you kind of get through this environment of repurchase at a cash flow opportunity?

Dale E. Williams

Certainly that is something that we will consider at some point but what we have been very consistent in saying for the last three or four months is at this point the thing that is most important is initially protecting the business in terms of credit agreement. Even though we think the stock is a very good value, we don’t want to get the company strained and in trouble by going out and buying stock when we need to be focused on reducing debt to protect the company on the credit agreement. Once we are completely comfortable and feel like things are turning positively, we may reconsider that.

Operator

Our next question comes from Joan Storms - Wedbush Morgan.

Joan Storms - Wedbush Morgan

A follow up from a previous question and people have been talking about what all of the negatives are on the gross margin side, but in regards to the positive what are you doing on the sourcing side that’s helping you? As well as I think you answered that sort of the factory efficiencies by taking a shift out, etc. to reduce inventory, but are there any other things that you’re doing despite the lower sales and the factory?

Dale E. Williams

Absolutely. From a sourcing standpoint we are seeing some general improvement in our costs related to sourcing on our other materials, comfort materials. We have a concerted program of shifting more of our supply to low-cost countries, so we’re getting some benefit there. In the sourcing we continue to get very productivity within the factories of continuing to improve efficiency, continuing to improve yields, even in an environment where we’re producing less, so the factories are having a very good year even in a lower production situation. So the only issue there is the deleverage of the fixed costs and producing less volume.

And I will say one of the things that we talked about in the first quarter that was say a drag on gross margin and we expected it to improve in the second quarter was around returns. And we saw an increase in return rate in the first quarter but in the second quarter we saw return rates revert back to our normal levels and we explained what the first quarter impact is. Returns are essentially based on the prior 90-day sales so when we saw a big drop off in revenue in the first quarter, the returns were related to the prior quarter sales but you don’t just drop - the way the calculation works is very conservative when you’re sales are declining and actually conservative also when your sales are increasing but we thought that would stabilize and it has and that was a positive factor in the second quarter also. And we would expect that to continue through the rest of the year.

Operator

That concludes our question and answer session.

Dale E. Williams

I just want to thank everybody for participating this evening. It is interesting times but we look forward to talking to you again in October when we’ll review the third quarter results. Thanks for joining us.

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Source: Tempur-Pedic International, Inc. Q2 2008 Earnings Call Transcript
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