Tempur Sealy International Inc

NYSE:TPX

Earnings Call Transcript 2018-Q3

[Operator]

Good day, ladies and gentlemen, and welcome to the Tempur Sealy Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time.

I'd now like to introduce your host for conference call, Ms. Aubrey Moore, Investor Relations. You may begin, ma'am,

[Aubrey Moore, Tempur Sealy International, Inc.]

Thank you, operator. Good morning, everyone, and thank you for participating in today's call. Joining me in Lexington headquarters are Scott Thompson, Chairman, President and Chief Executive Officer; and Bhaskar Rao, Executive Vice President and Chief Financial Officer. After prepared remarks, we will open the call for Q&A.

Forward-looking statements that we may make during this call are pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that any such forward-looking statements, including the company's expectations regarding sales, earnings, net income, and adjusted EBITDA, and anticipated performance for 2018 and subsequent periods 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, regulatory, competitive, operating, and other factors discussed in the press release issued today. These factors are also discussed in the company's SEC filings, including but not limited to, Annual Reports on Form 10-K, and the company's Quarterly Reports on 10-Q under headings Special Note Regarding Forward-Looking Statements and/or 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. This morning's commentary will include non-GAAP financial information. The press release contains reconciliations of this non-GAAP financial information to the most directly comparable GAAP information, except as otherwise discussed in the press release, as well as information regarding the methodology used in our constant currency presentations. We have posted the press release on the company's investor website at investor.tempursealy.com and have also filed it with the SEC. Our comments will supplement the detailed information provided in the press release.

And now, with that introduction, it is my pleasure to turn the call over to Scott.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Thank you, Aubrey. Good morning and thank you for joining us on our 2018 third quarter earnings call. I will start with some comments regarding our progress in resetting the foundation of our company and positioning us for long-term earnings growth. Then Bhaskar will review the quarterly financial performance with you in detail. Finally, I'll wrap up with a review of our long-term corporate initiatives.

While we're dealing with rapid change in our industry, the team continues to progress quickly on positioning the company to create shareholder value over the long-term. I would like to start by highlighting our progress on improving two key aspects to our business: our product portfolio and our distribution network.

First, let's talk about product. We've recently completed our initial phase of the introduction of our new Tempur products in North America, which include the entry level Adapt and ProAdapt models. These products have done what they were designed to do, take share in the $2,000 to $3,000 price band. They have exceeded our expectations. Overall, North America Tempur mattress units grew a robust 29%. And I should also mention that following the revamp of our pillow collection, our pillow sales grew 30% in the quarter. These results further solidify Tempur's position as a dominant brand in the premium bedding product category.

In addition to our success with the new Tempur products, our new Sealy Hybrid continues to outperform internal expectation and has become one of the bestselling hybrids ever with record sales in the quarter. In short, we can now say that our two big launches this year have been successful and will help set our foundation for years to come. In a highly competitive and traffic challenged mattress retail environment, our retail partners understand that providing real value at high price point is essential to growing their profitability. By having some of the best products in the premium category, we believe we're well-positioned for success.

With over three decades of experience, our world-class research and development team is firing on all cylinders. We expect this momentum to continue as we introduce the new high-end Tempur models and an all-new Stearns & Foster lineup in the coming months.

Now, turning to distribution. As we've mentioned in the past, we've identified gaps in our distribution network and we're working hard to address them. While our preferred method of distribution will always be our loyal third-party retail partners, we need to be wherever the customer wants to shop. So, one of our key focus areas has been building out our direct-to-consumer business. In the quarter, we continue to see early success with our North America direct channel growing 27% and our International direct growing 32%. Our largest driver in North America performance was our own Tempur retail store which continues to perform well. We believe these high-end showrooms are attracting incremental customers by offering a special shopping experience in low pressure environment with knowledgeable, non-commissioned sweep consultants. Customer satisfaction score and engagement with the brand are both very high.

During the quarter, we opened three additional Tempur stores, bringing our total store count to 38 stores. We're still sizing up the North American opportunity. We currently plan to have 60 stores to 80 stores opened by the end of 2019 and we envision over the long-term about 150 stores. Our Tempur stores complement our existing third-party retail partners well by increasing our brand awareness in the local market. And after careful analysis, we've found that regions with the largest presence of Tempur-Pedic company-owned stores have exhibited some of the strongest wholesale growth for Tempur-Pedic products.

In other words, based on early results, our company-owned stores seem to actually grow the pie for our third-party retailers. In addition to the strength of our own retail stores, we also grew share within various alternative distribution channels. This is another prong in our effort to be wherever the customer wants to shop. As consumers become more comfortable purchasing online, we are adapting to their preferences through the expansion of not only our own e-commerce platform for Tempur, but also through expansion with third-party online retailers. While our balance of share is still very low our sales through the third-party online retailers experienced significant growth in the quarter. While we are proud of the successes we had had from a product and distribution standpoint, we face several significant headwinds in the quarter that adversely impacted our results.

First, during the quarter, we continued to experience greater than expected unfavorable mix within the Tempur brand into our new Adapt and ProAdapt models. Our recent Tempur product rollout started with the entry level of $2,000 to $3,000 price band because this was the price band where we were previously under-represented. While we're pleased with the incredible performance of our new product, we were the victims of our own success as we experienced higher than expected cannibalization of our products above $3,000 which have yet to be refreshed this quarter.

We expect this headwind to subside as we roll out the Luxe model in the fourth quarter and the Breeze model in early 2019, both of which are priced over $3,000. Second, Mattress Firm, the largest bedding retailer in the U.S., continues what we consider to be unprofitable promotion activities including heavy discounts and free product offerings. These actions particularly impacted our low-end Sealy business. In an environment where retail traffic is at a premium, retailers need to maximize the average ticket and that means premium product offerings. We see this all around the world. Successful retailers have to move high end product. Low price, high volume does not generally work well in high cost brick-and-mortar bedding retail. In fact, subsequent to quarter end, Mattress Firm filed for Chapter 11 bankruptcy protection after reporting close to $300 million of negative operating income. That equates to losing about a $100 on every mattress sold or about 10% of ASP. Our thoughts are with the Mattress Firm employees and their families during this difficult time and we're hopeful that they're able to successfully reorganize and emerge as a healthier player in the bedding industry. We believe the elimination of Mattress Firm's recent promotional behavior would benefit all industry participants.

Third, we had to face an influx of low end import mattresses. Specifically, we've seen a significant increase in imports from China which has been a major headwind for our low price points Sealy products and put pressure on supply/demand balances in the industry. In September, we and other industry participants filed a petition with the U.S. Department of Commerce and the U.S. International Trade Commission alleging that many of these Chinese imports are being dumped into the U.S. market at prices below cost. As a result of this petition, the Commission commenced an investigation which is expected to take 9 months to 13 months to complete.

Fourth, commodities, net of yet to be realized announced pricing increases continue to be a significant headwind in the quarter. Input costs are a large percentage of cost of goods sold and we are experiencing increases across all categories. We've demonstrated a history of passing these commodity price increases on and we've already started this process, having announced four pricing actions in the last 12 months in North America. However, these increases take time to pass on which result in temporary earnings pressure. We expect commodity headwinds to continue through the fourth quarter of this year but at a much reduced rate.

Fifth, we increased our level of bad debt expense related to a well-publicized retail department store bankruptcy. We fully reserved their account receivable balance. This account was not a top 5 customer during the third quarter. Although these various items I've discussed impacted our performance in the quarter, we believe that many of these headwinds are temporary in nature and should abate over time.

As we've mentioned in the past, 2018 continues to be a transitional year. While this transition is complex, and will take some time, we are encouraged by the progress that we're making as we strengthen our competitive position throughout the world.

As we enter 2019, we expect earnings to grow as we complete the Tempur high-end product launch, realize the full benefit of our announced pricing actions, and move past some of the temporary factors that I just mentioned. I'm proud of the entire Tempur Sealy team's performance in the face of rapidly changing market conditions, and feel confident in our ability to deliver significant long-term value to our shareholders.

I'll now turn the call over to Bhaskar to walk us through the third quarter financial statements.

[Bhaskar Rao, Tempur Sealy International, Inc.]

Thank you, Scott. Before going into the details, a few key financial highlights from the third quarter. Global net sales were $730 million, an increase of $18 million from the third quarter of 2017. Adjusted gross margin declined 100 basis points to 42.3%. Adjusted operating margin declined 70 basis points to 13.4% of net sales. Adjusted EBITDA was $128 million and adjusted earnings per share for the quarter was $1.02.

On a segment basis, sales in North America increased slightly. Within the North American segment, sales in the wholesale channel were consistent with the prior year, and sales in the direct channel increased a very robust 27% in the quarter. During the quarter, our reported gross profit and operating income in North America were impacted by one-time restructuring items related to the integration of Comfort Revolution and transitions related to our manufacturing footprint. In total, these items adversely impacted reported GAAP gross profit by $9 million and operating income by $13 million as compared to the prior year. The following results are adjusted for these items.

North American adjusted gross profit declined 130 basis points to 39.9% as compared to the prior year. This was driven by significant commodity increases not yet offset by our announced pricing actions, and the previously mentioned temporary unfavorable mix to entry level products within our Tempur brand.

These gross margin headwinds were partially offset by favorable brand mix as Tempur grew faster than Sealy, some improved pricing and operational improvements. Excluding the unfavorable $13 million from commodities in the quarter, our North American gross margin improved as compared to the prior year. Therefore, from a pure operating standpoint, we are realizing improvements.

Moving forward, we expect the cannibalization impact within Tempur-Pedic to begin to lessen in the fourth quarter as we launch the new higher price point Luxe models, and to further dissipate as we complete the launch within our ultra-premium Tempur Breeze in 2019.

Regarding commodities, we have historically been able to pass along increases in commodity cost through our own price increases. In response to significant commodity inflation, we previously discussed – we announced our first price increase in late 2017. That increase went into effect in mid-March of this year. As commodity prices continue to rise, we announced a second price increase which went into effect in mid-October. In addition, due to the robust demand for our newly launched TEMPUR-Adapt and ProAdapt products, we announced a separate price increase specific to those mattresses that also went into effect in mid-October. Additionally, to further address cost issues, we recently announced pricing actions on our adjustable bases that will go into effect in the first quarter of 2019. While we manufacture the mattresses we sell in the U.S., we do import a few non-mattress products such as adjustable bases. We took pricing actions on our adjustable bases in order to pass cost from the recently announced import tariffs on to the consumer.

Once fully implemented, we expect these price increases to aggregate to offset the inflationary cost pressures and tariffs. However, on average there is about a six-month lag for us to fully catch up. North American adjusted operating margin declined 150 basis points to 15.9% as compared to the third quarter of 2017. This was primarily driven by the decline in gross margin. International net sales increased 2% on a reported basis and increased 5% on a constant currency basis. On a reported basis, the wholesale channel decreased 3% and the direct channel increased a robust 32%.

International performance was below our expectations due to ongoing challenges in Europe, primarily in Germany. Asia continues to perform well. If you consolidate the Asian joint venture, International sales for the quarter increased 7% on a constant currency basis. During the quarter, we made significant progress on our initiative to enter into licensee relationships in certain targeted markets. As a reminder, we completed an evaluation of our international operation and intend to convert our presence in certain markets with low returns, difficult operating environment and higher operational risk into licensee relationships with third parties.

In connection with these actions, we have classified those markets as discontinued operations and have adjusted our financial statements accordingly. This impact has been reclassified into one line on the income statement. A recast of the prior quarters dating back to the beginning of 2017 is available on our Investor Relations website solely for comparison purposes.

As we look forward with our international operations, we've identified opportunities to further streamline the overhead structure. We believe that keeping our organization lean and nimble is necessary to compete in the global bedding market. We anticipate having restructuring activities in the fourth quarter primarily associated with head count reductions in Europe.

During the third quarter, our International gross margin improved 60 basis points to 53% as compared to the third quarter of 2017. This was mainly driven by the royalty reclassification and operational productivity, partially offset by unfavorable mix, foreign exchange and commodities. International adjusted operating margin improved 20 basis points to 19.6%. This was driven by operating expense leverage and improvements in gross margin that was partially offset by the royalty reclassification.

Now turning back to the company's global performance. Adjusted operating income was $98 million. Adjusted EBITDA was $128 million, down slightly from last year, which was driven by unfavorable Tempur product mix, commodity inflation and increases in bad debt expense. This was partially offset by increases in volume, expense management including reductions in incentive compensation and pricing benefit.

The adjusted tax rate was 26%, interest expense was $24 million and adjusted EPS for the quarter was $1.02. Our most recent outlook for commodity headwinds has increased modestly to $55 million from our previous estimate of $50 million for the full year of 2018. As a reminder, coming into the year, we had expected headwinds of approximately $30 million. So clearly, commodities have been incrementally unfavorable. In addition to commodities, we now expect to experience headwinds from tariffs on adjustable bases imported from China.

Before moving to the balance sheet, we are pleased to announce we have reached an agreement with the U.S. IRS and Danish Tax authorities for the years 2001 to 2011. While the settlement does not have a material impact on our financial or liquidity position, it does resolve a decade old matter and removes a significant loss contingency from the company. We're in the process of entering into negotiations for the appropriate royalty rates for the years after 2011, which is not expected to have a material impact on the company.

Now, moving on to the balance sheet and cash flow items. We generated operating cash flow from continuing operations of $113 million in the third quarter. Cash cycle was unfavorable by five days compared to the third quarter of 2017. This was principally driven by the higher inventory levels required to support the launch of our new Tempur products in North America.

At the end of the third quarter, net debt was $1.7 billion, a decrease of $64 million from the third quarter of 2017. Our leverage ratio was 4.05 times, which is slightly above the target range of 3 times to 4 times. We expect to be within the target range by the end of 2018.Lastly, we updated our financial guidance for the full year of 2018. We currently expect adjusted EBITDA to be in the range of $425 million to $435 million. This change in guidance is due to the increase in bad debt expense, underperformance internationally primarily in Europe, higher than expected cannibalization within our North America and Tempur-Pedic line, and incremental commodity headwinds primarily related to new tariffs which are not yet offset by pricing actions set for 2019.

I wanted to flag a few items for modeling purposes. For the full year 2018, we currently expect D&A of $110 million, total CapEx of $75 million including maintenance CapEx of $60 million, interest expense of $95 million, a tax rate of 27% and a diluted share count of 55 million shares.

And now, I'll turn the call back over to Scott.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Thank you, Bhaskar, great job. Turning to our long-term corporate initiatives, first, developing innovative bedding products in all the markets we serve. We're in the process of flooring the second phase of our new Tempur-Pedic products with the launch of our LuxeAdapt mattresses. The premium design had LuxeAdapt provides the ultimate Tempur-Pedic suite experience. Our APR plus technology is the highest density Tempur material that provides the best pressure relief and highest comfort features we've ever developed. While it's early, our initial results for the LuxeAdapt are very encouraging. In early 2019, we're excited about the launch of the all-new Tempur Breeze product, which will be the most innovative cooling system in the market, more than two times cooler than our current industry-leading Breeze model. This launch will be the final piece of our new Tempur product rollout, which will complete the strongest collection of beds in the company's history. One of the most prominent features of this collection is the compelling step-up story between models as we've built incremental value into each of the progressive tier products. In addition to the final phase of our Tempur launch, in early 2019, we'll also be launching our all-new Stearns & Foster lineup. This leading design utilizes the finest material and legendary craftsmanship featured beautiful, premium and timeless work. The all-new IntelliCoil technology provides personal support for your unique size and shape. This lineup also features for the first time proprietary memory foam engineered exclusively for Stearns & Foster by Tempur-Pedic, offering the ultimate comfort without sacrificing durability.

The second long-term initiative is to invest significant marketing dollars to promote our worldwide brands. Our Tempur-Pedic, Sealy, Stearns & Foster brands are some of the most well-known and highly considered brands in the marketplace. And we continue to support them with an elevated level of advertising spend relative to our three-year average. Marketing in an area that is changing rapidly and we are adjusting to the new reality concerning where customers learn about our products, we'll have more on that area in the future.

The third long-term initiative is to optimize worldwide distribution to make sure our products are properly represented in all channels, relating to customers choose where they want to shop and we're not trying to influence which channel they choose. You might note that in the last three years, our direct-to-consumer channel has grown from 4% of our business to 9% as we follow the customers in ever-changing purchase habits. Our research clearly shows the vast majority of consumers want to test the beds in store before making purchase decisions. So our top priority is to support our third-party retail partners. However, there is this growing segment of customers who prefer to purchase bedding products online. We have made an investment in building out our own e-commerce platform, and we are working more closely with other alternative channels, such as large online marketplaces.

Our last initiative is to drive increased EBITDA. Despite several near-term headwinds, we believe new products, the expansion of our Tempur retail stores, our increased focus on alternative channels, our recently inactive price increases, and ongoing productivity initiatives are laying the groundwork for earnings growth in 2019 and beyond. With iconic brands, industry-leading products, flexible operating model and omni-channel distribution platform, Tempur Sealy is well-positioned to improve customers' lives and create long-term shareholder value.

Operator, will you please open the call up for questions.

[Operator]

Our first question comes from Seth Basham with Wedbush Securities.

[Seth M. Basham, Wedbush Securities, Inc.]

Thanks a lot and good morning.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Good morning.

[Seth M. Basham, Wedbush Securities, Inc.]

My first question is on the Tempur-Pedic product line this quarter. You talked about cannibalizations being higher than expected. Can you try to quantify for us how much that cost you relative to your expectations?

[Scott L. Thompson, Tempur Sealy International, Inc.]

It was more than we expect, and we called out a couple of things, we called out what, commodities and cannibalization? Commodities was the biggest impact, that was the delta and then cannibalization would be second.

[Operator]

Thank you. Our next question comes from Peter Keith with Piper Jaffray.

[Robert A. Friedner, Piper Jaffray & Co.]

Hi, it's actually Bobby Friedner on for Peter. Good morning. Thanks for taking my question.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Good morning.

[Robert A. Friedner, Piper Jaffray & Co.]

There's clearly a lot of cross-currents on margin right now. Just wondering, just like high level, if you can walk through the various puts and takes on margin, I was thinking out through (28:08) 2019. In terms of detail, what you see as ongoing headwind, what might become a tailwind or what might be neutral? Thank you.

[Scott L. Thompson, Tempur Sealy International, Inc.]

You want to start that, Bhaskar, and then I'll help to clean up.

[Bhaskar Rao, Tempur Sealy International, Inc.]

Sure, sure. As I think about 2019 from a margin perspective a couple of things, as we mentioned in the prepared material, we have our new products that will be from the Tempur side that will be complete in the – by the first quarter. So we'll get positive mix. In addition, what we'd expect is the continuing ops productivity from a manufacturing perspective and that should be a tailwind for us. In addition, as we think about it is I would expect Tempur to grow faster than Sealy. So we would see positive, let's call it, positive brand mix as we get into 2019 as well.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah. I think kind of stepping back when I think about the margin issue you're talking about, look we had the commodities that hit us. We've addressed the issue through price increases, but the lag time between when the cost hit us and we get the price increases, we're working through that. That clearly flows to the number and something that we're dealing with. And then you have the negative mix issue, which we've known about we're going to have from the time we planned the launches for Tempur. It's been greater than we thought but at the same time we've got new product hitting the marketplace that is designed to correct that trade-down or product mix issue. And those are really – and then you just got the normal savings and stuff we're doing operationally that all that's net positive. So the headwinds that you feel and see in the numbers appear to me to be temporary in nature as we work through, but clearly have been greater than we expected.

[Bhaskar Rao, Tempur Sealy International, Inc.]

The only other item I'd like to mention is we would expect direct to grow faster than the business...

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah, from a channel...

[Bhaskar Rao, Tempur Sealy International, Inc.]

...channel perspective.

[Scott L. Thompson, Tempur Sealy International, Inc.]

We should – yeah, we should get some channel favorability.

[Operator]

Thank you. Our next question comes from Curtis Nagle with BAML.

[Curtis Nagle, Bank of America Merrill Lynch]

Great. Thanks very much. Would you guys be able to break out performance on top-line basis in North America for Sealy and Tempur? And then just as a quick follow-up, look, I understand there have been a lot of transitory issues here. A lot of things out of your control, but after two guide downs, I guess what gives you the confidence that you guys are being appropriately conservative for the rest of the year and we're not going to see another disappointing quarter?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Well, that's the nature of predicting the future sometimes. You don't get it exactly right. And it has been a dynamic year with some things that have been within our control, some things that have not been in our control. We've done the best job we can on doing the guidance. I think one of the reasons we're confident is when we look at the Tempur product and we'll talk about, we'll call it current trends. If you look at like October, the growth rate on a revenue standpoint in North America has grown, has basically doubled from an acceleration standpoint. And that double is being driven by Tempur with still some challenges in Sealy. From a unit growth standpoint, what Tempur on a unit growth standpoint in October was up what, Bhaskar, north of 50%?

[Bhaskar Rao, Tempur Sealy International, Inc.]

Correct.

[Scott L. Thompson, Tempur Sealy International, Inc.]

So the current trends are robust, they could change. But certainly the current trends are robust. When you look on a near term trend in International, the growth rate that we reported in the third quarter we basically continued that same growth rate into October.

[Operator]

Thank you. Our next question comes from Bobby Griffin with Raymond James.

[Bobby Griffin, Raymond James & Associates, Inc.]

Good morning. Thank you, guys, for taking my questions. I guess I was hoping to get a little bit more color on the charges in North America during the quarter and exactly what type of changes went into the manufacturing footprint and how should we think about onetime items and onetime charges going forward in that segment?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Sure. So in the North America, we had a couple of items happening, specifically around Comfort Revolution. So we did – as just as a reminder, we did acquire 100% of that entity during the third quarter and effectively what we've done is we brought those two separate operations together. So we had people cost associated with it as well as just the cost associated with restructuring those two organizations into one. And then the final one would be our supply chain optimization. So we optimized our manufacturing footprint, primarily associated with people cost as well as getting ourselves unwound from a pension associated with that.

As I think about the pro formas going forward, one item we did indicate as we are looking at our International operations and we would expect some restructuring costs primarily head count in the fourth quarter. And when you do those restructuring costs like International, Bhaskar, you got what 12-month payback?

[Bhaskar Rao, Tempur Sealy International, Inc.]

That's correct.

[Scott L. Thompson, Tempur Sealy International, Inc.]

That flowing through the numbers.

[Bhaskar Rao, Tempur Sealy International, Inc.]

That's correct.

[Operator]

Thank you. Our next question comes from Brad Thomas with KeyBanc Capital Markets.

[Bradley B. Thomas, KeyBanc Capital Markets, Inc.]

Yeah. Thanks. Good morning.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Good morning.

[Bradley B. Thomas, KeyBanc Capital Markets, Inc.]

I just has – I was hoping you could just help us think about how sales and margins and gross profit dollars will sort of trend over the next couple of quarters here with the new products rollout in North America, with the pricing actions that you're taking. I guess, if I'm connecting the dots here, seeing very good results out of the Adapt, ProAdapt, new products rolling out. So I would imagine that you all are expecting North America sales to accelerate, as you move into 4Q and 1Q and the margin trend to get better, but do you still like – should we still be expecting gross margins down these next few quarters. I guess just help me think how the P&L moves in the quarters ahead here, please? Thanks.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Okay, let me talk for a little while, and see if I can help with some of that, and then I'll let Bhaskar kind of kick in. First of all, I think obviously from the data I gave you on October, yes, we would expect sales to accelerate into the fourth quarter, because I just said North America sales trends doubled from a pace standpoint. When you talk about margin, I mean obviously it has to do in the fourth quarter with the Luxe product hitting and later on with the Breeze product in early 2019.

We don't have a lot of Luxe in the market right now. The launch is on-time, on-schedule, on-budget, but as we sit here today it's probably only maybe 5% or 6% floored out in the marketplace, so we don't have a lot of data yet, but where it has floored, it has done well. The best place we have to look at that is our own Tempur stores, because it's been in market there the longest, and there is no question that the Luxe model on our own stores has increased ASP which is what it is designed to do. So we feel good about it but again it's early.

The price increase is in place in the fourth quarter, and I know, Bhaskar, you helped me with the number, but my recollection is that, if the price increase had been in effect on the beginning of the third quarter and then out there for the entire quarter, we would have picked up what $10 million in incremental EBITDA to give you some quantification of that. And that would have offset the negative headwind we're feeling from the commodities and other stuff. So I've given you a number on what price actions impact was, and we've got new product hitting. So in general, we feel pretty – yeah, look, we feel actually very good about Tempur. As I said, the unit volumes were up 50% in October. Now, we've got a little bit of a headwind, obviously, Sealy and we would expect Sealy from a revenue standpoint to be challenged on a margin standpoint probably not challenged because what we're losing is generally the lower end product below $1,000. So that any other items in the (36:53) I think I've helped reconcile it.

[Bhaskar Rao, Tempur Sealy International, Inc.]

I think that's fair. If I would just think about it from a macro perspective specifically in the third quarter, we got hit with the full effect of commodities and the full effect of cannibalization. As I think about the fourth quarter, we do get the benefit of the price increases as well as the Luxe rolling out. So from an anticipation standpoint, we would think that or I would think that third quarter is, what, is tough for us and things get better with those items I mentioned, as well as the new products coming to help us from a mix standpoint.

[Operator]

Thank you. Our next question comes from Michael Lasser with UBS.

[Michael Lasser, UBS Securities LLC]

Good morning. Thanks a lot for taking my question. How do you reconcile the optimism that you have from the contribution of price increases versus what is clearly a very competitive environment in the category you saw your business be impacted by not only cannibalization, the lower price point bed, but also the intense promotional activity and the cheaper – poor products. And then as a follow-up, how much benefit have you seen from the Mattress Firm stores that have already closed? And what's your anticipation from the benefit that you're going to see from the 700 stores that they expect to close moving forward? Thank you so much.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Great. Good questions. It's interesting and at a very high level, it would look like the bedding market is kind of split into two markets. There's no question that part of the market is challenged and we'll call – I'm going to call it, below a $1,000 but wherever you want to draw the line. More competition, more points of distribution, more business coming through web pages and stuff and I should mention that our alternative channel business is up over 100%. So I mean clearly a lot of customers moving around where they're – what channel they're going to use to buy beds and look, that's a challenged area. But we're working on it. Like I said, we've got a 100% growth in our alternative channels. So that market, Chinese imports take or pick topics there.

If you move high-end, the high-end customer does not appear to be being impacted by those items. There is another public bedding company. I think they've had pretty robust sales they reported over the last seven weeks. Our Tempur product clearly is doing very well and performing. Now, we do have a product mix issue that relates to our freshening of the brand that we're dealing with. But as far as just the strength of the high-end customer in North America, that particular segment does not feel challenged. If anything, that feels quite frankly robust. So I'm going to say it's really two different markets is the way, I guess, it's showing up.

Now on a – I'd update Mattress Firm probably is more of a stress item for us on the lower end of the market and that they have really walked away from the premium sector. So we don't really see them much as a premium retailer.

Now, you asked about store closings, which is a fascinating question. They're obviously working through some significant real estate issues that they have and are closing stores and that kind of stuff. I don't think we've seen enough data to have a firm conclusion. Early indications are that when they close stores, some of those sales flow through to some other retailers, but it's way too early to try to quantify it or to really guide you in that area, but I would tell you that at least the early indications are that our other retailers get a, what I might call, slight benefit from what we're seeing so far because it's early and our own stores get a slight benefit in a very small sample size. So we're continuing to watch it. I would expect that when they close stores they're like right across the street from each other. I would expect they would recapture a large amount of those revenues themselves. But on the other stores, they weren't right next to each other that there would be a good bit of that business that would flow through to the marketplace. But that's one person's estimate and I think we'll study that over time.

[Operator]

Thank you. Our next question comes from John Baugh with Stifel.

[John Allen Baugh, Stifel, Nicolaus & Co., Inc.]

Good morning and thank you. I was wondering on Sealy if you could, A, quantify the bad debt number, talk a little more numerically about where the revenue performance is, and maybe where you expect it to be? And give us some sense of what the earnings contribution is from Sealy domestically not internationally and how that maybe influence these numbers as we go out into the 2019.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah, I'm going to come to (42:12) that. I think if you look through the cash flow statement you would eventually figure out that what there's a bad debt reserve of about $7 million...

[Bhaskar Rao, Tempur Sealy International, Inc.]

Incremental, correct.

[Scott L. Thompson, Tempur Sealy International, Inc.]

... incremental in the quarter. So we'll call that a $7 million dollar bad guy unanticipated. At the same time, we've been working with those customers for a long time and they've been very good customers and we continue to hope and hope their restructuring goes successful. But there's about a $7 million hit in the quarter relative to, what I'll call, credit issues that you asked about. I think it's impossible to disaggregate Tempur from Sealy when you're trying to figure out contribution profit because we've integrated the operations. So I can't really answer that because I think the operations are so integrated that it's difficult.

From a revenue standpoint, down low single digits.

[Bhaskar Rao, Tempur Sealy International, Inc.]

Correct.

[Scott L. Thompson, Tempur Sealy International, Inc.]

And I suspect that we're going to continue to feel some headwinds on Sealy. It's all coming from, what I'll call, below $1,000. If you look at ASP, just overall ASP is up both for the company worldwide and certainly – and Sealy ASP is up, but it's up because the very low end is what you're seeing getting, is moving around some. I think the biggest opportunity in the Sealy brand in North America, which is where your question is pointed is really the alternative channels and we're working very aggressively with those channels who are very open to the Sealy brand, and hopefully we'll have some success in 2019 and have some news for you. But right now, we're working on it.

[Operator]

Thank you. Our next question comes from William Reuter with Bank of America Merrill Lynch.

[William Michael Reuter, Bank of America Merrill Lynch]

Hi. Good morning. Multiple times you've referenced the changing competitive dynamics in terms of the China bedding guys, which I guess have been dumping product at lower prices. I guess, is that still something that you're continuing to see? And then secondarily, are you seeing much change in terms of the bed-in-the-box guys, and do you think that they are taking share? Thanks.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Sure. First of all, yeah, there's a lot of change in – and we're talking North America here, distribution in North America, whether it be the Mattress Firm bankruptcy and contraction, whether it be Sears and some of the issues related to the department stores, or whether it be Chinese imports, and yes, sure, Chinese imports are still coming in and there're still an issue at the low end.

Interestingly, the bed-in-the-box guys, as a group, which used to be kind of the headline that people wanted to talk about. They don't appear to be as impactful in the industry. I think the Chinese imports quite frankly are hitting them harder than anybody. You can't get good numbers obviously and there's a lot of puffery in some of the stuff that comes out of that particular segment of the business. My gut feeling is that probably as a group if they're growing they're not growing very much in mattresses in North America and it wouldn't surprise me if in North America in mattresses that as a group that units were actually declining. I think their revenues in total might be growing with dog beds and other things in international and bases as they try to keep a growth rate. But it feels like to me that the bed-in-the-box industry's, what I'll call rapid growth rate for sure, those days are behind them is my gut feel, but again, you can't get quality numbers.

[Operator]

Thank you. Our next question comes from Bob Drbul with Guggenheim.

[Robert Drbul, Guggenheim Securities LLC]

Hi, good morning. I was just wondering if you could talk about the inventory levels, especially against the sales growth going into the fourth quarter coming out of the third quarter, please?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Sure, Bhaskar, go ahead.

[Bhaskar Rao, Tempur Sealy International, Inc.]

Sure. So if you think about our inventory levels on a year-over-year basis, I think about it in inventory days compared relative to prior year we did see an increase in our inventory days and that's primarily associated with our preparation for the Luxe launch. So from an anticipation standpoint is as that Luxe launch launches or as it gets out there, the days should – it should improve.

[Robert Drbul, Guggenheim Securities LLC]

Yeah. You've also got a little bit of inventory in there planning for tariffs?

[Bhaskar Rao, Tempur Sealy International, Inc.]

Absolutely. So primarily associated with the adjustables.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yes. That's correct.

[Bhaskar Rao, Tempur Sealy International, Inc.]

But in total, inventory is clean, that's not even an – it's not an issue.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Correct. Yeah, that's fair to say.

[Operator]

Thank you. Our next question comes from Carla Casella with JPMorgan.

[Carla Casella, JPMorgan Securities LLC]

Hi. One follow-up on the tariff issue. The tariff, you're not seeing that have any impact on some of the lower cost imports, I guess because they're not under the items that were under the tariff purview yet, is that correct?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah, I don't think the tariff has had any impact on slowing down China imports as of now. That is correct.

[Bhaskar Rao, Tempur Sealy International, Inc.]

(47:48).

[Scott L. Thompson, Tempur Sealy International, Inc.]

That is correct.

[Bhaskar Rao, Tempur Sealy International, Inc.]

(47:52).

[Scott L. Thompson, Tempur Sealy International, Inc.]

Correct. It may become significant, but as we sit here today, I don't think it's had any impact on slowing down China imports.

[Operator]

Thank you. Our next question comes from Curtis Nagle with BAML.

[Curtis Nagle, Bank of America Merrill Lynch]

Yeah. Just a quick follow-up, I guess, on my guidance question. I guess hypothetically if you guys were to say re-floor a large retailer that you're not currently doing business with, would that have an impact on your guidance?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah, I can't imagine what retailer you're thinking about, but I think saying if we sold more beds would our guidance go up. Yeah, look, yeah, I mean look, at a very high level, it's a hypothetical, which lawyers always tell me I'm not supposed to talk about but sometimes I don't listen to them. But look, hypothetically, if we were to do business again with Mattress Firm, sure, you would expect sales to go up. You'd expect EBITDA to go up, you probably would have some investments in floor models and POP, which you have to work through. But they're – I'm going to say they're 20% of the market and they're contracting, so I don't know where they are, but look, no matter whether they're 17% of the market or 20% of the market, that's a large segment of the North American bedding business where we have a balance of share of zero. So any increase in balance of share in that particular segment would certainly be incrementally positive for the company if it's done in the right way.

[Operator]

Thank you. Our next question is a follow-up question from Carla Casella with JPMorgan.

[Carla Casella, JPMorgan Securities LLC]

Hi. You also gave some information on your – the cost increases. Have you – can you give us a breakout of how much – what percentage of your costs today are raw materials versus transportation versus any other kind of key overhead costs?

[Scott L. Thompson, Tempur Sealy International, Inc.]

You could probably do a big bucket. Bhaskar, was it 70%, 75%?

[Bhaskar Rao, Tempur Sealy International, Inc.]

Sure. The vast majority of our costs are associated with raw materials. So the way I would think about that is in the vicinity of, Scott, it's fair, 75% to 80% is raw material associated.

[Operator]

Thank you. Our next question is a follow-up question from Michael Lasser with UBS.

[Michael Lasser, UBS Securities LLC]

Good morning. Thanks a lot again for taking my question. Can you give us a breakdown of your sales by the sub $1,000 bed and do that – do those beds in that segment in the market over on their index from a profitability perspective?

And then, Scott, how do you think about the long-term ability to achieve some of the aspirational EBITDA targets that you had previously put out there?

[Scott L. Thompson, Tempur Sealy International, Inc.]

Yeah. I can help with some of that. For competitive reasons, we're probably not going to break it up in detail from a revenue standpoint but below $1,000 is significantly under indexed is from a profitability standpoint, right? I mean I don't use the word significant. There may even be some product down below a $1,000 which is really just helping cover fixed cost. So from that standpoint if I can – I can answer that part of the question. As far as aspirational targets, clearly, we've run into some headwinds. One of the biggest ones being Mattress Firm. So we'll work through that. But as we currently sit, our current guidance certainly doesn't get us close to any aspirational targets that would trigger any of those plans that I think you're referring to.

[Operator]

And I'm not showing any further questions at this time. I'd like to turn the call back over to Scott for closing.

[Scott L. Thompson, Tempur Sealy International, Inc.]

Thank you, operator. To the almost 7,000 employees worldwide, thank you for what you do every day to make the company successful. To our retail partners, thank you for your outstanding representation of our brands. To our shareholders and lenders, thank you for your confidence in Tempur Sealy's management team and its board of directors. This ends the call today. Thank you, operator.

[Operator]

Ladies and gentlemen, this concludes today's presentation. You may now disconnect and have a wonderful day.