Tempur Sealy International Inc (TPX) 0 Q0 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Tempur-Pedic International Third Quarter 2006 Earnings Conference Call.

At this time, all participants are in a listen-only mode.

We will be facilitating a question-and-answer session towards the end of today's conference. [OPERATOR INSTRUCTIONS]

As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host of today's call, Barry Hytinen, from Tempur-Pedic Investor Relations.

Please proceed, sir.

--in today's call.

Joining me today in Lexington are Tom Bryant, President and CEO, and Dale Williams, CFO.

After prepared remarks, we will open the call for Q&A.

Please note -- statements made by Tempur-Pedic during the call that are forward looking are made pursuant to the Safe Harbor provision 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.

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 heading Special Note Regarding Forward-Looking Statements and Risk Factors.

Any forward-looking statement speaks only as of the date on which it is made.

The Company undertakes no obligation to update any forward-looking statements.

The press release is posted on the Company's website and filed with the SEC.

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

Thanks, Barry, and to our listeners, thank you for joining us this evening.

Tempur-Pedic delivered a solid quarter during what seems to be a year of relatively flat unit growth for our industry.

GAAP EPS doubled to a new quarterly record of $0.34.

Net income increased 66% to $29 million.

Sales were up 17% to $241 million.

Cash flow from operations was up 56% to $47 million.

The third quarter results represented progress on several of the key initiatives we put in place to accelerate growth, improve productivity, and generate strong cash flow.

To accelerate growth and expand market share, we are focused on improving account productivity in our retail channel.

This focus extends to both established and new accounts.

To ensure we spend enough time with our retail partners, we have expanded our sales force by 33% this year, and we'll continue to add additional reps to the sales team as needed.

Compared to last year, our average salesperson has fewer stores to call on and can, therefore, spend more time with each customer, working with them on merchandising, training, and educating retail associates about the benefits of our products.

To date, we are pleased with our progress as established accounts are performing substantially better versus this time last year.

Improved domestic pillow sales have been another benefit of spending more time with our retail partners.

Improving attach rates, when pillows are sold along with a mattress, have resulted from retailers seeing the ease of selling a complete sleep system, as well as the win-win nature of the sale.

As part of this effort, we are seeing good traction from our new trade advertising campaign we recently rolled out promoting the benefits of selling pillows as part of a complete system.

As discussed in prior calls, we have deliberately slowed the growth of new retail stores to ensure the stores we add meet or exceed our high standards.

While we are still adding new accounts, we are selective, both in terms of the quality of the stores and the geographic location.

In the U.S., we added approximately 150 net new stores and approximately 50 net new stores internationally.

We are currently on track in the U.S. and internationally to meet our full-year expectations for new stores.

And since we view retailers as an extension of our brand, we are diligently monitoring our partners.

While we are pleased with improving account productivity, we believe we still have significant opportunities to continue this momentum.

For example, based on independent research, we believe Tempur-Pedic has significantly less floor space at retail compared to our sales.

Therefore, we are working to expand floor space through increased distribution of existing products, as well as continuing to extend the product line.

We recently began shipping three mattress models and two new pillows.

The Rhapsody and the Grand beds showcase our new proprietary formulation, TEMPUR-HD.

Dealer and consumer acceptance has been very strong, and we are gaining incremental floor space.

Demand for these products continues to be much higher than expected.

In an effort to accelerate production, we incurred additional one-time costs to expedite raw materials.

As of the end of the quarter, we still had not met the demand for all of the floor model requests.

However, we expect to complete the rollout this quarter.

Product development is another key ongoing initiative.

We have increased our investment in R&D, adding additional personnel, and we're in the process of building a new test center.

Over time, we will extend our product line and develop new comfort and medical products to expand our leadership position.

While we have seen our performance improve, there are segments where we want to see more progress.

Specialty retail and Japan continues to under-perform as we are disappointed by certain international third-party distributors.

Part of our strategy for Japan is to extend our furniture and bedding stores, so we're in the process of developing a new mattress line to meet the unique customer demand.

We are also expanding our sales force and opening new retailers.

Internationally, third party sales have been impacted by our decision to cut off some distributors due to continued violation of their distribution agreements regarding parallel exporting.

This decision resulted in a period of time during which we had no representation in place.

Improved productivity and strong cash flow are also strategic initiatives for our business.

Our operation scheme has seen significant improvements in a variety of areas, helping to offset margin declines related to channel and product mix.

Yields in our factories are up substantially.

Cost savings from sourcing and distribution are also having a big impact.

Additionally, consistent with our long-term goals, operating margins improved in the quarter as we achieved significant operating cost leverage despite lower gross margin.

We also look forward to improved efficiencies and distribution savings coming from our new plant next year.

Based on the unit growth we are seeing domestically, we are accelerating the testing in Albuquerque to minimize start-up exposure in the first quarter.

While this activity may impact fourth quarter costs to a small extent, it will position us to meet increased demand levels in 2007.

In summary, our brand awareness is expanding.

We are growing market share, and we are scaling our operations to meet future demand.

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

Dale?

Thanks, Tom.

Let's first look at sales performance.

The Company achieved net sales of $241 million, up 17%, or $35 million, compared to the same period last year.

We experienced growth in both our domestic and international businesses.

Domestic net sales of $164 million represents an increase of $32 million, or 24%.

International net sales were up slightly to $76.5 million, an increase of $2.7 million, or 4%.

Foreign exchange rate impact was a positive $2.7 million, meaning on a constant dollar basis, our international business was flat in total.

On the channel side, our growth was led by retail.

Domestic retail was up 31%, and furniture and bedding retail was up an outstanding 43%, or $37 million.

Domestic direct sales were down 9% for the quarter, which is an improvement from the declines in the first half of the year, and we are working to stabilize our performance in this channel.

International retail was up 12%.

International direct was down $1 million, reflecting our decision earlier this year to exit the business in certain European countries.

As Tom previously discussed, international third party was down about $2 million.

On the product side, our growth was driven by mattresses and other products.

Mattress sales were up 22%, or $30 million.

This growth was driven by 14 points of unit growth and the balance on price and mix.

Pillows were down 3%, or $1 million.

Domestically, mattress sales were up 27%, or $26 million.

This growth was attributable to exceptionally strong unit growth of 26% and the balance on price and mix.

Domestic average selling price was temporarily depressed by discounted floor models for the rollout of our new products.

Domestic pillow sales were up 15%, or $2 million, on unit growth of 6%, with mix representing the balance of the growth.

We are seeing strong demand for our higher-priced pillows, which reflects the improved average selling price.

As Tom noted earlier, our efforts to sell a complete sleep system is helping lift pillow sales.

Internationally, mattress sales were up 10%, or $4 million, on flat unit growth.

Prior-year units were benefited by the large rollout of our Scandinavian bed collection.

International pillows were down largely due to continued pressure in Japan and the third party issues Tom mentioned.

In addition, in the third quarter of 2005, we were shipping our new pillow line into Japan.

It's certainly worth noting that after excluding Japan and certain third parties, our international business is generally performing at or above our expectations.

Our key European markets hit sales records in the third quarter of 2006, and we remain confident in the long-term outlook for this portion of our business.

As Tom mentioned, however, we are taking actions, where appropriate, to improve performance.

Gross margin for the quarter was 48.2%, which was slightly below our expectations.

On a year-over-year comparison, the gross profit rate decreased due primarily to four factors.

First, we were negatively impacted by channel mix, as direct is down about three points as a percent of our total revenue versus last year.

Second, product mix continues to impact margins as pillows are growing slower than our total business.

However, we are pleased by the recent pillow sales growth domestically.

The third factor was discounted floor models, which on a year-over-year basis negatively impacted gross profit by approximately $2 million.

And, lastly, as Tom mentioned earlier, in an attempt to meet demand for our new products, we incurred one-time surcharges for expediting raw materials of approximately $1 million.

At this point, we believe we have our supply chain adequately ramped to meet demand.

Fortunately, our ongoing productivity initiatives have helped offset a great deal of the impact of these factors.

After taking these factors into account, we now expect the gross margin for the full year to be down about 200 basis points as compared to 2005.

Operating income was $54 million, or 22.3%, up $11 million, or 150 basis points, compared to the same period in 2005, reflecting leverage on operating costs more than offsetting the gross profit pressure.

Stock-based compensation expense was $1.2 million in the quarter versus $700,000 in the year-ago period.

Net income was up -- I'm sorry -- was $29 million, up from $17 million last year on a GAAP basis.

However, the third quarter of 2005 was impacted by a one-time tax repatriation charge of $6 million, which we pro forma'd last year.

Fully diluted earnings per share doubled to $0.34 despite a higher-than-expected tax rate.

Compared to the rate in the second quarter, the higher third quarter tax rate reduced EPS by a little more than $0.01.

The tax rate increased as a result of changing geographic mix within the business.

Capital expenditures were $6 million, of which approximately $2 million was related to the construction of our Albuquerque facility.

This compares to $19 million of total capital expenditures in the third quarter of 2005.

Cash flow from operations was $47 million for the third quarter based on improved net income and working capital.

Cash flow from operations for the nine months ended September 30, 2006 was $133 million, compared to $79 million in the year-ago period, an increase of 68%.

As we have discussed before, we have been very focused on lowering inventories and improving working capital.

However, we continued to experience some stock-outs within the quarter.

So in the fourth quarter, our intention is to increase inventories in our distribution network to eliminate stock-outs and minimize expediting costs.

Reflecting this improved cash flow, we lowered total debt by nearly $44 million.

Now, we'd like to address our guidance for full-year 2006.

As noted in the press release, the Company is confirming its prior diluted earnings-per-share guidance to range from $1.26 to $1.31.

At this time, we anticipate earnings per share will be towards the high end of this range.

For sales, the Company is confirming its prior net sales guidance to range from $940 million to $970 million.

At this time, we anticipate net sales will be towards the lower end of this range.

This guidance assumes a tax rate of approximately 38% and 86 million shares outstanding for the fourth quarter.

A higher tax rate in the third and fourth quarter reduced EPS by approximately $0.01 in each quarter as compared to the tax rate in the second quarter.

As noted in our press release, these expectations are based on information available at the time of the release and are subject to changing conditions, many of which are outside the Company's control.

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

[OPERATOR INSTRUCTIONS]

Joel Havard, BB&T Capital Markets.

Let's see.

One question, then we'll see about the follow-up here.

The trim the last several years of results on the selling expense side has clearly been the right way.

With you guys adding personnel, how does that translate into the carry costs?

You know, where are you getting the leverage that you're seeing thus far?

How much opportunity is still there, or are we hitting the point where you need to start thinking about adding back as a percent?

You know, clearly dollars will continue to go up.

Just could you explore that for us?

Well, this is Tom Bryant.

Thanks, Tom.

From the standpoint on the selling side as it relates to, as we mentioned, expanding our sales organization, we've been very aggressive at that, and we've been able to do that by reducing the size of the territories.

And our reps have a combination of a base salary and commission, so, obviously, the commissions will stay as a percentage, as a constant percentage, and I'll let Dale talk a little bit about some leverage that may or may not happen in the future.

Well, from a leverage standpoint, we continued to try to maintain our infrastructure.

You know, we feel like we've built a good infrastructure in the sales organization.

We do add field sales personnel, but we're not adding to the management structure back at headquarters and spread throughout the country, so we still have a lot of opportunity to continue to leverage the sales force as well as the marketing spend on the Company.

All right.

Dale, does that mean then that the incremental dollars -- I mean given that you're talking about a one-third expansion in the headcount, in the field sales force, you're saying you're comfortable with the management level, management infrastructure?

These folks are driving productivity --

Absolutely.

-- from sales, and the incremental dollars are going to be more or mostly ad driven?

Is that a fair assessment of [inaudible]?

Yes, one-third add to the field sales force has already occurred.

Yes.

And is that then roughly where you want it for the next year or so?

Well, this is Tom again.

It will depend on how many additional stores we open up, and it will depend on how many additional models of mattresses we introduce and the size of the space, I should say, we have in those stores because that somewhat dictates how long a sales rep may stay in a particular store when they go in for training purposes and rapport building.

So we're going to remain flexible as we move forward.

If we need more reps, then we'll add them.

All right, Tom, and thanks.

Sorry, the last follow-up here is what incremental dollars do you think you guys might be considering in the budget process to put into '07 versus however '06 shakes out?

In sales and marketing?

Yes, sir.

We'll continue to look for leverage in that area.

Okay.

Fair enough.

Thanks guys.

Good luck.

Thank you.

Steve Colbert, Canaccord Adams.

Congratulations on the quarter.

Thanks, Steve.

Looking at gross margins, I know you mentioned last year in Q3 a significant impact from fuel and commodity issues.

Are you benefiting yet from lower natural gas prices and other commodities, or does that take a while to work through the system?

Basically, it takes the chemical companies to decide to roll back their pricing, which really has not occurred yet.

Certainly, on the lower fuel costs, you don't have as much on the fuel surcharges for transportation, so there is some benefit there.

But in terms of the chemical costs that went up third quarter, fourth quarter last year, we haven't seen the U.S. chemical companies take any price rollbacks yet.

It's certainly something that we continue to push for, and we hope that we'll be able to get something there on that side of the equation going into next year, but until it happens, it's not something that we'll count on.

Okay, fair enough.

And then mattress units, sales appear to be obviously quite strong domestically.

Is there strength in any particular price point?

Have you seen a shift in the trends from the past?

And what's your take on the consumer out there?

Well, we've been very pleased with the response that we've received from, of course, the new models that we've added to the product line, but also, the existing products continue to do well.

One of the keys, we think, to our success is expanding that floor space, and as I mentioned in the prepared remarks, that currently we represent a higher percentage of the sales of a -- for a store than we have in floor space.

So we still think we have an opportunity to continue to expand the number of slots or the space on the floor, and that's a key.

But right now, we're seeing a nice across-the-product-line type of performance coming from all of our price points, and of course, we're maintaining the strategy of competing only in the premium market, that $1,000 and above for a queen-size.

I would add -- this is Dale -- that with the revamped Classic, we've seen Classic perform better, which is a very good thing that we were looking to do, and that's why we renewed the Classic.

We felt it was getting a little stale, and we've seen that work.

Okay.

And then just one quick follow-up.

Looking at the other two new beds, particularly the Grandbed, I know you don't want to talk specifically about accounts or products, but it seems to have garnered far greater success than I had imagined it would.

Is there any way you can quantify how the Grand's doing?

Well, we have been very pleased.

You know, we did not expect to get the type of distribution that we've received given the positioning of that product and the price of the product.

So it was a pleasant surprise as we rolled out this product, and we've also been very pleased as the sell-through, you know, not just placing it on the floors of the stores but the stores have come back very quickly and ordered, and it seems to be doing very well in the market.

The success of it is part of the reason why it's taken us a little bit longer to get it floored by everybody who wants it because once the store has it, they have priority on replenishment, as opposed to new stores.

Okay, fair enough.

All right.

Thanks.

That's it for me, guys.

Congratulations again.

Thanks.

Robert Straus, Merriman Ford.

Nice quarter.

Just a couple questions here.

Dale, one of the things that you have spoken about in past quarters is the sales trends at those retail stores with competition and the fact that those stores would perform better than those stores without competition.

Can you fill us in on what you saw this quarter on that level?

Yes, that trend continued.

We continue to see better performance in stores that have competition than stores that do not have competition.

And regarding the stock-out comments that you made, can you give us a little bit more color behind that?

Yes.

Well, basically, people wanting product that we didn't have enough supply of, so we were having to expedite cover supplies from overseas.

We were having to expedite shipping to them.

And people have -- the performance of these units exceeded the ramp that we expected.

And particularly when part of your supply chain is overseas, it can take a while to get that ramped up to the levels that we've needed them.

When initially you give your suppliers a forecast and they work through that forecast and then the forecast turns out to be too low, it takes them a while to respond.

And this is primarily the Grandbed and Rhapsodybed that you're talking of?

Correct.

Okay.

Nice quarter, guys.

Thank you.

Thanks.

Mark Rupe, Ryan Beck.

Great quarter.

As you guys look into the New Mexico facility, I know the capacity is about 55,000.

Any thoughts on where '07 might break down on how much you'll use that versus Virginia?

Well, Mark, what our plan is -- you know, once we get through a process of getting it up and running, our plan would be to try to run Albuquerque and Virginia based on supporting Albuquerque supporting the Western half of the U.S. and Virginia supporting the Eastern half of the U.S.

Got it, okay.

You know, one of the benefits of Albuquerque is having a plant closer to the market and being able to save on the transportation costs of having to ship product cross country.

Got it.

Any thoughts on when that might be fully ramped?

Is it a quarter, two-quarter process?

Oh, in terms of the level that we think that we probably need it to be ramped to, it's probably between one and two quarters, yes.

Okay.

And then, also, Rick Anderson was hired about 90 days ago or so, and I know -- I believe on the last call you mentioned that you expected a positive impact from his hiring.

Any thoughts on his initial impact?

Yes.

Rick has gotten off to an excellent start.

It's a learning curve, but with his background in consumer marketing, he's hit the ground running, and we've been very pleased with his performance and how he's taken on the responsibility.

Okay.

And then, lastly, the retail channel mix shift has been a big impact on your guys' margins for the last couple of years. '07 appears to be like it's going to have less of an impact.

Is that fair to say?

Well, as retail becomes a bigger and bigger piece of the business -- you know, it's now 80% of our business -- obviously, the tremendous amount of the shift has occurred and is behind us.

You know, retail will continue to become a bigger piece of the business, but the difference between 80% of the -- 50% of the business a few years ago and 80% is a much bigger move than moving from 80 to 85 or 80 to 90.

Got it.

I mean do you think it could be more than 85 retail long-term?

It's hard to say.

You know, as we continue to grow the business, we would expect that -- the retail business to continue to grow faster than the DR business.

So with growth, the retail business will continue to become a bigger piece of our sales.

Perfect.

Thank you.

Joe Altobello, CIBC World Markets.

First question.

In terms of the guidance, you know, obviously, you guys are going to be at the low end of sales and the high end of earnings.

Could we go through some of the puts and takes that have occurred since you guys gave the initial guidance?

You know, it's probably oversimplifying it, but it sounds like the only things that have really changed is your international pillow business is a little bit weaker than you expected but probably your cost savings have been a little bit better.

Yes, Joe, that pretty much hits it on the head.

In terms of -- started the year how we expected the year to go.

The U.S. business is performing very much in line with our expectations.

Where we've had weaker-than-expected results is internationally.

You know, part of that was due to foreign exchange.

Recently, in this quarter, it's been predominantly related to Japan, but -- so the international side of the business does -- is kind of negatively affecting our outlook in terms of total revenue for the year, but we have had -- continue to have outstanding productivity within the business and cost leverage in the business that is enabling us to perform at the higher end of the earnings.

Okay.

And then on that latter point to the productivity, if you look at what you guys have achieved in '06 and then out into '07, you know, obviously, you probably won't give us numbers, but what order of magnitude opportunity is there in '07 versus '06?

Is it sort of equal?

Should that start to moderate a little bit in terms of your productivity or the improvement in productivity?

Well, you know, we will continue to have mix shifting within the business, which will continue to give us some gross margin pressure.

We will have Albuquerque start up, which will give us some gross margin pressure.

We expect to continue to get operating leverage in the business.

So our expectations at this point would be that from an operating margin standpoint, we would be kind of flat to slightly down next year, as we're going to be this year.

Okay, great.

Thanks.

[OPERATOR INSTRUCTIONS]

Reza Vahabzadeh, Lehman Brothers.

In terms of the competitive environment, have you seen any changes in the last few months?

We haven't seen any significant changes.

I mean I think we are all aware of the new products that have come on to the market, but in terms of any significant new competitors, we haven't seen anything.

I think everyone at this point has some type of a competing product out there, so we haven't really seen much new.

What about the sort of discounting and price promotions by some of your competitors?

It seems to be predominantly on the innerspring side of the business.

You know, specialty side of the business continues to perform very well, us included, and the discounting that we've heard some about appears -- seems to be on the spring side.

Okay.

And in terms of the sales environment, obviously, gasoline prices have come off recently.

Have you noticed any change in your sales trends in the last four to six weeks versus the preceding time period?

Related to gas prices?

No, I mean in general, whether it was gas prices or other factors, just general consumer sentiment.

Well, I mean we've only -- we just read the same reports that you guys have seen that the -- seems like there's some shifting in consumer confidence as it relates to gas prices, so that's about all we've seen is what's been reported.

Okay, fair enough.

And then when do you think your product mix and channel mix will sort of stabilize or normalize?

Is there a time in the next couple of quarters when that happens?

Well, as I said before, on the channel side, we expect to become -- continue to become more and more of a retail business.

You know, that's been the trend.

We see no reason why that trend would not continue, that the retail business would continue to grow faster than the other channels.

On the product side, again, we also expect that we will continue to become more and more of a mattress company.

Our mattress business continues to be the growth driver of the business.

That's the predominant focus of the Company is driving and growing our mattress business.

And so those are trends that we expect to be long-term trends.

It's just a question of how much impact those trends have.

You know, we have a lot of that impact behind us, so I think we'll continue to see mix shift.

The impact of that mix shift lessens over time as you become more concentrated in those channels and product lines.

Yes, I mean if you take a look at our mattress business and related products like foundations and frames and products that we sell along with the mattresses, I mean are -- from a mix standpoint on product, mattresses and other accounts for about 86, 87% of our revenue now.

So that's quite a change over the last few years.

So to Dale's point, we wouldn't expect that to continue accelerating the way it has in the past.

And, lastly, what's the -- sort of your best guesses for CapEx for next year?

CapEx for next year?

Yes.

At this time, our expectation would -- you know, Albuquerque will be behind us.

We believe that generally our maintenance and growth capital normal requirements would be somewhere in the neighborhood of $20 million a year plus or minus a little bit year to year just depending on how projects go.

So that's kind of a ballpark.

We'll give you more color on that as we complete budgets and prepare to give guidance for next year.

Fair enough.

Thank you.

[Matthew Freninger].

This is [Ryan Freninger].

Good quarter, guys.

Thank you.

A couple of questions.

First, can you break out -- I don't know if I missed it -- but the advertising from commissions?

Break out advertising from commissions?

Yes.

Sorry.

I guess a better way is what was the advertising spend in the quarter?

Advertising spend in the quarter was $22.3 million.

Okay, so my question then becomes -- well, the advertising spend came down significantly in this quarter, and I realize part of it was a function of volume year over year in the quarters.

But can you give us a view going forward as to how you're going to think about advertising spend as a percentage of revenue?

Sure.

One of the things that impacted us this quarter was simply that in the U.S., we didn't clear as much advertising on TV, as well as from radio, that we had expected, and that can be attributed to record spending surrounding the campaigns that are going on.

So as to going forward, that's obviously still having some impact on us and will have up until Election Day as spending has increased and the availability has become tighter for TV advertising.

But after the election, we expect to see what we've seen in the past during election years, that it rebounds and we're able to pick it back up.

So our objective is to maintain our media spending as a percent of our revenue at about the same percent, that 10 to 11% range, so that's the objective going forward.

Okay, and then second question is can -- is there anything we should be thinking about that would negatively impact average unit selling price in the fourth quarter or going here the next quarter or so?

Or how should we think about the trend for average unit price?

We would expect average unit selling price to pick up.

You know, earlier, in the second quarter, it was down a little bit because of the Classic closeout, and obviously, the mix shift affects average unit selling price as well.

But with the new higher-priced models out there starting to mix it up, we saw average selling price pick up this quarter despite a lot of floor units negatively impacting that and the continued mix shift impacting that.

So at this point, we would expect average unit selling price to tweak up a little bit.

So the rollout of floor models is relatively complete?

Yes, relatively.

There are still some customers who are wanting the new products that don't have it, but we started rolling them out in the second quarter.

We substantially got caught up in the third quarter, but there still are some people that would like to have the product that we haven't been able to get it to yet, so we'll complete it here in the next quarter.

All right.

And then my last question -- I just want to make sure I heard this properly.

But I think you mentioned that there were some international geographies where at some point in the quarter they had no representation they normally do due to some third-party distributor disagreements?

Yes, what we were referring to there is that we had several of our distributors who had violated the agreement in regards to diverting a product, and we had to take some action after giving them adequate warning that this was a violation so that we basically terminated the agreements that we had and then went out and found new third-party distributors to represent us in those countries where we made that determination that they were in violation.

And that's one of the efforts that we mentioned that we were doing in order to cut off the flow of product into the gray market in Japan.

All right, thanks.

So then here for this fourth quarter and going forward, these issues should then be wrapped up?

In terms of --

[Inaudible].

Well, certainly in terms of the third party having the new distributors in place, that has been done, and we should then be working with these new distributors, start training them and getting them up to speed on the product line.

Okay.

Last small question.

I'll let someone else jump in.

What do you think is the ramp-up time for these guys to get up to full steam?

It will vary.

I mean it's like similar to opening new accounts here, where you have to train a sales force and you have to get them up to speed on the product knowledge, but it will vary depending on the individuals involved.

We should have them up to speed this quarter.

Once again, congrats on the quarter, guys, and I appreciate your taking my questions.

Thank you.

[Matthew McClintock], Lehman Brothers.

I'm filling in for Bob Drbul today, and I just have one question, so I'll make it fast.

I was just wondering if you could essentially give us an update on the hotel rooms, putting TEMPUR beds in the hotel rooms?

And I think there was something that you were going to start that plan once New Mexico came online?

Right, exactly.

You know, we've not had adequate capacity in the U.S. to go aggressively after the hospitality market, and as we bring the new factory online, we intend to do that.

We're in the process now of hiring approximately 20 independent reps, people who are already in that industry calling on the hotels and have the rapport built up.

These will be independent reps who will be coming on board in the fourth quarter to get them up to speed and trained to go out and start trying to aggressively position our product, along with attending trade shows, which we've not done in the past.

There are a number of important trade shows for the hospitality industry.

And we've also started an advertising campaign, trade advertising, trade publications, letting those potential customers know that Tempur-Pedic has a product and has a program, and, hopefully, this will start paying some dividends around the time that we bring New Mexico online next year.

Okay, great.

Albert Kabili, Goldman Sachs.

A question, I guess, on the lowered -- the bottom end of the revenue outlook.

The $30 million spread, is that all coming from international because it seems like a big number to just be coming off from international.

Well, we didn't say we were at the bottom of the revenue guidance; we said toward the lower end of the revenue guidance, number one.

Number two, because of a $30 million spread, that's why we gave that color that we would be at the lower end of the guidance as opposed to the upper end.

We -- as we went into the year, the guidance was 12 to 16% growth for the Company.

We looked for the business to -- U.S. and international business to grow at about the same rate this year.

The U.S. business has been right on track of what we expected and wanted to do this year.

The international business has been a little bit off track.

You know, the first quarter is off track predominantly because of a bad currency situation.

Second quarter, it was -- international business had a decent quarter, but it was a little bit below the track that we were looking for.

Here in the third quarter, they've continued below the track we're looking for.

So the predominant swing in revenue expectations is the international side of the business.

Okay.

And then in terms of the stock-outs, it looks like you're right on pace where you were thinking of for the U.S. business, so could you give us some color on the stock-outs and what's creating it then?

Sure.

The stock-outs surround the new products, and again, going back to when we projected our placement of those products, that's how we built up the forecast -- production forecast -- how many slots were we going to get, how many stores would we get into.

And in essence, what happened was the trade, our retail partners, accepted those products at a higher rate than we expected, which caused a production problem, basically, the fact that we couldn't make the product fast enough and also from the standpoint of some of the raw materials needed to make those new products, so that was the reason why we had to expedite those products.

As we mentioned, there was a cost associated with that during the quarter, but we thought it was the right thing to do to try and live up to our commitments that we'd made to expedite those raw materials in here.

But it all surrounded the new products, and basically, the good news for us was that the demand was high and, of course, the challenge was getting up to speed and getting caught up, and that's -- we're still in that process.

And one thing I would just add there is we've talked for some time that the Virginia facility is running 24/7.

You know, when you have a production facility running all out, you're not able to respond as quickly to slight changes in demand between models, and so that's something that we're looking forward to Albuquerque giving us that extra capacity to be able to more quickly respond to variations within forecasts by model to the demand by model.

Okay.

And could you give us some color on -- in terms of the sales growth this quarter?

How much of it is the new products versus existing products?

Was that roughly 17% in sales growth?

No, that's not something that we do.

Okay.

And the final question.

In terms of Albuquerque, it's going to add about $10 million in depreciation expense next year.

Could you also let us know how much extra in overhead costs it will be adding next year to get that plant ramped up and going?

Well, our expectation for the year, and we continue to work through those expectations and we'll provide more color when we give guidance for next year, but at this point, between the efficiency savings in Albuquerque, the transportation savings, the additional depreciation, the start-up costs, etcetera, we're looking for Albuquerque to cost us in the neighborhood of $8 million next year.

All right.

Thank you.

Randy Scherago, First Albany.

Just two follow-up questions.

There has been some amelioration of chemical prices in Europe.

Do you have any sense of when you might see some of that effect by either importing them from Europe or putting pressure on domestic chemical companies and your raw material sources?

And the second is regarding the sales cycle to the hospitality industry, how long do you think it takes to get into the franchises buying and sort of going from the corporate to the franchisees, making decisions in a hospitality industry, as far as buying beds?

On the chemical side, in Europe, we never saw the run-up last year that we saw in the U.S.

The chemical issue -- price issues in the business were strictly a U.S. issue.

We didn't get the big price increases in Europe.

Our European prices have been fairly stable, and magically, the U.S. prices ended up stabilizing at about the level where you were indifferent if you bought it locally or you imported it.

So it's something that we look at.

It's something that we continue to monitor.

See an opportunity, I -- to import chemicals, we'll do that.

And hopefully, that will create some downward pressure at some point on the U.S. chemical prices.

Second part of your question, I'll let Tom answer.

Yes, as far as the hospitality, I think it would be difficult to generalize because of the fact that there are so many different structures out there in terms of franchise operations, independents, and how much control some of the hotel chains have at the corporate [inaudible].

So I think what we're going to have to do is work through that.

It will vary as to how -- if we are successful at getting, say, a larger chain as to how quickly that can be transitioned over throughout the chain.

We don't know that at this point.

We're going to have to learn that as we go.

But I heard sort of optimism that you would see hospitality sales in the first quarter already.

Is it --

Oh, yes.

I mean we have seen some hospitality sales already.

We just haven't had an aggressive approach, meaning we haven't had a sales organization.

We've had one salesperson.

We're in about 13,000 hotel rooms as we speak today, but we would expect to see sales coming as we put these salespeople on.

But in some cases, it may be a local hotel, it may be a regional chain, or hopefully, at some point, we could get a national.

But at this point, we just don't know until we get into it.

Okay, thank you.

John Baugh, Stifel Nicolaus.

How do we -- two questions real quick.

One, what was the marketing or advertising spend in the year-ago third quarter?

And then, secondly, how do we think about inventory going forward?

It's been a huge source of cash this year with the new plant coming on.

When does that cease to be a source and maybe a use?

Well, the first part of your question, advertising spend in the third quarter last year was $23.6 million, so it's down a little bit year over year.

We didn't have elections to contend with last year, which can impact the availability of advertising.

Second part of your question, inventory has been a source of cash this year.

Last year, we intentionally built inventories in the business.

As I said in my comments, I expect to build some inventory here in the fourth quarter just because we've been running a little bit tight.

Actually, what Albuquerque will do, instead of adding to inventories, will allow us to continue to run the business more efficiently with a lower inventory level by having two factories able to respond much more rapidly, as opposed to one factory in the U.S. that's running all out.

The factories will be able to respond much faster to the changing demand patterns, and we'll be able to operate the business with a little bit less inventory.

Good.

So up a little bit in the fourth quarter and then staying up maybe in the first quarter and then leveling off, not declining a little as we go through '07 -- is that a good way to think about it?

Yes.

Great.

Thank you very much.

Joe Feshbach, Joe Feshbach Partners.

That really was a great quarter.

Congratulations.

Thank you.

Just a couple follow-ups on the whole operating leverage and advertising thing as they go together.

You know, one thing -- I mean 26% domestic unit growth is pretty impressive.

I think very impressive.

And in light of a somewhat diminished advertising spend, does that sort of argue for the idea that maybe the incremental dollar of advertising isn't as persuasive as, say, word of mouth?

I mean it seems to me that you've just got a great word-of-mouth momentum going.

No, I'm not sure if it would -- that would be a conclusion that I would agree with.

I mean I think also when you look at advertising and building brand awareness and establishing the brand in the mind of the consumer, even the advertising that we do today may not result in an impact that is measurable today.

Some of that is carried over and is built upon in the future, as well.

So it's not like you spend a dollar today and you're going to get that immediate return.

You get some return, but you also will get a benefit going forward.

So we're very cognizant of where we are in our brand cycle in terms of that brand-building process, and we think that we certainly need to continue to invest in advertising to get this awareness up to where we ultimately want to be.

All right.

Still, Dale mentioned that there was obviously some gross margin pressure, which has been widely discussed, from the start-up of Albuquerque, and you also mentioned that you expected to get operating leverage in a general -- at least in a general sense, Dale, I think into '07.

What specific parts of the income statement should we be looking at for some incremental operating leverage going now next year and the years beyond?

Should we still see some operating leverage in sales and marketing and G&A?

Yes.

In both?

Yes to both.

And then as I look at your numbers generally in sales and marketing, there do seem to be seasonal spending patterns [inaudible] very high in the first quarter, very low in the fourth.

Should we expect that again in the fourth, etcetera?

Typically -- last year, we were very low in the fourth because of the business situation we were in.

That is not a real historic pattern.

The historic pattern is strong sales and marketing costs in the first quarter, eases off in the second quarter, usually picks up in the third quarter.

We were flat second quarter to third quarter this year because of the election cycle.

So in the fourth quarter, we would expect to see sales and marketing costs at or even a little bit better than the third quarter, up -- better, as in higher -- due to the election cycle easing and trying to get things -- we tried to spend late in the year to get things off to a good start the following year.

Fair enough.

And then the last quick one -- thanks for indulging me -- is, you know, you guys have been generating major free cash flow so far this year.

I don't know.

I haven't bothered to calculate through the nine months, but it's significant, and CapEx should be declining somewhat with the ramp-up of Albuquerque next year.

You're the least leveraged, at least compared to Simmons and Sealy.

We've got this basket of -- you know, related to your bonds.

Can you talk a little bit about what the plan is to fine-tune or financially engineer the balance sheet to make sure that we're getting optimum returns on capital, etcetera, whether it's dividends, buybacks, just sort of what you guys are thinking about strategically?

Well, at this point, we are -- continue to be limited by the bonds.

We did a significant repurchase program, ran into the max that we could do on the bond deal.

The bond covenants allow us to -- at this point would allow us to do a little bit each quarter.

Basically, right now on a cumulative basis, we would be available under that basket to repurchase about $27 million worth of stock, but we have the opportunity next August to call those bonds.

That's the first call date.

So it's something that we will continue to look at and evaluate, and depending on interest rates and other factors, look to possibly remove those bonds and the restrictions around them and the high interest cost around them next August.

I guess maybe stated another way then really quickly, just is there a -- kind of a level of leverage that you guys think is appropriate longer term?

Are you comfortable being leveraged 2 turns of EBITDA?

Is that the kind of thing that we should look forward to?

I mean this is obviously a stable industry with great free cash flow characteristics.

Well, we've been as high as 4.

A couple of years ago, we got down to about 1.5.

We went back up with the repurchase to about 2 times.

Right now, we're about 1.6 times, so we certainly are comfortable with leverage.

Obviously, the cash flow dynamics of the business are extraordinarily strong, so leverage is not something that concerns us, and we're just -- you know, continue to work through and discuss what type of longer-term optimal capital structure we would like to have.

We don't have a firm conclusion on that at this point.

All right.

Fair enough.

Again, great quarter and great on the unit sales.

Thanks.

Thank you.

Michael Cox, Piper Jaffray.

In the interest of time, I just have one question.

On the international side in terms of the distributors, I believe that you guys have switched those around in the past, and it doesn't seem to have ebbed the flow of product to this [great] market in Japan.

I was just wondering what the new restrictions have been put in place around the new distributors to prevent that from occurring again?

Yes, I think maybe just to clarify, in the past, we [sort of] did not exercise the option under the agreement in terms of cutting off a distributor.

You know, we always try to work with a third-party distributor to try and get them to come around and agree to comply.

Whereas, you know, it became obvious in certain situations that that was not going to happen, then we took that action.

So that's more or less the difference there.

So in terms of going forward, the distributors -- I guess you'll exercise that option more quickly is the restriction?

Yes, I mean, hopefully -- frankly, hopefully, we won't have to face this again.

We think that we've sent a good message throughout the network that we're serious about our agreements and about diverting a product, so we're hoping we won't have to do that.

Okay, great.

Thanks.

Keith Hughes, SunTrust.

Also in the interest of time, I'll make this quick.

The capacity you talked about in Albuquerque earlier, is that still a doubling of U.S. capacity?

Yes, it is.

And the --

Once it's ramped up.

Once it's ramped up, and that will be roughly summer of next year?

You know, it will take --

More or less?

Yes.

The $8 million of cost that you had referred to earlier, what kind of capacity utilization do we have to get the plant to for that number to bear out?

That's basically -- I don't have the capacity utilization sitting in front of me, but I think it's based on a very modest growth expectation on the business next year and balancing the production between those two facilities.

You know, Albuquerque will be our most efficient facility, and we do get savings from a transportation standpoint, and we'll get savings from a distribution standpoint of being able to, once we're comfortable with it, operate the business with still less inventory.

Ladies and gentlemen, that concludes the time that we have for question-and-answer today.

I would now like to turn the call back over to management for any closing remarks.

Please proceed, gentlemen.

Thank you.

We are extremely confident of the long-term prospects for Tempur-Pedic and believe we'll remain the clear leader in this specialty category and expand our position as the worldwide leader in premium bedding.

Consumers are showing a strong willingness to choose our products, and brand awareness continues to expand.

Our momentum has increased, and we believe we have significant opportunities for growth while continuing to improve our operating productivity and cash generations.

Thanks again for joining us this evening.

We look forward to talking with you again late January, when we will review the fourth quarter.

Good evening.

Ladies and gentlemen, thank you for your participation in today's conference.

This concludes today's presentation.

You may now disconnect.