form10q.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 
 
FORM 10-Q
 
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 
For the quarterly period ended September 30, 2008

 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 

For the transition period from   
     
              to                     
 
Commission file number 001-31922
 
 
TEMPUR-PEDIC INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)
 
     
Delaware
  
33-1022198
(State or other jurisdiction of
incorporation or organization)
  
(I.R.S. Employer
Identification No.)
     

 
1713 Jaggie Fox Way
Lexington, Kentucky 40511
(Address, including zip code, of principal executive offices)
 
Registrant’s telephone number, including area code: (800) 878-8889
  
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No   
 
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer,  a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 
Large accelerated filer x          Accelerated filer o          Non-accelerated filer o

 
(Do not check if a smaller reporting company) Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨  No x
 
The number of shares outstanding of the registrant’s common stock as of October 29, 2008 was 74,832,873 shares. 
 

 
 
 


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Special Note Regarding Forward-Looking Statements
 
    This quarterly report on Form 10-Q, including the information incorporated by reference herein, contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which include information concerning our plans, objectives, goals, strategies, future events, future revenues or performance, capital expenditures, the impact of the adoption of recently issued accounting pronouncements, the antitrust class action lawsuit and pending tax assessments, statements regarding our financial flexibility, statements relating to the impact of initiatives to accelerate growth, expand market share and attract sales from the standard mattress market, expand business within established accounts and into under-penetrated markets, reduce costs and improve manufacturing productivity, the impact of net operating losses, the vertical integration of our business, our ability to source raw materials effectively, the development, rollout and market acceptance of new products, our ability to further invest in the business and in brand awareness, growth in our Healthcare segment, the impact of the macroeconomic environment in both the U.S. and internationally on sales, the effects of changes in foreign exchange rates on our reported earnings, expected sources of cash flow, our ability to effectively manage cash and our debt/leverage ratio and other information that is not historical information. Many of these statements appear, in particular, under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in ITEM 2 of Part I of this report. When used in this report, the words “estimates,” “expects,” “anticipates,” “projects,” “plans,” “intends,” “believes” and variations of such words or similar expressions are intended to identify forward-looking statements. These forward-looking statements are based upon our current expectations and various assumptions. There can be no assurance that we will realize our expectations or that our beliefs will prove correct.
    
    There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained in this report. Important factors that could cause our actual results to differ materially from those expressed as forward-looking statements are set forth in this report, including under the heading “Risk Factors” under ITEM 1A of Part II of this report and under the heading “Risk Factors” under ITEM 1A of Part 1 of our annual report on Form 10-K for the year ended December 31, 2007. There may be other factors that may cause our actual results to differ materially from the forward-looking statements.
    
    All forward-looking statements attributable to us apply only as of the date of this report and are expressly qualified in their entirety by the cautionary statements included in this report. Except as may be required by law, we undertake no obligation to publicly update or revise any of the forward-looking statements, whether as a result of new information, future events, or otherwise.
 
    When used in this report, except as specifically noted otherwise, the term “Tempur-Pedic International” refers to Tempur-Pedic International Inc. only, and the terms “Company,” “we,” “our,” “ours” and “us” refer to Tempur-Pedic International Inc. and its consolidated subsidiaries.

3
 
PART I.
FINANCIAL INFORMATION
 
FINANCIAL STATEMENTS

TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
(Unaudited)

 
Three Months Ended
  
Nine Months Ended
   
September 30,
      
September 30,
  
   
2008
      
2007
      
2008
      
2007
  
Net sales
$
252,814
    
$
294,094
    
$
738,697
    
$
817,768
  
Cost of sales
  
147,323
      
152,484
      
419,109
      
423,930
  
Gross profit
  
105,491
      
141,610
      
319,588
      
393,838
  
Selling and marketing expenses
  
39,956
      
48,830
      
137,906
      
144,630
  
General, administrative and other expenses
  
22,644
      
25,231
      
73,139
      
72,775
  
Operating income
  
42,891
      
67,549
      
108,543
      
176,433
  
                               
Other income (expense), net:
                              
Interest expense, net
  
(6,294
)
    
(8,261
)
    
(19,630
)
    
(21,394
)
Other income (expense), net
  
96
      
(33
)
    
(995
)
    
(536
)
Total other expense
  
(6,198
)
    
(8,294
)
    
(20,625
)
    
(21,930
)
                               
Income before income taxes
  
36,693
      
59,255
      
87,918
      
154,503
  
Income tax provision
  
12,622
      
20,437
      
30,105
      
52,974
  
Net income
$
24,071
    
$
38,818
    
$
57,813
    
$
101,529
  
                               
Earnings per common share:
                              
Basic
$
0.32
    
$
0.50
    
$
0.77
    
$
1.25
  
Diluted
$
0.32
    
$
0.49
    
$
0.77
    
$
1.22
  
                               
Cash dividend per common share
$
0.08
    
$
0.08
    
$
0.24
      
0.22
  
                               
Weighted average common shares outstanding:
                              
Basic
  
74,815
      
77,725
      
74,704
      
81,522
  
Diluted
  
74,992
      
79,173
      
74,944
      
83,069
  
 
See accompanying Notes to Condensed Consolidated Financial Statements. 
4
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
 
 
September 30,
2008
  
December 31,
2007
 
(Unaudited)
    
ASSETS
              
               
Current Assets:
              
     Cash and cash equivalents
$
87,677
    
$
33,315
  
     Accounts receivable, net
  
137,112
      
163,730
  
     Inventories
  
69,703
      
106,533
  
     Prepaid expenses and other current assets
  
10,922
      
11,133
  
     Deferred income taxes
  
14,725
      
11,924
  
Total Current Assets
  
320,139
      
326,635
  
               
     Property, plant and equipment, net
  
190,714
      
208,370
  
     Goodwill
  
199,523
      
198,286
  
     Other intangible assets, net
  
67,157
      
68,755
  
     Other non-current assets
  
4,785
      
4,386
  
Total Assets
$
782,318
    
$
806,432
  
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
              
               
Current Liabilities:
              
     Accounts payable
$
56,159
    
$
56,206
  
     Accrued expenses and other
  
74,184
      
66,080
  
     Income taxes payable
  
15,997
      
4,060
  
     Current portion of long-term debt
  
—
      
288
  
Total Current Liabilities
  
146,340
      
126,634
  
               
     Long-term debt
  
518,750
      
601,756
  
     Deferred income taxes
  
30,404
      
29,645
  
     Other non-current liabilities
  
2,410
      
259
  
Total Liabilities
  
697,904
      
758,294
  
               
Commitments and contingencies—see Note 9
              
               
Stockholders’ Equity:
              
     Common stock—$.01 par value; 300,000 shares authorized; 99,215 shares issued as of September 30, 2008 and December 31, 2007
  
992
      
992
  
     Additional paid in capital
  
289,011
      
283,564
  
     Retained earnings
  
280,367
      
241,812
  
     Accumulated other comprehensive income
  
2,443
      
13,550
  
     Treasury stock, at cost; 24,382 and 24,681 shares as of September 30, 2008 and December 31, 2007, respectively
  
(488,399
)
    
(491,780
)
Total Stockholders’ Equity
  
84,414
      
48,138
  
               
Total Liabilities and Stockholders’ Equity
$
782,318
    
$
806,432
  

See accompanying Notes to Condensed Consolidated Financial Statements. 
5
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
 
Nine Months Ended
September 30,
 
2008
  
2007
       
CASH FLOWS FROM OPERATING ACTIVITIES:
              
     Net income
$
57,813
    
$
101,529
  
     Adjustments to reconcile net income to net cash provided by
       operating activities:
              
         Amortization of deferred financing costs
  
888
      
845
  
          Depreciation and amortization
  
24,847
      
25,326
  
          Amortization of stock-based compensation
  
6,101
      
5,081
  
          Allowance for doubtful accounts
  
5,859
      
4,541
  
          Deferred income taxes
  
(1,634
)
    
(3,101
)
          Foreign currency adjustments
  
74
      
661
  
          Loss on sale of equipment
  
679
      
101
  
          Changes in operating assets and liabilities:
              
               Accounts receivable
  
18,600
      
(22,585
)
               Inventories
  
36,680
      
(14,228
)
               Prepaid expenses and other current assets
  
(1,287
)
    
(5,035
)
               Accounts payable
  
(149
)
    
10,250
  
               Accrued expenses and other
  
8,301
      
10,636
  
               Income taxes
  
12,142
      
15,839
  
          Net cash provided by operating activities
  
168,914
      
129,860
  
               
CASH FLOWS FROM INVESTING ACTIVITIES:
              
     Payments for trademarks and other intellectual property
  
(600
)
    
(636
)
     Purchases of property, plant and equipment
  
(7,844
)
    
(8,181
)
     Acquisition of businesses
  
(1,529
)
    
(5,756
)
     Proceeds from sale of equipment
  
172
      
135
  
          Net cash used by investing activities
  
(9,801
)
    
(14,438
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
              
     Proceeds from long-term revolving credit facility
  
65,429
      
347,547
  
     Repayments of long-term revolving credit facility
  
(89,691
)
    
(119,293
)
     Repayments of long-term debt
  
(1,359
)
    
(45,416
)
     Proceeds from Series A Industrial Revenue Bonds
  
—
      
15,385
  
     Repayments of Series A Industrial Revenue Bonds
  
(57,785
)
    
(5,765
)
     Common stock issued, including reissuances of treasury stock
  
695
      
8,078
  
     Excess tax benefit from stock based compensation
  
301
      
10,025
  
     Treasury stock repurchased
  
—
      
(299,998
)
     Dividends paid to stockholders
  
(17,933
)
    
(17,895
)
     Payments for other
  
(14
)
    
(1,530
)
          Net cash used by financing activities
  
(100,357
)
    
(108,862
)
               
NET EFFECT OF EXCHANGE RATE CHANGES ON CASH
  
(4,394
)
    
1,232
  
               
Increase in cash and cash equivalents
  
54,362
      
7,792
  
               
CASH AND CASH EQUIVALENTS, beginning of period
  
33,315
      
15,788
  
               
CASH AND CASH EQUIVALENTS, end of period
$
87,677
    
$
23,580
  
               
Supplemental cash flow information:
              
     Cash paid during the period for:
              
Interest
$
18,960
    
$
19,243
  
Income taxes, net of refunds
$
17,884
    
$
30,946
  

See accompanying Notes to Condensed Consolidated Financial Statements.
6
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
(In thousands, except per share amounts)
 
(1) Summary of Significant Accounting Policies
 
    (a) Basis of Presentation and Description of Business—Tempur-Pedic International Inc., a Delaware corporation, together with its subsidiaries is a U.S.-based, multinational company. The term “Tempur-Pedic International” refers to Tempur-Pedic International Inc. only, and the term “Company” refers to Tempur-Pedic International Inc. and its consolidated subsidiaries. Tempur World, Inc. was formed on January 1, 2000 to combine the manufacturing facilities and the global distribution capabilities of all TEMPUR® products. Tempur-Pedic International was formed in 2002 to acquire Tempur World, Inc. This acquisition (Tempur Acquisition) was effective as of November 1, 2002.
 
    The Company manufactures, markets, and sells mattresses, pillows and other related products. The Company manufactures essentially all its pressure-relieving TEMPUR® products at three manufacturing facilities, with one located in Denmark and two in the U.S. The Company has sales distribution subsidiaries operating in the U.S., Europe, and Asia Pacific and has third party distribution arrangements in certain other countries where it does not have subsidiaries. The Company sells its products through four sales channels: Retail, Direct, Healthcare, and Third party.
 
    The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X and include all of the information and disclosures required by generally accepted accounting principles in the United States (U.S. GAAP) for interim financial reporting. These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the consolidated financial statements of the Company and related footnotes for the year ended December 31, 2007, included in the Company’s Annual Report on Form 10-K.
 
    The results of operations for the interim periods are not necessarily indicative of results of operations for a full year. It is the opinion of management that all necessary adjustments for a fair presentation of the results of operations for the interim periods have been made and are of a recurring nature unless otherwise disclosed herein.
 
    (b) Reclassifications—Certain prior period amounts have been reclassified to conform to the 2008 presentation including the presentation of General, administrative and other expenses which includes research and development expenses previously disclosed separately in the Condensed Consolidated Statements of Income. These changes do not materially affect previously reported subtotals within the Condensed Consolidated Financial Statements for any previous period presented.
 
    (c) Basis of Consolidation—The accompanying financial statements include the accounts of Tempur-Pedic International and its subsidiaries. All subsidiaries are wholly owned. Intercompany balances and transactions have been eliminated.
 
(d) Use of Estimates—The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
 
(e) Foreign Currency Translation—Assets and liabilities of non-U.S. subsidiaries, whose functional currency is the local currency, are translated at period-end exchange rates. Income and expense items are translated at the average rates of exchange prevailing during the period. The adjustment resulting from translating the financial statements of foreign subsidiaries is included in Accumulated other comprehensive income, a component of Stockholders’ Equity.
7
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
(f) Financial Instruments and Hedging—The Company accounts for derivative instruments and hedging activities in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities (as amended)” (SFAS 133). In accordance with this standard, derivative instruments are recorded on the balance sheet as either an asset or liability measured at its fair value. Changes in the fair value of derivative instruments are either recognized in income immediately to offset the gain or loss on the hedged item, or deferred and recorded in Stockholders’ Equity as a component of Accumulated other comprehensive income. The ineffective portion of the change in fair value of a hedge is recognized in income immediately. Derivative financial instruments are used in the normal course of business to manage interest rate and foreign currency exchange risks.
 
(g) Cash and Cash Equivalents—Cash and cash equivalents consist of all investments with initial maturities of three months or less.
 
    (h) Inventories—Inventories are stated at the lower of cost or market, determined by the first-in, first-out method, and consist of the following:

   
September 30,
2008
    
December 31,
2007
  
Finished goods
   $ 44,301     $ 75,692  
Work-in-process
     7,861       11,135  
Raw materials and supplies
     17,541       19,706  
    $ 69,703     $ 106,533  
 
    (i) Long-Lived Assets—In accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of long-lived assets is assessed by a comparison of the carrying amount to the estimated future undiscounted net cash flows expected to be generated by the asset or group of assets. If estimated future undiscounted net cash flows are less than the carrying amount of the asset or group of assets, the asset is considered impaired and an expense is recorded in an amount required to reduce the carrying amount to the fair value. Fair value generally is determined from estimated discounted future net cash flows (for assets held for use) or net realizable value (for assets held for sale).
 
    (j) Goodwill and Other Intangible Assets—Intangible assets with estimable useful lives are amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment. The Company performs an annual impairment test on all existing goodwill and other indefinite lived assets in the fourth quarter of each year. The Company performed the annual impairment test in the fourth quarter of 2007 and determined that no impairment exists. If facts and circumstances lead the Company’s management to believe goodwill or other indefinite lived assets may be impaired, the Company will evaluate the extent to which the related cost is recoverable by comparing the future estimated discounted cash flows to the carrying amount and write-down that carrying amount to fair value to the extent necessary.
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
    
    The following table summarizes information relating to the Company’s Other intangible assets, net:
  
         
September 30, 2008
    
December 31, 2007
  
   
Useful
    
Gross
          
Net
    
Gross
          
Net
  
   
Lives
    
Carrying
    
Accumulated
    
Carrying
    
Carrying
    
Accumulated
    
Carrying
  
   
(Years)
    
Amount
    
Amortization
    
Amount
    
Amount
    
Amortization
    
Amount
  
Unamortized indefinite life intangible assets:
                                          
Trademarks
         $ 55,000     $ —     $ 55,000     $ 55,000     $ —     $ 55,000  
                                                       
Amortized intangible
  assets:
                                                      
Technology
     10     $ 16,000     $ 9,467     $ 6,533     $ 16,000     $ 8,267     $ 7,733  
Patents & Other Trademarks
     5-20       11,374       7,680       3,694       11,233       7,533       3,700  
Customer database
     5       4,845       4,426       419       4,868       4,334       534  
Foam formula
     10       3,700       2,189       1,511       3,700       1,912       1,788  
                                                         
Total
           $ 90,919     $ 23,762     $ 67,157     $ 90,801     $ 22,046     $ 68,755  
 
    Amortization expense relating to intangible assets for the Company was $603 and $1,063 for the three months ended September 30, 2008 and 2007, respectively.  For the nine months ended September 30, 2008 and 2007 amortization expense relating to intangible assets was $1,810 and $3,140, respectively.
 
The changes in the carrying amount of Goodwill for the nine months ended September 30, 2008 are as follows:

Balance as of December 31, 2007
   $ 198,286  
     Goodwill resulting from acquisitions during the period
     895  
     Purchase price adjustment
     1,622  
     Foreign currency translation adjustments and other
     (1,280 )
Balance as of September 30, 2008
   $ 199,523  
 
    On February 1, 2008, the Company acquired its third party distributor in New Zealand. The total purchase price was approximately $1,438. The assets purchased were initially valued at approximately $948 and include inventory and fixed assets, among other assets. The remainder of the purchase price was allocated to Goodwill. During the quarter ended September 30, 2008, the Company recorded an adjustment to unrecognized tax benefits related to the Tempur Acquisition as further described in Note 10.
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
  
    Goodwill as of September 30, 2008 and December 31, 2007 has been allocated to the Domestic and International segments as follows:

   
September 30,
2008
    
December 31,
2007
  
Domestic
   $ 91,551     $ 89,929  
International
     107,972       108,357  
    $ 199,523     $ 198,286  
 
    (k) Accrued Sales Returns—Estimated sales returns are provided at the time of sale based on historical sales channel return rates. The level of sales returns differs by channel with the Direct channel typically experiencing the highest return rate.  Estimated future obligations related to these products are provided by a reduction of sales in the period in which the revenue is recognized. Accrued sales returns are included in Accrued expenses and other in the accompanying Condensed Consolidated Balance Sheets.
 
    The Company had the following activity for sales returns from December 31, 2007 to September 30, 2008:

Balance as of December 31, 2007
   $ 5,463  
     Amounts accrued
     32,531  
     Returns charged to accrual
     (32,615 )
Balance as of September 30, 2008
   $ 5,379  
 
    (l) Warranties—The Company provides a 20-year warranty for U.S. sales and a 15-year warranty for non-U.S. sales on mattresses, each prorated for the last 10 years. The Company also provides a 2-year to 3-year warranty on pillows. Estimated future obligations related to these products are charged to operations in the period in which the related revenue is recognized. Warranties are included in Accrued expenses and other in the accompanying Condensed Consolidated Balance Sheets.
 
    The Company had the following activity for warranties from December 31, 2007 to September 30, 2008:

Balance as of December 31, 2007
   $ 3,425  
     Amounts accrued
     3,152  
     Warranties charged to accrual
     (2,453 )
Balance as of September 30, 2008
   $ 4,124  
10
   TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    (m) Income Taxes—Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company is regularly under audit by tax authorities around the world. The Company accounts for uncertain foreign and domestic tax positions as required by Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) according to the facts and circumstances in the various regulatory environments.
 
    (n) Revenue Recognition—Sales of products are recognized when the products are shipped to customers and the risks and rewards of ownership are transferred. The Company extends volume discounts to certain customers and reflects these amounts as a reduction of Net sales. No collateral is required on sales made in the normal course of business. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable. The Company determines the allowance based on historical write-off experience and current economic and market conditions, and regularly reviews the adequacy of its allowance for doubtful accounts. Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote. The allowance for doubtful accounts included in Accounts receivable, net in the accompanying Condensed Consolidated Balance Sheets was $9,436 and $8,056 as of September 30, 2008 and December 31, 2007, respectively.
 
    (o) Advertising Costs—The Company expenses advertising costs as incurred except for production costs and advance payments, which are deferred and expensed when advertisements run for the first time. Direct response advance payments are deferred and are amortized over the life of the program.
 
    (p) Research and Development Expenses—Research and development expenses for new products are expensed as they are incurred. Research and development costs charged to expense were approximately $1,330 and $1,603 for the three months ended September 30, 2008 and 2007, respectively.  For the nine months ended September 30, 2008 and 2007 research and development costs charged to expense were approximately $4,621 and $4,278, respectively. Research and development expenses are included in General, administrative and other expenses in the accompanying Condensed Consolidated Statements of Income.
 
    (q) Treasury Stock—The Board of Directors may authorize share repurchases of the Company’s common stock (Share Repurchase Authorizations). Share repurchases under these authorizations may be made through open market transactions, negotiated purchase or otherwise, at times and in such amounts as the Company, and a committee of the Board, deem appropriate. Shares repurchased under Share Repurchase Authorizations are held in treasury for general corporate purposes, including issuances under various employee stock option plans. Treasury shares are accounted for under the cost method and reported as a reduction of Stockholders’ Equity. Share Repurchase Authorizations may be suspended, limited or terminated at any time without notice.
 
    (r) Stock-Based Compensation—The Company accounts for share-based payments as required by SFAS 123(R) “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) requires compensation expense relating to share-based payments be recognized in the financial statements. The cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the vesting period of the equity award.
11
  TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
(2) Recently Issued Accounting Pronouncements
 
    In September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and expands disclosure about fair value measurements to include the methods and assumptions used to measure fair value and the effect of fair value measures on earnings.  SFAS 157 requires the fair value of an asset or liability to be based on market-based measures which will reflect the credit risk of the company. In February 2008, the FASB released FASB Staff Position No. SFAS 157-2, “Effective Date of FASB Statement No. 157,” which delays the effective date of SFAS 157 for nonfinancial assets and liabilities until January 2009.  Effective January 1, 2008, the Company adopted the provisions of SFAS 157 related to financial assets and liabilities.  SFAS 157 does not require new fair value measurements.  The adoption of SFAS 157 did not have a material impact on the Company’s financial position or operating results. Additionally, in October 2008, the FASB issued FASB Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (FSP 157-3). FSP 157-3 clarifies the adoption of SFAS 157 in a market that is not active.
 
    In December 2007, the FASB issued SFAS 141(R), “Business Combinations” (SFAS 141(R)), which establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquired business. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The Company will apply the provisions of SFAS 141(R) to business combinations for which the acquisition date is on or after January 1, 2009.
 
    In March 2008, the FASB issued SFAS 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133” (SFAS 161). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, results of operations and cash flows.  The new standard also improves transparency about how and why a company uses derivative instruments and how derivative instruments and related hedged items are accounted for under SFAS 133. The Company is evaluating the potential impact of adopting SFAS 161, which is effective January 1, 2009.

(3) Property, Plant and Equipment
 
    Property, plant and equipment, net consists of the following:
 
 
  
September 30, 2008
    
December 31, 2007
  
Land and buildings
  
$
122,021
    
$
123,973
  
Machinery and equipment, furniture and fixtures, and other
  
  
189,961
      
186,175
  
Construction in progress
  
  
6,282
      
7,210
  
 
  
  
318,264
      
317,358
  
Total accumulated depreciation
  
  
(127,550
 )     
(108,988
 ) 
 
  
$
190,714
    
$
208,370
  
 
12
  TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
(4) Long-term Debt
 
    (a) Long-term Debt—Long-term debt for the Company consists of the following:

     September 30, 2008    
 December 31, 2007
  
2005 Senior Credit Facility:
            
Domestic Long-Term Revolving Credit Facility payable to lenders, interest at
Index Rate or LIBOR plus applicable margin (4.61% and 5.86% as of September 30, 2008 and December 31, 2007, respectively), commitment through and due June 8, 2012
   $ 518,750     $ 543,000  
                 
2005 Industrial Revenue Bonds:
                
Variable Rate Industrial Revenue Bonds Series 2005A, interest rate determined
     by remarketing agent
     —       57,785  
                 
Other:
                
Mortgage payable to a bank (bearing fixed interest of 4.7% to 5.2% as of December 31, 2007)
     —       1,259  
      518,750       602,044  
Less: Current portion
     —       (288 )
Long-term debt
   $ 518,750     $ 601,756  
 
    (b) Secured Credit Financing—On October 18, 2005, the Company entered into a credit agreement (2005 Senior Credit Facility) with a syndicate of banks. The 2005 Senior Credit Facility, as amended, consists of domestic and foreign credit facilities that provide for the incurrence of indebtedness up to an aggregate principal amount of $640,000. The domestic credit facility is a five-year, $615,000 revolving credit facility (Domestic Revolver). The foreign credit facility is a five-year $25,000 revolving credit facility (Foreign Revolver). Both credit facilities bear interest at a rate equal to the 2005 Senior Credit Facility’s applicable margin, as determined in accordance with a performance pricing grid set forth in Amendment No. 3, plus one of the following indexes: LIBOR and for U.S. dollar-denominated loans only, a Base rate. The Base rate of U.S. dollar-denominated loans are defined as the higher of either the Bank of America prime rate or the Federal Funds rate plus .50%. The Company also pays an annual facility fee on the total amount of the 2005 Senior Credit Facility.  The facility fee is calculated based on the consolidated leverage ratio and ranges from .125% to .25%.
 
    On May 29, 2008, the Company entered into an interest rate swap agreement to manage interest costs and the risk associated with changing interest rates. Under the interest rate swap, the Company pays at a fixed rate and receives payments at a variable rate. This swap effectively fixes the floating LIBOR-based interest rate to 3.755% on $350,000 of the outstanding principal balance under the 2005 Senior Credit Facility. The amount of the outstanding balance subject to the swap will decline over time. The Company has designated this swap agreement as a cash flow hedge and expects the hedge to be highly effective in offsetting fluctuations in the designated interest payments resulting from changes in the benchmark interest rate. The Company will select the LIBOR-based rate on the hedged portion of the 2005 Senior Credit Facility during the term of the swap. The effective portion of the change in value of the swap is reflected as a component of Accumulated other comprehensive income and released to Interest expense. net as debt payments are paid or accrued. The ineffective portion is recognized as Other income (expense). The fair value of this swap was $2,133 at September 30, 2008, and was included in Other non-current liabilities in the accompanying Condensed Consolidated Balance Sheets. As of September 30, 2008, the Company has other comprehensive loss of $2,133 related to the effectively hedged portion of the swap. There was no hedge ineffectiveness over this period. Over the next 12 months, the Company expects to reclassify $1,889 of deferred losses on derivative instruments from Accumulated other comprehensive income to earnings due to the payment of variable interest associated with the floating 2005 Senior Credit Facility.
13
  TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    The 2005 Senior Credit Facility is guaranteed by Tempur-Pedic International, as well as certain other subsidiaries of Tempur-Pedic International, and is secured by certain fixed and intangible assets of Dan Foam ApS and substantially all the Company’s U.S. assets. The 2005 Senior Credit Facility contains certain financial covenants and requirements affecting the Company, including a consolidated interest coverage ratio and a consolidated leverage ratio. The Company was in compliance with all covenants as of September 30, 2008.
 
    The 2005 Senior Credit Facility provides for the issuance of letters of credit which, when issued, constitute usage and reduce availability under the Revolvers. The aggregate amount of letters of credit outstanding under the Revolvers was $9,898 at September 30, 2008. After giving effect to letters of credit and $518,750 in borrowings under the Domestic Revolver, total availability under the Revolvers was $111,352 at September 30, 2008.
 
    (c) Industrial Revenue Bonds—On October 27, 2005, Tempur Production USA, Inc., a subsidiary of Tempur-Pedic International Inc. (Tempur Production), completed an industrial revenue bond financing for the construction and equipping of Tempur Production’s new manufacturing facility (the Project) located in Bernalillo County, New Mexico. On April 1, 2008, Tempur Production redeemed all outstanding Series A Bonds in the amount of $57,785.  The redemption price plus accrued interest was funded by a $58,000 borrowing under the Domestic Revolver.
 
    Bernalillo County also agreed to issue Series 2005B Taxable Fixed Rate Industrial Revenue Bonds (the Series B Bonds, and collectively with the Series A Bonds, the Bonds). The Series B Bonds were sold to Tempur World LLC, and will be held by Tempur World, LLC representing the Company’s equity in the Project. In connection with issuance of the Series B Bonds, the Company made an investment in Series B bonds in a like amount. The Company has the right to offset the Series B Bonds against its investment in the Series B Bonds, and accordingly, the amounts have been recorded net in the accompanying Condensed Consolidated Balance Sheets. On September 1, 2008, Tempur World, LLC redeemed the majority of the outstanding Series B Bonds in the amount of $23,002. The remaining $100 of the outstanding Series B Bonds have a final maturity date of September 1, 2030. The interest rate on the Series B Bonds is fixed at 7.75%.

(5) Fair Value of Financial Instruments
 
    The Company adopted SFAS 157 as of January 1, 2008, as related to financial instruments. SFAS 157 establishes a three-level hierarchy for fair value measurements. The hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.

·  
Level 1 – Valuation is based upon unadjusted quoted prices for identical assets or liabilities in active markets.
·  
Level 2 – Valuation is based upon quoted prices for similar assets and liabilities in active markets, or other inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instruments.
·  
Level 3 – Valuation is based upon other unobservable inputs that are significant to the fair value measurements.
 
14
    TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    The classification of fair value measurements within the hierarchy is based upon the lowest level of input that is significant to the measurement.  At September 30, 2008, the Company had only an interest rate swap and foreign currency forward contracts recorded at fair value. The fair values of these instruments were measured using valuations based upon quoted prices for similar assets and liabilities in active markets (Level 2) and are valued by reference to similar financial instruments, adjusted for restrictions and other terms specific to the contracts. The following table provides a summary of the fair value of measurements by level for assets and liabilities measured at fair value on a recurring basis:
 
     
Fair Value Measurements at September 30, 2008 Using:
  
 
September 30, 2008
  
Quoted Prices in Active
Markets for Identical
Assets (Level 1)
  
Significant Other
Observable Inputs (Level 2)
  
Significant
Unobservable Inputs
(Level 3)
  
Liabilities:
                        
Interest rate swap
   $ 2,133     $ —     $ 2,133     $ —  
Foreign currency forward contracts
     394               394          
 
    The carrying value of Cash and cash equivalents, Accounts receivable, and Accounts payable approximate fair value because of the short-term maturity of those instruments. Borrowings under the 2005 Senior Credit Facility (as defined in Note (4)(b)) are at variable interest rates and accordingly their carrying amounts approximate fair value.

(6) Stockholders’ Equity
 
    (a) Capital Stock—Tempur-Pedic International authorized shares of capital stock are 300,000 shares of common stock and 10,000 shares of preferred stock. Subject to preferences that may be applicable to any outstanding preferred stock, holders of the common stock are entitled to receive ratably such dividends as may be declared from time to time by the Board of Directors out of funds legally available for that purpose. In the event of liquidation, dissolution, or winding up, the holders of the common stock are entitled to share ratably in all assets remaining after payment of liabilities, subject to prior distribution rights of preferred stock, if any, then outstanding.
 
    (b) Share Repurchase Programs—On January 25, 2007, the Board of Directors authorized the repurchase of up to $100,000 of the Company’s common stock. The Company repurchased 3,840 shares of the Company’s common stock for a total of $100,000 and completed purchases from this authorization in June 2007. On July 19, 2007, the Board of Directors approved an additional share repurchase authorization to repurchase up to $200,000 of the Company’s common stock. The Company repurchased 6,561 shares of the Company’s common stock for approximately $200,000 and completed purchases from the July 2007 authorization in September 2007. On October 16, 2007, the Board of Directors authorized an additional share repurchase authorization of up to $300,000 of the Company’s common stock. During the three months ended December 31, 2007, the Company repurchased 659 shares of the Company’s common stock for approximately $19,900. Under the existing share repurchase authorization, the Company has $280,100 available for repurchase.  No shares were repurchased during the nine months ended September 30, 2008. Share repurchases under this authorization may be made through open market transactions, negotiated purchase or otherwise, at times and in such amounts as the Company and a committee of the Board deem appropriate. This share repurchase authorization may be suspended, limited or terminated at any time without notice.
15
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    (c) Dividend Program—The Company’s Board of Director’s declared a first quarter 2008 dividend of $0.08 per common share, which was paid on March 14, 2008 to stockholders of record as of February 27, 2008. The Company’s Board of Director’s declared a second quarter 2008 dividend of $0.08 per common share which was paid on June 16, 2008 to stockholders of record as of May 31, 2008. The Company’s Board of Director’s declared a third quarter 2008 dividend of $0.08 per common share which was paid on September 12, 2008 to stockholders of record as of August 29, 2008. On October 16, 2008, the Company announced that it would suspend the payment of its quarterly cash dividend.
 
(7) Stock-Based Compensation
 
    The Company applies the provisions of SFAS 123(R), which establishes the accounting for employee stock-based awards. The Company currently has three stock-based compensation plans: the 2002 Option Plan (the 2002 Plan), the 2003 Equity Incentive Plan (the 2003 Plan) and the 2003 Employee Stock Purchase Plan (the ESPP) which are described under the caption “Stock-based Compensation” in the notes to the Consolidated Financial Statements of the Company’s Form 10-K for the year ended December 31, 2007.
 
    The Company granted new options to purchase 9 and 2,132 shares of common stock during the three and nine months ending September 30, 2008, respectively, and recognized compensation expense associated with these grants of approximately $677 and $1,100 during the three and nine months ended September 30, 2008, respectively. The Company granted new options to purchase 18 and 402 shares of common stock during the three and nine months ended September 30, 2007, respectively, and recognized compensation expense associated with these grants of approximately $453 and $752 during the three and nine months ended September 30, 2007, respectively. As of September 30, 2008, there was $6,636 of unrecognized compensation expense associated with the options granted in 2008, which is expected to be recorded over the weighted average remaining vesting period of 3.3 years. The options granted in the three months ended September 30, 2008 had a weighted average grant-date fair value of $2.44 per option, as determined by the Black-Scholes option pricing model using the following assumptions:

Expected volatility of stock
     59.5 %
Expected life of options, in years
     2.0  
Risk-free interest rate
     2.5 %
Expected dividend yield on stock
     3.8 %
 
    The Company recorded approximately $2,060 and $1,701 of total stock-based compensation expense for the three months ended September 30, 2008 and 2007, respectively. The Company recorded $6,101 and $5,081 of total stock-based compensation expense for the nine months ended September 30, 2008 and 2007, respectively.

 (8) Accumulated Other Comprehensive Income
 
    The components of Accumulated other comprehensive income are as follows:

 
September 30,
  
December 31,
   
2008
      
2007
  
Derivative instruments accounted for as hedges, net of tax of $832
$
(1,301
)
  
$
—
  
Foreign currency translation
  
3,744
      
13,550
  
Accumulated other comprehensive income
$
2,443
    
$
13,550
  

    Comprehensive income for the three months ended September 30, 2008 and 2007 was $2,220 and $44,496, respectively.  Comprehensive income for the nine months ended September 30, 2008 and 2007 was $46,705 and $109,123.
 
 (9) Commitments and Contingencies
 
    (a) Purchase Commitments—The Company will, from time to time, enter into limited purchase commitments for the purchase of certain raw materials. Amounts committed under these programs are not significant as of September 30, 2008.
16
   TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    (b) Securities Litigation— Between October 7, 2005 and November 21, 2005, five complaints were filed against Tempur-Pedic International and certain of its directors and officers in the United States District Court for the Eastern District of Kentucky (Lexington Division) purportedly on behalf of a class of shareholders who purchased Tempur-Pedic International’s stock between April 22, 2005 and September 19, 2005 (the Securities Law Action).  These actions were consolidated, and a consolidated complaint was filed on February 27, 2006 asserting claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. Lead plaintiffs alleged that certain of Tempur-Pedic International’s public disclosures regarding its financial performance between April 22, 2005 and September 19, 2005 were false and/or misleading. On December 7, 2006 lead plaintiffs were permitted to file an amended complaint. The Company filed a Motion to Dismiss the Securities Law Action and on March 28, 2008, the Court granted that motion, dismissing all claims in the case with prejudice. The Court also entered final judgment in favor of the Company and all other defendants on March 28, 2008. The plaintiffs filed a notice of appeal from that judgment on April 24, 2008. Since filing the notice of appeal, the plaintiffs agreed to a stipulation to dismiss appeal with prejudice, which was entered on June 19, 2008, which fully and finally resolved the Securities Law Action in favor of the Company and all other defendants.
 
    Derivative Complaints—On November 10, 2005 and December 15, 2005, complaints were filed in the state courts of Delaware and Kentucky, respectively, against certain officers and directors of Tempur-Pedic International, purportedly derivatively on behalf of the Company (the Derivative Complaints).  The Derivative Complaints assert that the named officers and directors breached their fiduciary duties when they allegedly sold Tempur-Pedic International’s securities on the basis of material non-public information in 2005.  In addition, the Delaware Derivative Complaint asserted a claim for breach of fiduciary duty with respect to the disclosures that also were the subject of the Securities Law Action described above. After the dismissal of the Securities Law Action, a Stipulation of Dismissal and Agreed Order was entered in the Kentucky court action on April 28, 2008. Similarly, a Stipulation and Order of Dismissal with prejudice was entered in the Delaware court action on July 23, 2008.
 
    Antitrust Action—On January 5, 2007, a purported class action was filed against the Company in the United States District Court for the Northern District of Georgia, Rome Division (Jacobs v. Tempur-Pedic International, Inc. and Tempur-Pedic North America, Inc., or the Antitrust Action).  The Antitrust Action alleges violations of federal antitrust law arising from the pricing of Tempur-Pedic mattress products by Tempur-Pedic North America and certain distributors.  The action alleges a class of all purchasers of Tempur-Pedic mattresses in the United States since January 5, 2003, and seeks damages and injunctive relief. Count Two of the complaint was dismissed by the court on June 25, 2007, based on a motion filed by the Company. Following a decision issued by the United States Supreme Court in Leegin Creative Leather Prods., Inc. v. PSKS, Inc. on June 28, 2007, the Company filed a motion to dismiss the remaining two counts of the Antitrust Action on July 10, 2007. On December 11, 2007, that motion was granted and, as a result, judgment was entered in favor of the Company and the plaintiffs’ complaint was dismissed with prejudice. On December 21, 2007, the Plaintiffs filed a “Motion to Alter or Amend Judgment.” On May 1, 2008, that motion was denied. The plaintiffs filed a Notice of Appeal of these decisions on May 14, 2008, the parties have fully briefed the matter, and oral argument is currently scheduled for the week of December 8, 2008. The Company continues to strongly believe that the Antitrust Action lacks merit, and intends to defend against the claims vigorously. However, due to the inherent uncertainties of litigation, the Company cannot predict the outcome of the Antitrust Action at this time, and can give no assurance that these claims will not have a material adverse affect on the Company’s financial position or results of operation. Accordingly, the Company cannot make an estimate of the possible range of loss.
 
    The Company is involved in various other legal proceedings incidental to the operations of its business. The Company believes that the outcome of all such pending legal proceedings in the aggregate will not have a materially adverse affect on its business, financial condition, liquidity, or operating results.
17
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)

(10) Income Taxes
 
    The Company’s effective tax rate for the three months ended September 30, 2008 was 34.4%.  For the same period in 2007, the effective tax rate was 34.5%.  The Company’s effective tax rate for the nine months ended September 30, 2008 was 34.2%.  For the same period in 2007, the effective tax rate was 34.3%. Reconciling items between the federal statutory income tax rate of 35.0% and the effective tax rate include certain foreign tax rate differentials, state and local income taxes, valuation allowances on certain net operating losses, foreign income currently taxable in the U.S., the production activities deduction, and certain other permanent differences.
 
    The Company has not provided for U.S. federal, state income and foreign withholding taxes on $276.9 million of undistributed earnings from non-U.S. operations as of September 30, 2008 because the Company intends to reinvest such earnings indefinitely outside of the United States.  If Tempur-Pedic International were to distribute these earnings, foreign tax credits may become available under current law to reduce the resulting U.S. income tax liability.
 
    On October 24, 2007, the Company received an income tax assessment from the Danish Tax Authority with respect to the 2001, 2002 and 2003 tax years.  The tax assessment relates to the royalty paid by one of Tempur-Pedic International’s U.S. subsidiaries to a Danish subsidiary and the position taken by the Danish Tax Authority could apply to subsequent years. The total tax assessment is approximately $39.3 million including interest and underpayment penalties. On January 23, 2008 the Company filed timely complaints with the Danish National Tax Tribunal denying the tax assessments.  The National Tax Tribunal formally agreed to place the Danish tax litigation on hold pending the outcome of a Bilateral Advance Pricing Agreement (Bilateral APA) between the United States and the Danish Tax Authority.  A Bilateral APA involves an agreement between the Internal Revenue Service (IRS) and the taxpayer, as well as a negotiated agreement with one or more foreign competent authorities under applicable income tax treaties.  On August 8, 2008 the Company filed the Bilateral APA with the IRS and the Danish Tax Authority.  The Company believes it has meritorious defenses to the proposed adjustment and will oppose the assessment in the Danish courts, as necessary.  During the third quarter of 2008 the gross amount of unrecognized tax benefits relating to this matter was increased by $2.5 million, of which $0.8 million impacted the effective tax rate and $1.6 million was recorded as a component of Goodwill within the accompanying Condensed Consolidated Balance Sheets as it related to periods prior to the Tempur Acquisition.
 
    In addition to the impact of the above matter on the gross amount of the Company’s unrecognized tax benefits, it is reasonably possible under FIN 48 that the amount of the total unrecognized tax benefits may change in the next twelve months. An estimate of the amount of such change cannot be made at this time. There have been no significant changes to the status of any other unrecognized tax benefits during the quarter ended September 30, 2008. As of September 30, 2008, the amount reserved for unrecognized tax benefits was $9.5 million. Of the $9.5 million of unrecognized tax benefits, $7.9 would impact the effective rate if recognized.

    With a few exceptions, the Company is no longer subject to U.S. federal, state/local, or non-U.S. income tax examinations by tax authorities for years prior to 2005, 2003 and 2000, respectively.
18
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
(11) Earnings Per Common Share

   
Three Months Ended
    
Nine Months Ended
  
   
September 30,
    
September 30,
  
   
2008
    
2007
    
2008
    
2007
  
Numerator:
                        
Net income
   $ 24,071     $ 38,818     $ 57,813     $ 101,529  
                                 
Denominator:
                                
Denominator for basic earnings per common share-weighted average shares
     74,815       77,725       74,704       81,522  
Effect of dilutive securities:
                                
     Employee stock options
     178       1,448       240       1,547  
Denominator for basic earnings per common share-adjusted weighted average shares
     74,992       79,173       74,944       83,069  
                                 
Basic earnings per common share
   $ 0.32     $ 0.50     $ 0.77     $ 1.25  
                                 
Diluted earnings per common share
   $ 0.32     $ 0.49     $ 0.77     $ 1.22  
                                 
 
    The Company excluded 4,932 shares issuable upon exercise of outstanding stock options for the three months ended September 30, 2008 from the Diluted earnings per common share computation because their exercise price was greater than the average market price of Tempur-Pedic International’s common stock or if they were otherwise anti-dilutive. All outstanding stock options are included in the Diluted earnings per common share for the three months ended September 30, 2007. The Company excluded 3,606 and 4 shares issuable upon exercise of outstanding stock options for the nine months ended September 30, 2008 and 2007, respectively.

(12) Business Segment Information
 
    The Company operates in two business segments: Domestic and International. These reportable segments are strategic business units that are managed separately based on the fundamental differences in their operations. The Domestic segment consists of the two U.S. manufacturing facilities, whose customers include the U.S. distribution subsidiary and certain third party distributors in North America. The International segment consists of the manufacturing facility in Denmark, whose customers include all of the distribution subsidiaries and third party distributors outside the Domestic segment. The Company evaluates segment performance based on Net sales and Operating income.
19
TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    The following table summarizes Total assets by segment:

   
September 30,
    
December 31,
  
   
2008
    
2007
  
Total assets:
            
     Domestic
   $ 607,316     $ 608,346  
     International
     365,546       339,757  
     Intercompany eliminations
     (190,544 )     (141,671 )
    $ 782,318     $ 806,432  
 
    The following tables summarize other segment information: 

   
Three Months Ended
    
Nine Months Ended
  
   
September 30,
    
September 30,
  
   
2008
    
2007
    
2008
    
2007
  
Net sales from external customers:
                        
     Domestic
   $ 165,889     $ 200,451     $ 462,308     $ 546,575  
     International
     86,925       93,643       276,389       271,193  
    $ 252,814     $ 294,094     $ 738,697     $ 817,768  
                                 
Inter-segment sales:
                                
     Domestic
                                
     International
   $ 1,237     $ 921     $ 2,347     $ 2,608  
     Intercompany eliminations
     (1,237 )     (921 )     (2,347 )     (2,608 )
    $ —     $ —     $ —     $ —  
                                 
Operating income:
                                
     Domestic
   $ 21,607     $ 40,715     $ 43,613     $ 99,985  
     International
     21,284       26,834       64,930       76,448  
    $ 42,891     $ 67,549     $ 108,543     $ 176,433  
                                 
Depreciation and amortization (including    stock-based compensation amortization):
                                
     Domestic
   $ 6,954     $ 7,395     $ 22,785     $ 22,000  
     International
     2,782       2,762       8,163       8,407  
    $ 9,736     $ 10,157     $ 30,948     $ 30,407  
20
   TEMPUR-PEDIC INTERNATIONAL INC. AND SUBSIDIARIES
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)—(Continued)
(In thousands, except per share amounts)
 
    The following table sets forth Net sales by product group:

 
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
  
   
2008
    
2007
    
2008
    
2007
  
     Mattresses
$
174,869
  
$
207,341
  
$
506,553
  
$
571,916
  
     Pillows
  
31,414
    
34,418
    
91,909
    
101,094
  
     All other
  
46,531
    
52,335
    
140,235
    
144,758
  
 
$
252,814
  
$
294,094
  
$
738,697
  
$
817,768
  
 
(13) Subsequent Events
 
    On October 21, 2008, the Company’s Board of Directors approved the repatriation of $140.0 million in foreign earnings. The tax charge associated with the repatriation will be approximately $13.0 million, with the final tax effect to be based on the timing and amount of the actual distribution. After giving effect to the repatriation, undistributed earnings from non-U.S. operations reinvested indefinitely outside of the United States would be reduced to $136.9 million. The Company intends to reinvest such earnings indefinitely outside of the United States and has not provided for U.S. federal, state and foreign withholding taxes on these amounts.
21
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
    The following discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements and accompanying notes included in this quarterly report on Form 10-Q. The forward-looking statements in this discussion regarding the mattress and pillow industries, our expectations regarding our future performance, financial flexibility, liquidity and capital resources and other non-historical statements in this discussion include numerous risks and uncertainties, as described under “Special Note Regarding Forward-Looking Statements” and “Risk Factors” elsewhere in this quarterly report on Form 10-Q and in our annual report on Form 10-K. Our actual results may differ materially from those contained in any forward-looking statements. Except as may be required by law, we undertake no obligation to publicly update or revise any of the forward-looking statements contained herein.
 
Executive Overview
 
    General—We are the leading manufacturer, marketer and distributor of premium mattresses and pillows which we sell in approximately 80 countries globally under the TEMPUR® and Tempur-Pedic® brands. We believe our premium mattresses and pillows are more comfortable than standard bedding products because our proprietary pressure-relieving TEMPUR® material is temperature sensitive, has a high density and therapeutically conforms to the body.
 
    Business Segment Information—We have two reportable business segments: Domestic and International. These reportable segments are strategic business units that are managed separately based on the fundamental differences in their geographies. The Domestic operating segment consists of our U.S. manufacturing facilities, whose customers include our U.S. distribution subsidiary and certain third party distributors in North America. The International segment consists of our manufacturing facility in Denmark, whose customers include all of our distribution subsidiaries and third party distributors outside the Domestic operating segment. We evaluate segment performance based on Net sales and Operating income.

Strategy
 
    We believe we are the industry leader in terms of profitability. Our long-term goal is also to become the world’s largest bedding company in terms of revenue. In order to achieve this goal, we expect to continue to pursue certain key strategies:
 
 
•
  
Maintain our focus on premium mattresses and pillows and to regularly introduce new products.
 
 
•
  
Invest in increasing our global brand awareness through advertising campaigns that further associate our brand name with better overall sleep and premium quality products.
 
 
•
  
Extend our presence and improve our account productivity in both the Domestic and International Retail segments.
 
 
•
  
Invest in our operating infrastructure to meet the requirements of our business, including investments in research and development.
 
 
•
  
Take actions to further improve our financial flexibility and strengthen the business.
 
Results of Operations
 
    A summary of our results for the period ended September 30, 2008 includes the following:
 
 
•
  
Earnings per share (EPS) was $0.32 per diluted common share in the third quarter of 2008.
 
 
•
  
As of September 30, 2008, we have reduced Inventories by approximately $36.8 million to $69.7 million, compared to $106.5 million as of December 31, 2007.
 
 
•
  
We reduced total debt by $83.3 million to $518.8 million as of September 30, 2008 from $602.0 from December 31, 2007.
 
 
•
  
Operating cash flow increased 30.0% to $168.9 million for the nine-months ended September 30, 2008 from $129.9 million for the same nine-month period in 2007.
(Millions, except earnings per share)
  
Three Months Ended
September 30,
    
Nine Months Ended
September 30,
  
   
2008
    
2007
    
2008
    
2007
  
Net sales
   $ 252.8       100.0 %   $ 294.1       100.0 %   $ 738.7       100.0 %   $ 817.8       100.0 %
Cost of sales
     147.3       58.3       152.5       51.8       419.1       56.7       424.0       51.8  
                                                                 
Gross profit
     105.5       41.7       141.6       48.2       319.6       43.3       393.8       48.2  
Selling and marketing expenses
     40.0       15.8       48.9       16.6       137.8       18.7       144.6       17.7  
General, administrative and other expenses
     22.6       9.0       25.2       8.6       73.2       9.9       72.8       8.9  
                                                                 
Operating income
     42.9       17.0       67.5       23.0       108.6       14.7       176.4       21.6  
                                                                 
Interest expense, net
     (6.3 )     (2.5 )     (8.2 )     (2.8 )     (19.6 )     (2.7 )     (21.4 )     (2.6 )
Other income (expense), net
     0.1       —       —       —       (1.0 )     (0.1 )     (0.5 )     (0.1 )
                                                                 
Income before income taxes
     36.7       14.5       59.3       20.1       88.0       11.9       154.5       18.9  
Income tax provision
     12.6       5.0       20.5       6.9       30.1       4.1       53.0       6.5  
Net income
   $ 24.1       9.5 %   $ 38.8       13.2 %   $ 57.9       7.8 %   $ 101.5       12.4 %
                                                                 
Earnings per common share:
                                                                
Basic
   $ 0.32             $ 0.50             $ 0.77             $ 1.25          
Diluted
   $ 0.32             $ 0.49             $ 0.77             $ 1.22          
                                                                 
Cash dividend per share:
   $ 0.08             $ 0.08             $ 0.24             $ 0.22          
                                                                 
Weighted average per common share outstanding:
                                                                
Basic
     74,815               77,725               74,704               81,522          
Diluted
     74,992               79,173               74,944               83,069          

Three Months Ended September 30, 2008 Compared with Three Months Ended September 30, 2007
 
    We sell our premium mattresses and pillows through four distribution channels: Retail, Direct, Healthcare, and Third party. The Retail channel sells to furniture and bedding, specialty and department stores. The Direct channel sells directly to consumers. The Healthcare channel sells to hospitals, nursing homes, healthcare professionals and medical retailers. The Third party channel sells to distributors in countries where we do not operate our own wholly owned subsidiaries. A summary of Net sales by channel is set forth below:

 
CONSOLIDATED
  
DOMESTIC
  
INTERNATIONAL
  
 
Three Months Ended
  
Three Months Ended
  
Three Months Ended
  
 
September 30,
  
September 30,
  
September 30,
  
(Millions)
2008
  
2007
  
2008
  
2007
  
2008
  
2007
  
Retail
   $ 216.2     $ 251.5     $ 148.0     $ 177.4     $ 68.2     $ 74.1  
Direct
     11.3       18.0       9.2       15.2       2.1       2.8  
Healthcare
     11.6       12.4       3.7       4.2       7.9       8.2  
Third Party
     13.7       12.2       5.0       3.7       8.7       8.5  
    $ 252.8     $ 294.1     $ 165.9     $ 200.5     $ 86.9     $ 93.6  
 
23
    A summary of Net sales by product is set forth below:

 
CONSOLIDATED
  
DOMESTIC
  
INTERNATIONAL
  
 
Three Months Ended
  
Three Months Ended
  
Three Months Ended
  
 
September 30,
  
September 30,
  
September 30,
  
(Millions)
2008
  
2007
  
2008
  
2007
  
2008
  
2007
  
Net sales:
                                    
   Mattresses
   $ 174.9     $ 207.3     $ 121.4     $ 149.2     $ 53.5     $ 58.1  
   Pillows
     31.4       34.4       14.5       18.1       16.9       16.3  
   Other
     46.5       52.4       30.0       33.2       16.5       19.2  
    $ 252.8     $ 294.1     $ 165.9     $ 200.5     $ 86.9     $ 93.6  
 
    Net sales. Net sales for the three months ended September 30, 2008 decreased to $252.8 million from $294.1 million for the same period in 2007, a decrease of $41.3 million, or 14.0%. The primary area of sales weakness was in the U.S., coupled with a slowdown in certain European markets.  For the three months ended September 30, 2008, our Retail channel Net sales decreased to $216.2 million from $251.5 million for the same period in 2007, a decrease of $35.2 million, or 14.0%. Our Direct channel Net sales decreased to $11.3 million from $18.0 million for the same period in 2007, a decrease of $6.8 million, or 37.6%.  Our Healthcare channel Net sales decreased to $11.6 million from $12.4 million for the same period in 2007, a decrease of $0.7 million, or 6.0%.  Our Third Party Net sales increased to $13.7 million from $12.2 million for the same period in 2007, an increase of $1.5 million, or 12.0%. The factors that impacted Net sales for each segment are discussed below, in the respective segment discussion. We believe we are facing a challenging economic environment, and are not assuming the economic climate will recover in the short term.
 
    Domestic. Domestic Net sales for the three months ended September 30, 2008 decreased to $165.9 million from $200.5 million for the same period in 2007, a decrease of $34.6 million, or 17.2%. Our Domestic Retail channel contributed $148.0 million in Net sales for the three months ended September 30, 2008, a decrease of $29.4 million, or 16.6%, as compared to the same period in 2007. We believe that the macroeconomic environment adversely impacted our Domestic Retail channel with many consumers deferring high-end product purchases. Net sales in the Direct channel decreased by $6.0 million, or 39.4%. We believe the macroeconomic environment also negatively impacted Net sales in the Direct channel, as this channel attracts a customers which have also been adversely affected by the economic environment. The Domestic Third Party channel Net sales increased $1.3 million, or 34.5%, to $5.0 million, primarily related to the addition of new customers and the introduction of new products by our North American third party distributor.
 
    As a result of the macroeconomic environment, mattress sales in the third quarter of 2008 decreased $27.9 million, or 18.7%, over the same period in 2007. Pillow sales decreased $3.5 million, or 19.4%. As many of our pillows are sold along with a mattress, when mattress sales decline, pillow sales also are traditionally impacted. Other sales, which include adjustable bedbases, foundations and other related products, decreased by $3.2 million, or 9.7%. This decrease is primarily related to the decrease in mattress sales, the effects of which have been offset by the emphasized sales of adjustable bedbases.
 
    International. International Net sales for the three months ended September 30, 2008 decreased to $86.9 million from $93.6 million for the same period in 2007, a decrease of $6.7 million, or 7.2%. On a constant currency basis, our International sales declined approximately 12.8%. Our International segment was primarily impacted by macroeconomic factors in certain European markets. The International Retail channel decreased $5.8 million, or 7.9%, for the three months ended September 30, 2008. International mattress sales in the third quarter of 2008 decreased $4.6 million, or 7.9%, over the third quarter of 2007. Pillow sales for the third quarter of 2008 increased $0.5 million, or 2.9%, as compared to the third quarter of 2007.
 
    Gross profit. Gross profit for the three months ended September 30, 2008 decreased to $105.5 million from $141.6 million for the same period in 2007, a decrease of $36.1 million, or 25.5%. Several factors impacted our Gross profit margin during the quarter. These factors are identified and discussed below in the respective segment discussions.
 
24
    Domestic. Domestic Gross profit for the three months ended September 30, 2008 decreased to $58.8 million from $87.7 million for the same period in 2007, a decrease of $28.9 million, or 33.0%.  The Gross profit margin in our Domestic segment was 35.4% and 43.7% for the three months ended September 30, 2008 and September 30, 2007, respectively. For the three months ended September 30, 2008, the gross margin declined resulting from a combination of lower Direct channel Net sales, raw material cost inflation and lower production volumes related to the decrease in Net sales and our efforts to reduce inventories. Domestic Cost of sales for the three months ended September 30, 2008 decreased to $107.1 million from $112.8 million for the same period in 2007, a decrease of $5.6 million, or 5.0%.
 
    International. International Gross profit for the three months ended September 30, 2008 decreased to $46.7 million from $53.9 million for the same period in 2007, a decrease of $7.2 million, or 13.4%. The Gross profit margin in our International segment was 53.8% and 57.6% for the three months ended September 30, 2008 and September 30, 2007, respectively. The Gross profit margin for our International segment was impacted by raw material cost inflation and lower production volumes related to the decrease in Net sales and our efforts to reduce inventories. Our International Cost of sales for the three months ended September 30, 2008 increased to $40.2 million from $39.7 million for the same period in 2007, an increase of $0.5 million, or 1.2%.
 
    Selling and marketing expenses. Selling and marketing expenses include advertising and media production; other marketing materials such as catalogs, brochures, videos, product samples, direct customer mailings and point of purchase materials; and sales force and customer service compensation. We also include in Selling and marketing expenses certain new product development costs, including market research and testing for new products. Selling and marketing expenses decreased to $40.0 million for the three months ended September 30, 2008 as compared to $48.9 million for the three months ended September 30, 2007. Selling and marketing expenses as a percentage of Net sales were 15.8% and 16.6% for the three months ended September 30, 2008 and 2007, respectively. During the third quarter of 2008, we aligned Selling and marketing expenses with our revised full-year sales expectations primarily through leveraging advertising expenditures and cost control initiatives put in place earlier in the year.
 
    General, administrative and other expenses. General, administrative and other expenses include management salaries, information technology, professional fees, depreciation of furniture and fixtures, leasehold improvements and computer equipment, expenses for administrative functions, and research and development costs. General, administrative and other expenses decreased to $22.6 million for the three months ended September 30, 2008 as compared to $25.2 million for the three months ended September 30, 2007, a decrease of $2.6 million, or 10.3%. General, administrative and other expenses as a percentage of Net sales was 9.0% and 8.6% for the three months ended September 30, 2008 and 2007, respectively. We decreased our expenditures consistent with the cost control initiatives that were introduced earlier in the year. This effect was offset by an increase in our bad debt expense associated with the accounts-receivable from a U.S. customer seeking to reorganize its operations under Chapter 11 of the Bankruptcy Code.
 
    Interest expense, net. Interest expense, net, includes the interest costs associated with our borrowings and the amortization of deferred financing costs related to those borrowings. Interest expense, net, decreased to $6.3 million for the three months ended September 30, 2008, as compared to $8.2 million for the three months ended September 30, 2007, a decrease of $2.0 million, or 23.8%. The decrease is primarily attributable to a decrease in overall debt as well as a decrease in interest rates. The interest rate and certain fees that we pay in connection with the 2005 Senior Credit Facility are subject to periodic adjustment based on changes in our consolidated leverage ratio. On May 29, 2008, we entered into an interest rate swap agreement effective May 30, 2008, to manage interest costs and the risk associated with changing interest rates. Under this swap, the Company pays at a fixed rate and receives payments at a variable rate. The swap effectively fixes the floating LIBOR-based interest rate to 3.755% on $350.0 million of the outstanding balance under the 2005 Senior Credit Facility, with the outstanding balance subject to the swap declining over time.
 
    Income tax provision. Our Income tax provision includes income taxes associated with taxes currently payable and deferred taxes and includes the impact of net operating losses for certain of our foreign operations. Our effective income tax rates for the three months ended September 30, 2008 and for the three months ended September 30, 2007 differed from the federal statutory rate principally because of certain foreign tax rate differentials, state and local income taxes, valuation allowances on certain net operating losses, foreign income currently taxable in the U.S., the production activities deduction and certain other permanent differences.
 
    Our effective tax rate for the three months ended September 30, 2008 was 34.4%.  For the same period in 2007, the effective tax rate was 34.5%.
25
    On October 24, 2007, we received an income tax assessment from the Danish Tax Authority with respect to the 2001, 2002 and 2003 tax years.  The tax assessment relates to the royalty paid by one of Tempur-Pedic International’s U.S. subsidiaries to a Danish subsidiary and the position taken by the Danish Tax Authority could apply to subsequent years. The total tax assessment is approximately $39.3 million including interest and underpayment penalties. On January 23, 2008 the Company filed timely complaints with the Danish National Tax Tribunal denying the tax assessments.  The National Tax Tribunal formally agreed to place the Danish tax litigation on hold pending the outcome of a Bilateral Advance Pricing Agreement (Bilateral APA) between the United States and the Danish Tax Authority.  A Bilateral APA involves an agreement between the IRS and the taxpayer, as well as a negotiated agreement with one or more foreign competent authorities under applicable income tax treaties.  On August 8, 2008 the Company filed the Bilateral APA with the IRS and the Danish Tax Authority.  We believe we have meritorious defenses to the proposed adjustment and will oppose the assessment in the Danish courts, as necessary.  For the three months ended September 30, 2008, the gross amount of tax reserves relating to this matter was increased by $2.5 million, of which $0.8 million impacted the effective tax rate with $1.6 million was recorded as a component of Goodwill as it related to periods prior to the acquisition of Tempur World, Inc. in November 2002.
 
    In addition to the impact of the above matter on the gross amount of the Company’s unrecognized tax benefits, it is reasonably possible under FIN 48 that the amount of the total unrecognized tax benefits may change in the next twelve months.  An estimate of the amount of such change cannot be made at this time.  There have been no significant changes to the status of any other unrecognized tax benefits during the quarter ended September 30, 2008.

Nine Months Ended September 30, 2008 Compared with Nine Months Ended September 30, 2007
 
    A summary of Net sales by channel is set forth below:

 
CONSOLIDATED
  
DOMESTIC
  
INTERNATIONAL
  
 
Nine Months Ended
  
Nine Months Ended
  
Nine Months Ended
  
 
September 30,
  
September 30,
  
September 30,
  
(Millions)
2008
  
2007
  
2008
  
2007
  
2008
  
2007
  
Retail
   $ 623.5     $ 681.4     $ 407.2     $ 472.4     $ 216.3     $ 209.0  
Direct
     37.5       60.7       31.2       52.8       6.3       7.9  
Healthcare
     36.4       35.4       12.1       10.8       24.3       24.6  
Third Party
     41.3       40.3       11.9       10.6       29.4       29.7  
    $ 738.7     $ 817.8     $ 462.4     $ 546.6     $ 276.3     $ 271.2  
                                                 
 
    A summary of Net sales by product is set forth below:

 
CONSOLIDATED
  
DOMESTIC
  
INTERNATIONAL
  
 
Nine Months Ended
  
Nine Months Ended
  
Nine Months Ended
  
 
September 30,
  
September 30,
  
September 30,
  
(Millions)
2008
  
2007
  
2008
  
2007
  
2008
  
2007
  
Net sales:
                                    
   Mattresses
   $ 506.6     $ 572.0     $ 336.6     $ 406.7     $ 170.0     $ 165.3  
   Pillows
     91.8       101.1       40.1       48.4       51.7       52.7  
   Other
     140.3       144.7       85.7       91.5       54.6       53.2  
    $ 738.7     $ 817.8     $ 462.4     $ 546.6     $ 276.3     $ 271.2  
                                                 
 
    Net sales. Net sales for the nine months ended September 30, 2008 decreased to $738.7 million from $817.8 million for the same period in 2007, a decrease of $79.1 million, or 9.7%. The primary area of sales weakness was in the U.S., coupled with a slowdown in certain European markets. For the nine months ended September 30, 2008, our Retail channel Net sales decreased to $623.5 million from $681.4 million for the same period in 2007, a decrease of $57.9 million, or 8.5%. Our Direct channel Net sales decreased to $37.5 million from $60.7 million for the same period in 2007, a decrease of $23.3 million, or 38.3%.  Our Healthcare channel Net sales increased to $36.4 million from $35.4 million for the same period in 2007, an increase of $1.0 million, or 2.9%. Our Third Party Net sales increased to $41.3 million from $40.3 million for the same period in 2007, an increase of $1.0 million, or 2.6%. The factors that impacted Net sales for each segment are discussed below in the respective segment discussion.
26
    Domestic. Domestic Net sales for the nine months ended September 30, 2008 decreased to $462.4 million from $546.6 million for the same period in 2007, a decrease of $84.3 million, or 15.4%. Our Domestic Retail channel contributed $407.2 million in Net sales for the nine months ended September 30, 2008 for a decrease of $65.2 million, or 13.8%, over the prior year same period.  This decrease is due primarily to a challenging U.S. macroeconomic environment. The Healthcare channel Net sales increased $1.2 million, or 11.3%, as a result of our distribution partnerships and strategic relationships with healthcare companies who market joint product offerings through their established distribution, offset by the elimination of certain small Healthcare partners. Our Third Party channel Net sales increased $1.3 million, or 12.7%, as a result of certain new customers and new product introductions by our North American third party distributor. Our Direct channel Net sales decreased 40.9%, which was a result of the challenges in the U.S. macroeconomic environment.  Domestic mattress sales decreased $70.1 million, or 17.2%, over the same period in 2007, driven by the decreases in our Retail channel. Pillow sales decreased $8.2 million, or 16.9%. Many of our pillow products are sold with mattress purchases. As a result, when mattress sales decline, pillow sales are also traditionally impacted.
 
    International. International Net sales for the nine months ended September 30, 2008 increased to $276.3 million from $271.2 million for the same period in 2007, an increase of $5.2 million, or 1.9%. The increase was driven by favorable foreign exchange rates in 2008. On a constant currency basis, our International sales declined by approximately 8.2%.  Our International segment was primarily impacted by macroeconomic factors in certain key European markets, primarily late in the second quarter and in the third quarter. The International Retail channel increased $7.3 million, or 3.5%, for the nine months ended September 30, 2008. Our Direct channel Net sales decreased 20.6%.  Our Third party sales decreased 1.0%. Additionally, our Healthcare channel Net sales decreased $0.2 million, or 0.8%.  International mattress sales increased $4.7 million, or 2.8%, as compared to 2007. Pillow sales for the nine months ended September 30, 2008 decreased $1.0 million, or 1.9% as compared to the same period in 2007.
 
    Gross profit. Gross profit for the nine months ended September 30, 2008 decreased to $319.6  million from $393.8 million for the same period in 2007, a decrease of $74.3 million, or 18.9%. Several factors impacted our Gross profit margin during the quarter. These factors are identified and discussed below in the respective segment discussions.
 
    Domestic. Domestic Gross profit for the nine months ended September 30, 2008 decreased to $170.0 million from $237.5 million for the same period in 2007, a decrease of $67.6 million, or 28.4%.  The Gross profit margin in our Domestic segment was 36.8% and 43.5% for the nine months ended September 30, 2008 and September 30, 2007, respectively. The decrease in our Gross profit margin for the Domestic segment was impacted by declines in the Direct channel, an inflationary raw material cost environment and reduced production levels resulting from lower sales and our efforts to reduce inventories. Our Domestic Cost of sales decreased to $292.3 million for the nine months ended September 30, 2008 as compared to $309.1 million for the nine months ended September 30, 2007, a decrease of $16.7 million, or 5.4%.
 
    International. International Gross profit for the nine months ended September 30, 2008 decreased to $149.6 million from $156.3 million for the same period in 2007, a decrease of $6.7 million, or 4.3%. The Gross profit margin in our International segment was 54.1% and 57.6% for the nine months ended September 30, 2008 and September 30, 2007, respectively. For the nine months ended September 30, 2008, the Gross profit margin for our International segment was primarily impacted by an inflationary raw material cost environment and by decreased production levels related to lower sales and our efforts to reduce inventories. Our International Cost of sales for the nine months ended September 30, 2008 increased to $126.8 million from $114.9 million for the same period in 2007, an increase of $11.9 million, or 10.3%.
 
    Selling and marketing expenses. Selling and marketing expenses decreased to $137.8 million for the nine months ended September 30, 2008 as compared to $144.6 million for the nine months ended September 30, 2007. Selling and marketing expenses as a percentage of Net sales increased to 18.7% for the nine months ended September 30, 2008 from 17.7% for the same period for 2007. For the first quarter of 2008, much of our cost structure was in place and we were limited in our ability to take actions to reduce our selling and marketing costs to match our reduced sales levels. In the second and third quarters we were able to better align Selling and marketing expenses with our revised sales expectations through leveraging advertising and cost control initiatives put in place earlier in the year.
 
    General, administrative and other expenses. General, administrative and other expenses remained relatively even, at $73.2 million for the nine months ended September 30, 2008, in comparison to $72.8 million for the nine months ended September 30, 2007. General, administrative and other expenses as a percentage of Net sales was 9.9% and 8.9% for the nine months ended September 30, 2008 and 2007, respectively. For the first quarter of 2008, much of our cost structure was in place and we were limited in our ability to take actions to reduce our General, administrative and other expenses to match our reduced sales levels. In the second and third quarters, we were able to decrease General, administrative and other expenses through cost control initiatives to better align with our revised sales expectations.
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    Interest expense, net. Interest expense, net, decreased to $19.6 million for the nine months ended September 30, 2008, as compared to $21.4 million for the nine months ended September 30, 2007, a decrease of $1.8 million, or 8.2%. The decrease is related to a lower level of long-term debt as of September 30, 2008, as compared to the same time period in 2007 as well as lower interest rates on our 2005 Senior Credit Facility.
 
    Income tax provision. Our effective income tax rates for the nine months ended September 30, 2008 and 2007 differed from the federal statutory rate principally because of certain foreign tax rate differentials, state and local income taxes, valuation allowances on certain net operating losses, foreign income currently taxable in the U.S., the production activities deduction and certain other permanent differences.
 
    Our effective tax rate for the nine months ended September 30, 2008 was 34.2%.  For the same period in 2007, the effective tax rate was 34.3%.

Liquidity and Capital Resources
 
Liquidity
 
    Our principal sources of funds are cash flows from operations and borrowings. Our principal uses of funds consist of capital expenditures, payments of principal and interest on our debt facilities, payments of dividends to our shareholders and share repurchases from time to time pursuant to our share repurchase program. At September 30, 2008, we had working capital of $173.8 million including Cash and cash equivalents of $87.7 million as compared to working capital of $200.0 million including $33.3 million in Cash and cash equivalents as of December 31, 2007. The increase in cash was primarily attributable to the focus on improving cash flow during the nine months ended September 30, 2008.
 
    Our cash flow from operations increased to $168.9 million for the nine months ended September 30, 2008 as compared to $129.9 million for the nine months ended September 30, 2007. During 2008, we have been focused on driving our working capital improvements to maximize operating cash flow to increase our financial flexibility. The increase in operating cash flow for the period ending September 30, 2008, was primarily a result of reductions in Inventory and Accounts receivable. The decrease in inventory levels resulted in a cash inflow of approximately $36.7 million while Accounts receivable resulted in a cash inflow of approximately $18.6 million, the effects of which were offset by lower Net income.
 
    Net cash used in investing activities decreased to $9.8 million for the nine months ended September 30, 2008 as compared to $14.4 million for the nine months ended September 30, 2007, a decrease of $4.6 million. The decrease is primarily related to decreased capital expenditures and acquisitions.
 
    Cash flow used by financing activities was $100.4 million for the nine months ended September 30, 2008 as compared to $108.9 million for the nine months ended September 30, 2007, representing a decrease in cash outflows of $8.5 million. During 2008 we have focused on reducing our outstanding borrowings to improve our financial flexibility. During 2008 we used excess cash flows to reduce our outstanding borrowings and we did not make any repurchases under our stock repurchase authorizations during 2008. In addition, on October 16, 2008, we announced that we would suspend the payment of our quarterly cash dividend, and as a result we expect to redirect the use of approximately $6.0 million in the fourth quarter to debt repayment.
 
    On October 21, 2008, our Board of Directors approved the repatriation of $140.0 million in foreign earnings. The tax charge associated with the repatriation will be approximately $13.0 million, with the final tax effect to be based on the timing and amount of the actual distribution.

Capital Expenditures
 
    Capital expenditures totaled $7.8 million for the nine months ended September 30, 2008 and $8.2 million for the nine months ended September 30, 20