Somnigroup International - Earnings Call - Q3 2011

Transcript

Speaker 6

Good day, ladies and gentlemen, and welcome to the Somnigroup International Third Quarter 2011 earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session with instructions following at that time. If anyone requires assistance, please press star then zero on your touch-tone phone. As a reminder, this conference call is being recorded. Now, I'll turn the call over to Barry Hytinen, Senior Vice President. Please begin.

Speaker 2

Thanks, Tyrone, and thank you to everyone joining us on today's call. Joining me in our Lexington headquarters are Mark Sarvary, President and CEO, and Dale Williams, Executive Vice President and CFO. After prepared remarks, we will open the call for Q&A. Forward-looking statements that we make during this call are made pursuant to the safeguard provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that forward-looking statements, including the company's expectations regarding sales and earnings, involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company's business. The factors that could cause actual results to differ materially from those identified include economic, competitive, operating, and other factors discussed in the press release issued today.

These factors are also discussed in the company's SEC filings, including the company's annual report on Form 10-K under the headings "Special Note Regarding Forward-Looking Statements" and "Risk Factors." Any forward-looking statement speaks only as of the date on which it is made. The company undertakes no obligation to update any forward-looking statements. The press release, which contains a reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures, is posted on the company's website at somnigroup.com and filed with the SEC. Now, with that introduction, it is my pleasure to turn the call over to Mark.

Speaker 4

Thanks, Barry. Good evening, everybody, and thanks for joining us. Today, I'll provide an overview of our performance in the third quarter and an update on our strategic focus area. Dale will then provide a detailed review of the financial results, as well as our updated financial guidance. We're pleased with our third-quarter performance globally. Sales were up 30% from last year, and earnings per share were up 45%. Somnigroup International continues to gain market share both in the U.S. and internationally, primarily as a result of our strategic investments in new products and brand advertising. Gross margin improved 140 basis points year over year, a result of our productivity programs, favorable mix, and fixed cost leverage. The improvement in gross margin allowed us to maintain our commitment to significantly invest in marketing while still expanding operating margin 220 basis points to 25.2%.

Having said that, our gross margin in the third quarter was lower than in the second quarter, and Dale will provide more details on that when he talks about our financial results. Now, I'd like to provide an update on our strategic initiatives. Firstly, our commitment to ensure that there is a Somnigroup International mattress and pillow that appeals to everyone. In our international markets, the Cloud collection launch is progressing very well. The line is now in distribution in all markets, with the UK being the last major geography to start shipping. Retailer and consumer feedback remain very positive, and we believe the Cloud collection is highly incremental. We anticipate that our Cloud business will be an important contributor to our international markets' overall growth during 2012. In the U.S., our rollout of the Contour collection was completed on schedule in advance of the Labor Day shopping period.

This line is designed for those consumers with a preference for the original Somnigroup International feel and offers an improved product with a broader differentiation within the line compared to the products of replacers. We're very pleased with the response that this line has received both from retailers and consumers. Additionally, in the U.S., we showcased our new traditional pillow line in August at the Las Vegas Fitting Show and began shipping this quarter. These new pillows supplement the very popular iconic Somnigroup International molded pillows. These are filled pillows designed to appeal to consumers who prefer a more traditional pillow, one that is more huggable. A broader range is a key component of our strategy to ensure greater distribution for our pillow products. Lastly, from a new product perspective, as I mentioned on our second quarter call, we have several new product concepts in various stages of development.

Over the coming 12 to 24 months, we will introduce exciting new products that we anticipate will drive considerable growth and market share gains in the premium mattress space by meeting the needs of large consumer segments that we currently do not address. These new products cut across all of our lines and geographies. We're in the final stage of development for a new line we expect to introduce in January at the Las Vegas Show that we're very excited about, and we look forward to showing it to many of you in person. As our investors understand, due to the competitive nature of future product introductions, we'll make no further comments on this topic during the call. The next strategic imperative is making sure that everyone knows that they'll sleep better on a Somnigroup International mattress.

In the third quarter, we increased our marketing by over 55%, nearly $40 million, enabling us to build the Somnigroup International brand and increase awareness of the breadth of our product range. In the U.S., our investment in marketing is paying off well. The "Ask Me" campaign continues to expand, most recently with the message that a Somnigroup International mattress is available for a range of consumer preferences from soft to firm and everything in between. We tested increased levels of advertising in 29 of our key markets, and there we saw an appreciable step up in sales in those markets. We expect to expand this test during 2012. The North America business as a whole experienced 19% growth in mattress units, which we are confident is largely due to the effectiveness of our advertising. We're also pleased with the return on marketing investment in our international markets.

As a reminder, in 2011, we're implementing a strategic investment in advertising to raise awareness in several of our largest international markets, concentrated in the UK, Germany, and France, with additional investments in several smaller markets. We have seen an unambiguous lift in sales volume in those markets, and our retailers are enthusiastic about the consumer response. In addition, we're able to monitor the effectiveness of advertising by tracking web traffic during periods that we're on the air. We have seen a significant lift as a result of the investment. Last, I would like to update investors on our goal of making sure that Somnigroup International is available to everyone. This quarter, we opened approximately 150 doors, of which roughly half were in the U.S. Throughout 2011, we have gained slots with both the Cloud collection rollout in our international markets and with the Contour collection rollout in the U.S.

In closing, we had a strong third quarter in a macro environment that remains challenging, both in the U.S. and internationally. The mattress industry as a whole is significantly below historic norms. It's growing very slowly in most geographies and not at all in others. Nonetheless, we project significant growth for Somnigroup International in the fourth quarter and in the years ahead. We will continue to invest in technology, in product innovations, and in building consumer awareness of the Somnigroup International brand. We remain committed to becoming the world's favorite mattress and pillow brand. With that, I'll hand it over to Dale.

Speaker 5

Thanks, Mark. I'll focus my commentary on the third quarter financial results. In total, third quarter net sales were $383 million, an increase of 30%. On a constant currency basis, sales were up 26%. North American sales increased 30%, and international sales were up 28%. On a constant currency basis, our international sales increased 15%, reflecting the positive response to investments in marketing and new products. By channel, in North American retail, net sales were $257 million, an increase of 30%. Internationally, retail sales were up 37% to $86 million. On a product basis, total mattress sales were up 28%, driven by an 18% increase in units. North American mattress sales increased 28% on a 19% increase in units. The increased average unit selling price reflects favorable price and mix, partially offset by increased floor model discounts. In the international segment, mattress sales increased 31%.

On a constant currency basis, international mattress sales were up 18%, and mattress units increased 16%. In total, pillows were up 12%, driven by a 3% increase in units. North American pillow sales increased 5% on a unit growth of 2%. International pillow sales were up 21% on a 5% volume increase. On a constant currency basis, international pillow sales increased by 9%. Sales of our other product category, which includes items that are normally sold along with a mattress, were up 42%, reflecting continued improvements on ergo attach rates in the U.S. Gross margin for the quarter was 52.4%, up 140 basis points year on year, but down 50 basis points sequentially. I am disappointed the margin rate was not up more. However, the reasons behind this are mostly transitory.

While the underlying trends in our margin continue to be strong, in the third quarter, we made some strategic investments which lowered our overall gross margin. These investments include an IT system upgrade at our European manufacturing facility, new product launches, and a program that provides an opportunity for sales associates to purchase their own Somnigroup International sleep systems. All of these are supportive of long-term growth plans and provide a foundation for future growth. At the same time, we are experiencing unprecedented levels of demand for new product launches internationally. This demand, in combination with some productivity issues arising from the upgrade, resulted in unacceptably low levels of inventories in some international markets. Rather than risk extensive backorders and further impact customer service, we began shipping product from the U.S. to Europe and incurred incremental shipping costs. Despite this support from the U.S.

plants and a significant improvement in productivity by the end of the quarter, our international business ended the third quarter with a record backlog. To ensure the best possible levels of customer service, we will continue shipping to Europe in the fourth quarter. Now, let me give you a breakdown of the key drivers of our gross margin. On a year-over-year basis, the gross margin improvement related to our ongoing productivity programs generated improved efficiencies in manufacturing and distribution, favorable mix, and fixed cost leverage related to higher production volumes, partially offsetting these benefits for higher commodity costs and floor model discounts related to new product introductions.

On a sequential basis, the modest decline in gross margin resulted from the impact of productivity issues related to the Danish manufacturing facility, higher commodity costs, floor model discounts related to new product launches, and the retail sales associate program, partially offsetting these items for improvements related to our ongoing productivity programs and fixed cost leverage. Looking at operating expenses, we increased our advertising investment by 170 basis points, reflecting our commitment to ensure everyone knows they would sleep better on Somnigroup International. While our sales growth, we drove 80 basis points of operating expense leverage despite our increased investment in brand awareness. Our operating margins expanded by 220 basis points to 25.2%. Interest expense was $3.3 million. Net income was $61.9 million, up from $44.2 million last year. EPS was $0.90, up from $0.62 last year. Now, I'll turn to the balance sheet for a brief review.

We generated $75 million of operating cash flow and had $103 million of cash on our balance sheet. The majority of our cash balance is in our international markets. Receivables were up, reflecting higher sales, while our DSOs were down approximately three days from the third quarter of last year and flat sequentially. Inventory decreased three days sequentially, principally reflecting the completion of the initial distribution of the Contour line in the U.S. Our inventory days were down considerably more in the international markets, especially so for our new products. Turning to our share repurchase program, through open market purchases, we bought 1.34 million shares during the quarter at a total cost of $80 million. During the first three quarters of 2011, we bought back 4.25 million shares for a total cost of $240 million.

Our funded debt to EBITDA ratio decreased modestly to 1.36 times, despite an increase in debt outstanding deployed to purchase stock. As we've said before, our target leverage ratio is 1.5 to 2 times versus our debt covenant of 3 times. We continue to view the share repurchase program as an excellent means to return value to shareholders over the long term. We are pleased to announce that our board has expanded our share repurchase authorization by $80 million. Reflecting the shares repurchased in the third quarter, we currently have $200 million available under this authorization. Now, I would like to address our updated guidance for the full year. With our new outlook, we are balancing strong results through the first three quarters of 2011 while continuing to acknowledge the macroeconomic environment remains unclear. Industry conditions are volatile, and retail customers report that traffic is variable.

Therefore, we are projecting the end of the year in a manner reflecting this uncertainty. We currently expect net sales to range from $1,405 million to $1,425 million, and we currently expect EPS to range from $3.12 to $3.17 for a diluted share. Regarding our outlook for gross margins, in the fourth quarter, we anticipate a modest increase on a sequential basis as margins will remain challenged by incremental shipping costs related to rebuilding international inventories and a conservative commodity outlook. We expect interest expense for the full year to be $13 million. We anticipate the full-year tax rate to be 33.5%. We are lowering our share count projection to 69.5 million shares for the full year, which includes the net benefit from our repurchase activity through the third quarter. However, it does not assume benefit from the potential for a further reduction in shares outstanding.

As noted in our press release, our guidance and these expectations are based on information available at the time of the release and are subject to changing conditions, many of which are outside the company's control. This concludes our prepared remarks, and at this point, operator, we would like to open the call to questions.

Speaker 6

Thank you, ladies and gentlemen. If you have a question, simply press star then one on your touch-tone phone. If your question has been answered and you wish to move yourself from the queue, you can do so by pressing the pound key. We also ask that you limit your question to one question plus a follow-up. Again, if you have a question, simply press star then one on your touch-tone phone. Please limit your question to one question plus a follow-up. If you have any additional questions, you may re-enter the queue. Our first question is from Mark Roop of Longbow Research. The line is open.

Speaker 7

Hey, guys. Solid quarter. Hey, Dale, on the gross margin, I know you cited the three things, but obviously, there's the one thing that's flown into the fourth quarter as well. Is there any kind of framework you can give us that would provide the magnitude of what you were expecting in the third quarter and what this did to the gross margin in the third quarter, and then the thought process in the fourth quarter? I guess, lastly on that, does it get resolved by the end of the fourth quarter?

Speaker 5

Just to be clear, you're talking about the productivity and shipping?

Speaker 7

The Danish, yeah, exactly.

Speaker 5

Yeah, let me just put a little context on that. We upgraded our IT system in our Danish manufacturing facility. Our system there was old. It was several generations behind, so it was a major upgrade. You know, with any major upgrade, you have occasionally some hiccups at the start. Quite honestly, we were very pleased with the new system. There were absolutely no issues around the new system. What we saw was the old system had several thousand customizations to it, which the new system did not have. It primarily affected one element of the manufacturing operation, which was the cutting operation. That operation became a bottleneck in the factory, which impeded the ability temporarily of the factory to produce at a normal rate. By the end of the quarter, that productivity was improved. We were producing more in the Danish factory than we'd ever produced before.

Speaker 7

Right.

Speaker 5

We're also, because of the growing demand internationally, because of the advertising and because of the Cloud collection, though requiring more than we've ever produced in Denmark. We got into a situation of being short on inventories. We leave the quarter still well short on where we should be from an inventory standpoint to support the customer service levels that our customers have come to expect from us. In the third quarter, the cost of the temporary productivity shortage in Dan-Foam and the cost of shipping product from the U.S. to Europe cost us approximately $2 million. In the fourth quarter, we're actually expecting that to cost us between $3 million and $4 million.

Speaker 7

Okay.

Speaker 5

Now, we do, sitting here today, think everything's going to be back to normal by the end of the quarter. In fact, as I said, Dan-Foam today is producing at record levels, but we need to still ship from the U.S. and actually ship a little bit more from the U.S. than we did in the third quarter to be able to fulfill the backlog and to get the inventories to where we can have the proper service levels with our customers.

Speaker 7

Okay, that's very helpful. The other puts and take on the margin from third quarter to fourth quarter, the product rollout stuff, is that by and large behind us with the exception of maybe the UK?

Speaker 5

Yes.

Speaker 7

Okay. Perfect. I'll get back in the queue. Thank you.

Speaker 6

Thank you. Our next question is from Bradley Thomas of William Blair. The line is open.

Speaker 1

Hi, guys. This is actually Jason Campbell filling in for Brad this evening. You mentioned some nice door growth and slot growth. I was wondering, you know, you guys have obviously been pretty popular lately. Is there anything you've done to change maybe your training or how you're really gaining a lot of these slots or, you know, the salesperson awareness of your mattresses?

Speaker 4

The slot gains have been both in the U.S. and in international. They have been, you're correct, we have had solid growth in the U.S. We've had particularly good growth in international. That's because as we roll out the Cloud collection, a lot of our customers are moving from carrying essentially just the traditional line of mattresses to carrying the traditional and the Cloud and the Sensations, what we call the collections. This has given really quite a significant increase in slots. We've said before that we expect, over the full rollout of the Cloud collection, to gain a net of about two slots in international. It really is quite important. From a training point of view or training of the people selling in the stores, it's obviously crucial for people who are in stores, the RSAs representing our products, to know the product well.

Dale referred to the RSA program where if we get people to buy at a discounted rate our products so that they can sleep on them because we know that there's no better advocate than somebody who actually owns a Somnigroup International bed. On top of that, we're putting a lot of extra emphasis on training and calling on stores. We continue to invest in people, what we call feet on the streets, because again, there's no replacement for having somebody call on a store and talk to the people there and get to know them and explain how our beds differ, how they work, and how people prefer them. That's true in the U.S., and it's true in the major countries in the rest of the world.

Speaker 7

Thanks. Just a quick follow-up. Have you guys updated any of your longer-term door slot goals?

Speaker 5

No, not from the last time that we published those.

Speaker 7

Okay.

Speaker 5

I would expect you may have an update on that in mid-February when we have our Investor Day.

Speaker 7

All right. Good quarter. Thanks, guys.

Speaker 6

Thank you. Our next question is from Bhaskar Rao of Raymond James. The line is open.

Speaker 3

Good evening, Mark, Dale, Barry. This is actually Chad filling in for Bud, who's traveling tonight.

Speaker 7

Hi, Chad. Good evening.

Speaker 3

Hey, a question, I guess, kind of following up on the Danish production issue. Your international growth in local currency was very solid again this quarter at 15%, but it did moderate a bit versus the 18% that you put up last quarter. I think, if I remember correctly, the comp was a little bit easier. How much was the lost revenue impact from the production bottlenecks? Can you quantify how much it impacted reported sales for the quarter?

Speaker 5

We certainly would have had better revenue internationally without the significant increase in backlog. You can see internationally that if you look at the pieces, retail did very well, direct did very well. The part that was the one part of the business that was down and down quite a bit sequentially was third party. Third party was related to really two things. One, the conversion of CRIA from a third party to a subsidiary. It was a small impact. The primary impact was as we were, if you're familiar with Europe and the way particularly the Europe side of the business works, July and August, during those months, there's always some country that's on vacation for the month. Third quarter internationally is heavily determined by September. That's the big quarter internationally, particularly in Europe in the third quarter.

As we got into September and demand was increasing significantly, what we prioritized was the shorter lead time shipments, trying to make sure that we had all of our customer service levels covered. Third party tends to be a little bit longer lead time. We emphasized the shorter lead time customer service items that we needed to protect the retailers on. There was an impact. Like I said earlier, we had a record backlog going into the fourth quarter. I don't want to quantify exactly how much revenue may have flipped from third quarter to fourth quarter because of that, but it was a fair bit.

Speaker 7

Okay. Fair enough. I guess you gave, I believe you gave the door number consolidated, 150 door increase. Was it 75 and 75 international and domestic?

Speaker 1

Roughly correct, Chad. About half of it was in the U.S.

Speaker 7

Just one more housekeeping for me, and I'll defer to others. U.S. furniture and bedding sales in the quarter?

Speaker 5

U.S. furniture and bedding sales, $242 million.

Speaker 1

Yep. $242 million.

Speaker 7

Great. Thanks, guys. Good luck on the rest of the year.

Speaker 5

Thanks.

Speaker 6

Thank you. If you have a question, please press star then one on your touch-tone phone. If you have a question, please press star then one on your touch-tone phone. Our next question is from Keith Hughes of Somnigroup International. The line is open.

Speaker 3

Thank you. As you look at the Cloud collection rollout in Europe, will we start hitting the kind of run rate pace you think you'll get to early in 2012, or will it take, as the year goes along, to get there?

Speaker 4

We think it'll take a year. In fact, ultimately, it'll take more than a year. It takes time because not only does it take time to roll out, it takes time for it to roll out to every, you know, as many stores as any in any given chain, and also for people to get used to it. We've seen probably a faster rollout than we did in the U.S. because we're rolling all the models together. It'll be faster than the U.S., but it's not going to be, you know, we have our expectation and the normal experience is that it will build over time. It will build over the next year.

Speaker 3

Okay. The product you're shipping from the U.S. to Europe to make up for the production issues you had, is that primarily the Cloud collection, or would that include other models as well?

Speaker 5

It is primarily the Cloud collection, but there are a few other, you know, of the traditional Somnigroup International products that are being shipped. It is predominantly the Cloud collection.

Speaker 3

Do you do that out of Virginia?

Speaker 5

Actually, a lot of that production is coming out of Albuquerque.

Speaker 3

All right. Thank you.

Speaker 6

Thank you. Our next question is from Eric Hollowady of Stephens. The line is open.

Speaker 3

Thank you. Just a real quick question on the remainder of the European rollout. Could you just refresh us on what remains to be done? I believe you said the UK. Has that started already, or when do you anticipate that will be completed? If we could just revisit the update on that, that'd be great.

Speaker 4

The UK has literally started in the last few weeks, so it's just rolling out as we speak. The availability, it's now available pretty much everywhere. You know, it's all intents and purposes everywhere, but it's rolling out. It still takes time for it to get to all the different customers.

Speaker 3

Right. Mark, could you remind us how large that market is vis-à-vis your other international markets?

Speaker 4

We haven't done that in the past.

Speaker 3

Okay. Not even on a relative basis?

Speaker 4

No. You know, certainly, the UK is an important market for us. It's one of the larger economies in Europe. It's also, you know, and we believe that the Cloud collection will do very well there. In terms of breaking down, we don't break down our international business by country.

Speaker 3

Okay. Great. Thanks very much and good luck.

Speaker 4

Thanks.

Speaker 6

Thank you. Our next question is from John Baugh of Stifel Nicolaus. The line is open.

Speaker 0

Thank you. Good evening, Mark, Dale, Barry. Real quick, on the gross margin guidance for Q4, did I hear you right? You said it was going to be up sequentially from Q3?

Speaker 4

Yes.

Speaker 0

Okay. Yet, you're going to incur a more gross margin hit relating to the shipping cost and productivity there. I'm curious, even if I throw in, say, $3 million of cost for those items, $3 to $4 million, the flow-through number I get on your guidance is about 25% of the EBIT from the increased sales. You've been running closer to 30% to 35% for the year. You mentioned IRR materials, perhaps. I don't know. I'd just love some color on what else may be going on in there.

Speaker 4

Chemical costs are up. It would be nice to see some relief in chemicals, but until we see it, we're not going to count on it. Obviously, as we've talked all year, chemical costs are up this year. They went up at the end of the second quarter, so they're at a higher run rate than they were, a significantly higher run rate year over year than they were even in the first half. Sequentially, they're higher. We do have some additional step-up in marketing plans for the business. While we do expect gross margins to improve from three-quarters to four-quarters, the improvement is going to be muted a little bit by increasing the transatlantic shipping of product to support rebuilding the inventory levels internationally. We think that we will get through that as we get through the balance of this quarter.

Speaker 0

Dale, where would that step-up in marketing occur, both here and in international markets?

Speaker 5

Yeah, predominantly internationally. As you know, the fourth quarter is internationally the peak quarter for the year, which is different than here. Here, the fourth quarter is a little bit softer seasonally, but fourth quarter internationally is higher. We'll be ramping up that spend internationally.

Speaker 0

I know you're not guiding anything on 2012 yet, but is there any way to tip your hand about how you're thinking about marketing spend in 2012? Thank you.

Speaker 5

We stepped up our marketing spend this year, almost 200 basis points as we get into 2012. Like I said, we're not providing guidance at this stage. We're just still in the planning process. From a marketing standpoint, you would think that we would at least maintain the % marketing rate that we're using this year.

Speaker 0

Great.

Speaker 4

Yeah, that's fine.

Speaker 0

Thank you. Good luck.

Speaker 6

Thank you. Again, ladies and gentlemen, if you have a question, please press star then one on your touch-tone phone. If you have a question, simply press star then one on your touch-tone phone. Our next question is from Joshua Pollard of Goldman Sachs. The line is open.

Speaker 3

Hey, thanks for taking my call. First, I want to ask a housekeeping question around how you guys are calculating the sales when they show up in North America versus international. The sales that were actually shipped from North America but were sold in Europe, did those show up in North America sales or international sales?

Speaker 5

International.

Speaker 3

Could you say that again?

Speaker 5

International.

Speaker 3

Okay. Great. My second question was, you also talked about the Danish issue. I'm trying to understand, and it wasn't clear to me whether or not that would creep into 2012 and whether or not that changed your long-term, whether or not 2012 would be an anomaly to your some of the long-term goals of cutting additional costs out of the COGS line.

Speaker 5

Yeah, sitting here today, we don't expect it to continue into 2012. Like we said, the thing that the U.S. is doing is trying to help support rebuilding the inventory levels internationally. Fourth quarter is, as I said just a minute ago, the peak quarter in the year internationally. At a time of record revenues and getting behind the eight ball, if you will, getting behind the curve, the U.S. is helping the Denmark plant get caught back up from a service level standpoint. We expect everything to be back to normal, Denmark able to support the international business as we go into next year. It might be a positive thing if it can't because that would mean that demand further exceeds our expectations. From a production standpoint, it is coming up to speed very quickly. Every week it's doing record production levels.

Speaker 3

Where is your capacity utilization in Denmark? Is this something that you guys are going to need to address as you think about capital expenditure for 2012 and/or 2013?

Speaker 5

Right now our capacity utilization in Denmark is about 50%. You may say, why are you having trouble producing? Like I said, the system change caused one operation to become a bottleneck. We are working to change the process around that one system to make it more efficient. Actually, we believe once we get through this transition, it will actually be even much more efficient than it used to be. The other thing, though, is that capacity is a machine capacity of the overall plant. With the growth in demand, we're having to add shifts in Denmark. To add people requires finding people, the right kind of people that you want to hire, getting them on board, getting them trained, and then getting them productive.

In a growth scenario, once you hit a point where you need to add a shift, you actually take a temporary backward step from an overall productivity standpoint as the new people come on and get trained and become productive themselves. You start to see the productivity go back up. From an absolute capacity standpoint, we have sufficient capacity in Denmark as we ramp up employment to support the international business and the international growth plans for many years.

Speaker 3

If I could sneak one last one in there on your new product introduction and the effect that it had on gross margin, could you quantify that and also give us a framework for thinking about how new products should consistently affect your gross margin? Mark called out 2012 being a year where you guys expect to have, even starting in January, another rollout. I'm trying to understand, as I think about the 2012 numbers, how I should expect that, obviously to impact revenue, but also the gross margin.

Speaker 5

Yeah, the thing that I think the important thing to keep in mind is generally, because of the timeframe of how we introduced products or have historically introduced products, there's usually always something that's rolling out. The thing that was unique this year was on the Contour rollout. It was an extraordinarily compressed timeframe because it was not a new product line addressing a new need. It was a product line replacing an existing product line. Therefore, the timeframe we rolled out to all the stores was basically three months. It was a very compressed floor model rollout, which was why we expected to have more than usual impact of floor model discounts in the third quarter. We did have the floor model discount impact that we were expecting. That's a little bit of an unusual situation.

Like the Cloud rollout internationally, you're seeing floor model discounts flow throughout the year as we roll out market by market. When we did the Cloud in the U.S., the floor model discounts were spread over approximately 18 months, where here we took roughly the same number of floor models and put them out in three months. It was a very concentrated thing. As we get into next year and we have new product, the next new product rollout likely would not be so concentrated because it would be a new platform as opposed to replacing an existing platform. Does that help?

Speaker 3

That is helpful. Thank you very much.

Speaker 6

Thank you. Our next question is from Joe Artabello of Oppenheimer. Your line is open.

Speaker 1

Thanks. Good afternoon, guys. Just a couple of questions here. First, in terms of competition, did you guys see any impact on My Comfort at all in the quarter? It doesn't seem like that was the case given the strength in North America, but wanted to see if you were seeing anything there. Secondly, on that same front, what kind of distribution has that product gotten? Has it overlapped with yours at all?

Speaker 4

Oh, we're not going to talk specifics about a specific competitor, as we normally don't. Obviously, there is always competition in the industry, and there are a series of competitors, all of whom have over time introduced products that are comparable to ours. We've had a growth rate of 30% in the U.S. this last quarter, so we're quite pleased with how it's going. We anticipate one of the things that's happening that we see is that the growth of the specialty market is very significant. Obviously, we're very pleased with our role in helping it grow. The specialty market is growing very significantly, and all indications are that it will continue to do so. To some extent, we're not surprised to see other people come in, but we see enormous potential for growth.

We see enormous potential for growth, and the big driver of that is the proportion of the market, the proportion of the users that will be specialty in general and Somnigroup International consumers we see growing for some time to come.

Speaker 7

Okay. Thanks, Mark. That's actually helpful. Secondly, in terms of new products, you mentioned earlier, we're going to see a number of them over the next 12 to 24 months. Is there a particular price point that you feel is an opportunity? On that same front, would you consider an entry-level price point below Contour, or are you guys committed right now to the premium end?

Speaker 4

I'm not going to talk about specific products, but I will say this. As I said in the prepared comment, I really don't want to talk in specifics about new products because we're going to talk in great detail in January about it. The thing I'd say, though, is that we have taken the position that we have a product plan that literally goes out for three years, three and a half years. We have product launches scheduled out for three and a half years, in the U.S. and internationally. What's quite exciting is that each of these areas, or each of these product platforms, are ones that address consumer needs that we have been able to identify that are materially incremental to what we already supply. We're quite excited about it.

We see this as something that one of the things that we have continually done, as well as investing in advertising, is invest in product development and invest not just in product development as much as material and technology development so that we're in a position to make products that meet different consumer needs. It's really quite an exciting time right now. We will see the first wave of that in a couple of months.

Speaker 7

Okay, thanks, guys.

Speaker 6

Thank you. Our next question is from Peter Keith of Piper Sandler. The line is open.

Speaker 3

Hi. Thank you. Good afternoon, everyone. I wanted to just get a little more color on the mixed benefit that you highlighted that impacted gross margin. If we look back just to Q2, I think that was highlighted as the number one gross margin driver. Here, it looks like it was a little bit behind the manufacturing efficiencies. I was wondering, was there a slight deceleration in the overall positive impact? Could you just provide a little more color on what drove the overall benefits?

Speaker 5

The mix continues to be very good, but we also started lapping when we started rolling out the Lux last year. We started shipping the Lux in the third quarter, second half of the third quarter last year. It was providing a significant positive mix, uncontested, if you will, throughout the year. In the third quarter, it started lapping itself. You get a little less mix from the Lux, but the Lux continues to perform extraordinarily well. We also expect from a mix standpoint, and whether you want to call it price or mix, it's actually a combination of the two, the Contour versus the original line. Three products replacing three products, a little bit higher price for the new Contour line than what it was replacing. That's a combination of mix and pricing going on.

You don't see the full impact of that in the quarter because of the floor models, significant floor models going out on the Contour.

Speaker 3

Okay. All right. That's helpful, Dale. Thank you. Another gross margin-related question on the commodity costs. I'm guessing there's been some stepdown in your overall chemical costs over the last three months since you last spoke to us. Could you help us think about how that might look over the coming quarters and when, if the current prices were to hold, we actually might see commodity cost headwinds go away and maybe potentially turn into even a slight tailwind?

Speaker 5

Our commodity costs are up in the third quarter from what they were in the second quarter, which is what we expected. With oil moderating and staying moderated for a while, the upward pressure on our commodity costs seems to have eased, but we're not seeing reductions yet. Hopefully, those will come. It's something that's hard to predict because it's not just related to what's the price of oil. It's the price of the commodity chemicals that we buy, which can be related to the percentage mix of if it's produced by oil or natural gas. It's really heavily influenced by supply and demand. There are a lot of things that factor into supply and demand. We would be hopeful to, if oil stays at a moderated level, ultimately see some give back on the commodity increases that were driven by oil running up earlier in the year.

Until it happens, we can't predict it.

Speaker 3

Okay. All right. Congratulations on the results and good luck through the rest of the year.

Speaker 5

Thank you.

Speaker 4

Thanks.

Speaker 6

Thank you. Our next question is from John Anderson of William Blair. The line is open.

Speaker 3

Good afternoon. Thanks for taking my question. Europe is a bit of a blind spot, I think, for U.S. investors, for us, clearly. You had good organic growth there in the quarter, but the growth did decelerate sequentially on a somewhat easier comp. Taking out the impact of the productivity issue in Denmark, we would have expected, I guess, some acceleration there. I'm just wondering if you could talk a little bit about, bigger picture, what you're seeing in Europe in terms of industry trends. Are you seeing trends fairly stable or deteriorating, and any commentary on the premium segment would be helpful. Thank you.

Speaker 4

I think there are two big messages, and then I'll go through the detail. The first message is our business in international is going quite nicely, and in Europe in particular, where we're investing in advertising. We're quite pleased with those results. The second big message is the market in those three, you know, the mattress market in the big geographies where we're investing is not good. There has been quite, you know, obviously, the macro environment is not good and the industry is not good. We're growing despite a significant headwind. It continues to respond well. This investment in advertising was predicated on the fact that we have very good distribution in many of the largest geographies, but relatively low awareness. The hypothesis that supported our decision to invest in Europe was that if we could raise awareness, we should be able to lift sales levels.

We can now say that really does work and has worked and will continue to work and we will continue to invest behind it. This quarter was impacted to some extent by delivery constraints. Overall, in a difficult environment, we're doing quite well. From a macro point of view, you read the same newspapers that I do. Every day we wonder what's going to happen in Germany and in France and the UK and Spain and so on with what's going on. There's bound to be some macro effects. The fundamental and long-term opportunity, we're very confident about.

Speaker 3

That's helpful. One last question on gross margin. I think you cited kind of mix as a positive, I believe, in terms of the influence on gross margin year over year and sequentially. I thought that you had a very strong organic growth rate, obviously, in North America in the third quarter and somewhat slower internationally. I was under the assumption that the international business tended to be higher margin for you. Would that not have been a headwind, perhaps? Just more clarity on that would be helpful.

Speaker 5

Yeah. Mix can cover a number of things. It can cover the mix of the products. It also is a factor of geography mix. The growth rate in the U.S. versus the growth rate internationally gives you a negative geographic mix. You also have very, we had very strong growth in direct, which gives us a positive channel mix. Mix covers a lot of different things. Absolutely, geography mix was a negative. We look at mix across a number of different categories.

Speaker 3

Okay. Got it. Actually, one more, if I could squeak it in. The acquisition that you made, I think it was a little under $5 million in the quarter. Was that buying in the Korean operation?

Speaker 5

Yes. Yeah, we announced that as a subsequent event in our Q. I think we announced it on the July call. That was buying in the Korean operation.

Speaker 3

Perfect. Thanks, guys. Congrats on a good quarter.

Speaker 5

Thanks. Thanks.

Speaker 6

Thank you. Our next question is from Jessica Shone of Our Place Capital. The line is open.

Speaker 0

Hi. I was wondering if you guys could talk about the attach rates for the ergo adjustable products for a minute. I know you said the attach rates did improve. I was wondering if you're still seeing a large difference between the U.S. and internationally and what you think accounts for that.

Speaker 4

We don't give the exact number, but I will say that the ergo rate continues to improve significantly in the U.S., and quite honestly, there is no sign of that slowing. That's a very positive thing. It's something we're putting a lot of emphasis on. We've got advertising that's running specifically associated with it. We've got training specifically associated with it, and it's no doubt it continues to grow. We really are getting, but internationally, it's growing too, and we believe that we can get a very significant growth rate there, too.

Speaker 0

Okay, it's still in the U.S. Would you say it's still lagging?

Speaker 4

I can't talk about international as a whole. I switched to him. Sorry, I missed the question. There are some countries in Europe where attach rates are very high. On average, it's still higher for us. The attach rate is higher for us in the U.S. than it is on average in international.

Speaker 0

Okay. My second question was about the improved efficiencies in the manufacturing and the impact on gross margin, and how much longer you think those could still continue to positively impact it, if there was still a long ways to go or if most of the improvements were in place.

Speaker 4

That's not the way we're planning. No, I think we do believe there is efficient. We are sort of fundamental to our plans is that we build in an expectation of efficiency improvements every year. We have a five-year plan that we've been working on and which every year we update. We believe there are productivity improvements that we can see for a long way to come.

Speaker 0

Okay, thanks a lot.

Speaker 4

Thank you.

Speaker 6

Thank you. Our next question is from Mark Roop of Longbow Research. The line is open.

Speaker 1

Hey, guys. Just one follow-up here. I know it's a small piece of the business, but the U.S. pillow business, is there anything funky going on in the quarter? I know you got the new rollout coming, but it looks like it didn't grow nearly as fast. I know the comp was hard from last year, but is there anything going on there with the new rollout? Maybe people waiting for that or anything?

Speaker 4

It is a slower growth. If you look at it on an absolute level, it still was a record sales of pillows this last quarter. It is compared to a big rollout last year of one big customer that we had. We're up against what you would call a funky comp. Having said that, we believe that the growth of pillows is a big area of focus, which is why we are putting the emphasis behind it, why these new products that are just rolling out now are very important. We believe there is potential growth beyond what we've been getting.

Speaker 1

Okay. Just real fast on the 29 markets that you cited where you tested some heavier spend, was the duration of that during, I guess, 2011, and how significant was it? Is 29 the number? Is there a potential to do more than that in 2012 and beyond?

Speaker 4

No, that was an extended experiment, an extended monitored test. Through the bulk of the year, it was very good, very conclusive, and we will definitely expand it. We're going to do it thoughtfully, and we're picking our markets one by one, but there will definitely be more than 29 next year.

Speaker 1

Okay. Thank you, guys. Good luck.

Speaker 6

Thank you, ladies and gentlemen. This ends the Q&A portion of today's conference. I'd like to turn the call over to management for any closing remarks.

Speaker 4

Thank you again, everybody. We look forward to talking with you again in January when we'll review the fourth quarter and the full year. Thanks for joining us this evening.

Speaker 6

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect and have a wonderful day.