Item 2. Management’s Discussion and Analysis
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the 2019 Annual Report, including "Management’s Discussion and Analysis of Financial Condition and Results of Operations" included in ITEM 7 of Part II of the 2019 Annual Report, and the accompanying Condensed Consolidated Financial Statements and notes thereto included in this Report. Unless otherwise noted, all of the financial information in this Report is consolidated financial information for the Company. The forward-looking statements in this discussion regarding the mattress and pillow industries, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements in this discussion are subject to numerous risks and uncertainties. See "Special Note Regarding Forward-Looking Statements" elsewhere in this Report, in the 2019 Annual Report and the section titled "Risk Factors" contained in ITEM 1A of Part I of the 2019 Annual Report and in ITEM 1A, Risk Factors, in this Report. Our actual results may differ materially from those contained in any forward-looking statements.
In this discussion and analysis, we discuss and explain the consolidated financial condition and results of operations for the three and nine months ended September 30, 2020, including the following topics:
• an overview of our business and strategy, including uncertainty relating to COVID-19;
• results of operations, including our net sales and costs in the periods presented as well as changes between periods;
• expected sources of liquidity for future operations; and
• our use of certain non-GAAP financial measures.
Business Overview
General
We are the world's largest bedding manufacturer. We develop, manufacture and market bedding products, which we sell globally. Our product brand portfolio includes many highly recognized and iconic brands in the industry, including Tempur®, Tempur-Pedic®, Sealy® featuring Posturepedic® Technology, Stearns & Foster® and Comfort Revolution®. Our comprehensive suite of bedding products offers a variety of products to consumers across a broad range of channels and price points.
Our distribution model operates through an omni-channel strategy with two distribution channels in each operating business segment: Wholesale and Direct. Our Wholesale channel consists of third-party retailers, including third-party distribution, hospitality and healthcare. Our Direct channel includes company-owned stores, e-commerce and call centers.
Business Segments
We operate in two segments: North America and International. Corporate operating expenses are not included in either of the segments and are presented separately as a reconciling item to consolidated results. These segments are strategic business units that are managed separately based on geography. Our North America segment consists of Tempur and Sealy manufacturing and distribution subsidiaries and licensees located in the U.S. and Canada. Our International segment consists of Tempur and Sealy manufacturing and distribution subsidiaries, joint ventures and licensees located in Europe, Asia-Pacific and Latin America. We evaluate segment performance based on net sales, gross profit and operating income.
Capital Allocation
In the fourth quarter, we announced our new long-term capital allocation strategy, which includes a quarterly cash dividend beginning in 2021, an increase to our share repurchase authorization and a four-for-one stock split. Our complete capital allocation strategy includes the following components:
• Invest approximately $70 million annually for capital expenditures to invest in our people, products and processes.
• Initiate a quarterly cash dividend beginning in early 2021, subject to approval by the Board of Directors, targeting an annual distribution to our stockholders of approximately 15% of net income.
• Resume our share repurchase program and target to repurchase at least 3% of shares outstanding per year in the near-term, depending on market conditions.
• Evaluate acquisition opportunities with a focus on strategic acquisitions similar to those we have completed over the past few years.
26
Table of Contents
• Execute a four-for-one stock split, which will be effected through a stock dividend in the fourth quarter of 2020, to make our common stock more accessible and improve trading liquidity.
Environmental, Social and Corporate Governance
We have announced multiple initiatives to further reduce our global environmental footprint. In 2020, we began sourcing 100% renewable electricity for our U.S. and European Tempur-Pedic and Sealy manufacturing operations. Additionally, we remain committed to our investment in solar power technology and expect to complete the installation of the solar panel technology at our Albuquerque, New Mexico manufacturing facility in the first half of 2021. Finally, we announced a commitment to achieving zero landfill waste for our U.S. and European manufacturing operations by the end of 2022.
Keeping our employees safe and healthy is a top priority during this time of uncertainty caused by COVID-19. We have implemented precautionary measures to protect our employees, including restricting travel and face-to-face meetings, allowing employees to work from home where possible and adopting all region-specific public health protocols applicable to our global operations. While providing a healthy and safe work environment is a top priority during these unprecedented times, our entire organization is also focused on our commitments to our customers, suppliers and shareholders. During the second quarter of 2020, we began offering our Clean Shop Promise TM protocol to third-party retailers and our company-owned stores, which is being broadly adopted to provide customers with a sense of comfort as they return to shopping in stores. Additionally, we worked with various government and healthcare organizations to provide products and services.
Business Update
We believe the U.S. bedding industry has evolved to be healthy and is now structured for sustained growth. The industry is no longer engaged in uneconomical retail store expansion, startups have shifted from uneconomical strategies to becoming profitable, and legacy retailers and manufacturers have become skilled in producing profitable internet sales. Additionally, the U.S. Department of Commerce recently announced its preliminary determination of tariffs on certain imports which are expected to benefit U.S. manufacturers, including us.
We continue to study and optimize our operations in response to the challenges from the COVID-19 crisis. We have taken and continue to take precautionary measures to mitigate health risks during the evolving situation resulting from COVID-19.
We experienced a major reduction in total net sales when COVID-19 began materially impacting our North America business segment in mid-March. In the second quarter, order trends reached their lowest point in early April when they had declined approximately 80% as compared to prior year. Order trends significantly improved beginning in late May, and this improvement continued throughout the second and third quarters of 2020. This improvement was primarily due to the reopening of brick-and-mortar stores on a reduced or appointment only basis as restrictions were lifted, the acceleration of e-commerce business trends and a shift in consumer spending habits towards in-home products, including bedding products. We believe this may be a long-term shift in consumer spending habits, which could continue to favorably impact our business.
This unexpected and rapid increase in demand for bedding products has challenged the entire bedding industry and supply chain, including our business. Additionally, the U.S. government has mandated that domestic suppliers of certain materials used in the production of bedding products redirect such materials towards the production of personal protective equipment. The broad-based increase in demand coupled with supply chain constraints, primarily related to an encased innerspring component, has created operational challenges in the production of Sealy and Sherwood bedding products in the U.S. As a result, Sealy's third quarter sales growth was unfavorably impacted by these supply chain constraints, as we could not fulfill the domestic demand for Sealy mattresses. We expect these supply chain constraints to continue for the next few quarters. The Tempur-Pedic manufacturing process has not been as impacted by the current supply chain constraints.
Our business has a highly variable cost structure that can flex with changes in sales, as evidenced by our ability to quickly reduce costs in the second quarter of 2020 to maintain profitability when we were uncertain of the impact of COVID-19. In the third quarter of 2020, most of these cost reductions were reversed. This increase in spending reflects our forward-looking confidence in the business as we make the necessary investments to support long-term growth.
27
Table of Contents
Certain international markets are now experiencing new restrictions related to COVID-19 that are expected to cause some headwinds for the remainder of 2020. Additionally, in the fourth quarter of 2019, we shipped a large amount of floor models and back stock inventory as we expanded into new distribution networks, which we expect will impact comparisons with the fourth quarter of 2020. We are targeting net sales to increase by low double digits and adjusted EBITDA per credit facility, which is a non-GAAP financial measure, to grow by high teens in the fourth quarter of 2020, as compared to the same period in 2019.
We will continue to actively monitor the situation and may take further actions that alter our business operations as may be required by federal, state or local authorities or that we determine are in the best interests of our employees, customers, suppliers and stockholders. While we are unable to determine or predict the nature, duration or scope of the overall impact the COVID-19 pandemic will have on our business, results of operations, liquidity or capital resources, we believe that it is important to share where the Company stands today, how our response to COVID-19 is progressing and how our operations and financial condition may change as the fight against COVID-19 progresses. For further information regarding the potential impacts of COVID-19 on the Company, please refer to "Risk Factors" in ITEM 1A of Part II of this Report.
Commodities
Future changes in raw material prices could have an unfavorable impact on our gross margin. In the nine months ended September 30, 2020, commodity costs favorably impacted our gross margin. However commodity costs were higher than expected for the third quarter of 2020. We currently expect commodity cost inflation to continue into 2021. As a result, we plan to implement a price increase in the fourth quarter of 2020 across all of our U.S. brands, including Sealy, Stearns & Foster, and Tempur-Pedic products, which we expect to mitigate or fully offset the commodity cost inflation we anticipate in 2021.
Product Launches
In 2020, we are introducing the Tempur-Ergo Smart Base Collection with Sleeptracker technology and a new Sealy Posturepedic Plus line.
Acquisition of Sherwood Bedding
On January 31, 2020, we acquired an 80% ownership interest in a newly formed limited liability company containing substantially all of the assets of the Sherwood Bedding business for a cash purchase price of approximately $39.1 million. Sherwood Bedding is a major manufacturer in the U.S. private label and original equipment manufacturer bedding market, and this acquisition of a majority interest marks our entrance into the private label category. During the first quarter of 2020, we completed the integration of Sherwood Bedding into our portfolio of product brands. Since the acquisition, we have leveraged our overall brand portfolio to gain additional distribution for Sherwood products.
Results of Operations
A summary of our results for the three months ended September 30, 2020 include:
• Total net sales increased 37.9% to $1,132.3 million as compared to $821.0 million in the third quarter of 2019. On a constant currency basis, which is a non-GAAP financial measure, total net sales increased 37.7%, with an increase of 43.3% in the North America business segment and an increase of 10.1% in the International business segment.
• Gross margin was 46.8% as compared to 43.9% in the third quarter of 2019. Adjusted gross margin, which is a non-GAAP financial measure, was 46.9% in the third quarter of 2020. There were no adjustments to gross margin in the third quarter of 2019.
• Operating income increased 49.4% to $180.2 million as compared to $120.6 million in the third quarter of 2019. Operating income in the third quarter of 2020 included $45.2 million of amortization for aspirational plan stock-based compensation. Adjusted operating income, which is a non-GAAP financial measure, was $227.2 million in the third quarter of 2020. There were no adjustments to operating income in the third quarter of 2019.
• Net income increased 65.6% to $121.4 million as compared to $73.3 million in the third quarter of 2019. Adjusted net income, which is a non-GAAP financial measure, increased 114.3% to $155.4 million as compared to $72.5 million in the third quarter of 2019.
• Earnings before interest, tax, depreciation and amortization ("EBITDA"), which is a non-GAAP financial measure, increased 85.7% to $279.9 million as compared to $150.7 million in the third quarter of 2019. Adjusted EBITDA per credit facility, which is a non-GAAP financial measure, increased 86.3% to $279.3 million as compared to $149.9 million in the third quarter of 2019.
28
Table of Contents
• Earnings per diluted share ("EPS") increased 74.8% to $2.29 as compared to $1.31 in the third quarter of 2019. Adjusted EPS, which is a non-GAAP financial measure, increased 126.2% to $2.94 as compared to $1.30 in the third quarter of 2019.
• For the trailing twelve months ended September 30, 2020, leverage based on the ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility, which is a non-GAAP financial measure, was 1.92 times as compared to 3.22 times in the corresponding prior year period.
For a discussion and reconciliation of non-GAAP financial measures as discussed above to the corresponding GAAP financial results, refer to the non-GAAP financial information set forth below under the heading "Non-GAAP Financial Information."
We may refer to net sales or earnings or other historical financial information on a "constant currency basis," which is a non-GAAP financial measure. These references to constant currency basis do not include operational impacts that could result from fluctuations in foreign currency rates. To provide information on a constant currency basis, the applicable financial results are adjusted based on a simple mathematical model that translates current period results in local currency using the comparable prior corresponding period’s currency conversion rate. This approach is used for countries where the functional currency is the local country currency. This information is provided so that certain financial results can be viewed without the impact of fluctuations in foreign currency rates, thereby facilitating period-to-period comparisons of business performance. Constant currency information is not recognized under GAAP, and it is not intended as an alternative to GAAP measures. Refer to Part I, ITEM 3 of this Report for a discussion of our foreign currency exchange rate risk.
29
Table of Contents
THREE MONTHS ENDED SEPTEMBER 30, 2020 COMPARED TO THE
THREE MONTHS ENDED SEPTEMBER 30, 2019
The following table sets forth the various components of our Condensed Consolidated Statements of Income and expresses each component as a percentage of net sales:
Three Months Ended September 30,
(in millions, except percentages and per share amounts) 2020 2019
Net sales $ 1,132.3 100.0 % $ 821.0 100.0 %
Cost of sales 602.1 53.2 460.4 56.1
Gross profit 530.2 46.8 360.6 43.9
Selling and marketing expenses 229.7 20.3 168.6 20.5
General, administrative and other expenses 125.1 11.0 75.3 9.2
Equity income in earnings of unconsolidated affiliates (4.8) (0.4) (3.9) (0.5)
Operating income 180.2 15.9 120.6 14.7
Other expense, net:
Interest expense, net 20.1 1.8 20.8 2.5
Loss on extinguishment of debt 0.9 0.1 — —
Other (income) expense, net (0.5) — 1.3 0.2
Total other expense, net 20.5 1.8 22.1 2.7
Income from continuing operations before income taxes 159.7 14.1 98.5 12.0
Income tax provision (40.3) (3.6) (26.1) (3.2)
Income from continuing operations 119.4 10.5 72.4 8.8
Income from discontinued operations, net of tax 2.4 0.2 0.8 0.1
Net income before non-controlling interests 121.8 10.8 73.2 8.9
Less: Net income (loss) attributable to non-controlling interests 0.4 — (0.1) —
Net income attributable to Tempur Sealy International, Inc. $ 121.4 10.7 % $ 73.3 8.9 %
Earnings per common share:
Basic
Earnings per share for continuing operations $ 2.31 $ 1.33
Earnings per share for discontinued operations 0.04 0.01
Earnings per share $ 2.35 $ 1.34
Diluted
Earnings per share for continuing operations $ 2.25 $ 1.30
Earnings per share for discontinued operations 0.04 0.01
Earnings per share $ 2.29 $ 1.31
Weighted average common shares outstanding:
Basic 51.6 54.6
Diluted 52.9 55.8
30
Table of Contents
NET SALES
Three Months Ended September 30,
2020 2019 2020 2019 2020 2019
(in millions) Consolidated North America International
Net sales by channel
Wholesale $ 987.2 $ 710.1 $ 869.1 $ 602.2 $ 118.1 $ 107.9
Direct 145.1 110.9 107.4 79.8 37.7 31.1
Total net sales $ 1,132.3 $ 821.0 $ 976.5 $ 682.0 $ 155.8 $ 139.0
Net sales increased 37.9%, and on a constant currency basis increased 37.7%. The change in net sales was driven by the following:
• North America net sales increased $294.5 million, or 43.2%. Net sales in the Wholesale channel increased $266.9 million, or 44.3%, primarily driven by broad-based demand across both existing and new distribution networks. Net sales in the Direct channel increased $27.6 million, or 34.6%, primarily driven by growth from our e-commerce business, offset by slightly decreased performance at our company owned stores which were closed or operating under reduced hours or modified operations for a time during the third quarter as a result of the global pandemic.
• International net sales increased $16.8 million, or 12.1%. On a constant currency basis, International net sales increased 10.1%. Net sales in the Wholesale channel increased 8.2% on a constant currency basis. Net sales in the Direct channel increased 16.7% on a constant currency basis.
GROSS PROFIT
Three Months Ended September 30,
2020 2019
(in millions, except percentages) Gross Profit Gross Margin Gross Profit Gross Margin Margin Change
North America $ 438.6 44.9 % $ 286.8 42.1 % 2.8 %
International 91.6 58.8 % 73.8 53.1 % 5.7 %
Consolidated gross margin $ 530.2 46.8 % $ 360.6 43.9 % 2.9 %
Costs associated with net sales are recorded in cost of sales and include the costs of producing, shipping, warehousing, receiving and inspecting goods during the period, as well as depreciation and amortization of long-lived assets used in the manufacturing process.
Our gross margin is primarily impacted by the relative amount of net sales contributed by our Tempur and Sealy products. Our Sealy products have a significantly lower gross margin than our Tempur products. Our Sealy mattress products range from value to premium priced offerings, and gross margins are typically higher on premium products compared to value priced offerings. Our Tempur products are exclusively premium priced products. As sales of our Sealy products increase relative to sales of our Tempur products, our gross margins will be negatively impacted in both our North America and International segments.
Our gross margin is also impacted by fixed cost leverage based on manufacturing unit volumes; the cost of raw materials; operational efficiencies due to the utilization in our manufacturing facilities; product, brand, channel and country mix; foreign exchange fluctuations; volume incentives offered to certain retail accounts; participation in our retail cooperative advertising programs; and costs associated with new product introductions. Future changes in raw material prices could have a significant impact on our gross margin. Our margins are also impacted by the growth in our Wholesale channel as sales in our Wholesale channel are at wholesale prices whereas sales in our Direct channel are at retail prices.
Gross margin improved 290 basis points. The primary drivers of changes in gross margin by segment are discussed below:
• North America gross margin improved 280 basis points. The improvement in gross margin was primarily driven by fixed cost leverage and productivity on higher unit volumes of 200 basis points, brand mix of 90 basis points and
lower commodity costs. Additionally, we incurred $0.6 million of operational expansion costs related to the opening of a Sealy manufacturing facility, which partially offset the improvement in gross margin.
• International gross margin improved 570 basis points. The improvement in gross margin was primarily driven by favorable mix of 220 basis points, fixed cost leverage and productivity on higher unit volumes of 170 basis points and lower commodity costs .
OPERATING EXPENSES
Selling and marketing expenses include advertising and media production associated with the promotion of our brands, other marketing materials such as catalogs, brochures, videos, product samples, direct customer mailings and point of purchase materials and sales force compensation. We also include in selling and marketing expense certain new product development costs, including market research and new product testing.
General, administrative and other expenses include salaries and related expenses, information technology, professional fees, depreciation and amortization of long-lived assets not used in the manufacturing process, expenses for administrative functions and research and development costs.
Three Months Ended September 30,
2020 2019 2020 2019 2020 2019 2020 2019
(in millions) Consolidated North America International Corporate
Operating expenses:
Advertising expenses $ 101.2 $ 75.0 $ 91.5 $ 65.8 $ 9.7 $ 9.2 $ — $ —
Other selling and marketing expenses 128.5 93.6 67.6 60.5 30.2 30.2 30.7 2.9
General, administrative and other expenses 125.1 75.3 48.0 40.7 11.7 11.0 65.4 23.6
Total operating expenses $ 354.8 $ 243.9 $ 207.1 $ 167.0 $ 51.6 $ 50.4 $ 96.1 $ 26.5
Operating expenses increased $110.9 million, or 45.5%, and increased 160 basis points as a percentage of net sales. The primary drivers of changes in operating expenses by segment are explained below:
• North America operating expenses increased $40.1 million, or 24.0%, and decreased 330 basis points as a percentage of net sales. The increase in operating expenses was primarily driven by advertising and variable compensation costs.
• International operating expenses increased $1.2 million, or 2.4%, and decreased 320 basis points as a percentage of net sales. The increase in operating expenses was due to variable compensation costs and increased advertising investments.
• Corporate operating expenses increased $69.6 million, or 262.6%. The increase in operating expenses was primarily driven by $45.2 million of amortization for our long-term aspirational plan stock-based compensation. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards which became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020. Additionally, we expect to reach the maximum payout for our 2020 annual incentive and performance-based stock compensation plans, which increased operating expense in the third quarter of 2020. We will record additional amortization related to these compensation plans and the aspirational plan in the fourth quarter of 2020. For information regarding our aspirational plan refer to Note 9, "Stock-Based Compensation," of the "Notes to Condensed Consolidated Financial Statements," under Part I, ITEM 1, "Financial Statements" of this Report.
Research and development expenses for the three months ended September 30, 2020 were $6.1 million compared to $5.6 million for the three months ended September 30, 2019, a increase of $0.5 million, or 8.9%.
31
Table of Contents
OPERATING INCOME
Three Months Ended September 30,
2020 2019
(in millions, except percentages) Operating Income Operating Margin Operating Income Operating Margin Margin Change
North America $ 231.5 23.7 % $ 119.8 17.6 % 6.1 %
International 44.8 28.8 % 27.3 19.6 % 9.2 %
276.3 147.1
Corporate expenses ( 96.1 ) ( 26.5 )
Total operating income $ 180.2 15.9 % $ 120.6 14.7 % 1.2 %
Operating income increased $59.6 million and operating margin improved 120 basis points. The primary drivers of changes in operating income and operating margin by segment are discussed below:
• North America operating income increased $111.7 million and operating margin improved 610 basis points. The improvement in operating margin was primarily driven by improved operating expense leverage of 330 basis points and the improvement in gross margin of 280 basis points.
• International operating income increased $17.5 million and operating margin improved 920 basis points. The improvement in operating margin was primarily driven by the improvement in gross margin of 570 basis points and improved operating expense leverage of 320 basis points.
• Corporate operating expenses increased $69.6 million, which negatively impacted our consolidated operating margin by 610 basis points. The increase in operating expenses was primarily driven by $45.2 million of amortization for our long-term aspirational plan stock-based compensation. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards which became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020. Additionally, we expect to reach the maximum payout for our 2020 annual incentive and performance-based stock compensation plans, which increased operating expense in the third quarter of 2020. We will record additional amortization related to these compensation plans and the aspirational plan in the fourth quarter of 2020. For information regarding our aspirational plan refer to Note 9, "Stock-Based Compensation," of the "Notes to Condensed Consolidated Financial Statements," under Part I, ITEM 1, "Financial Statements" of this Report.
INTEREST EXPENSE, NET
Three Months Ended September 30,
(in millions, except percentages) 2020 2019 % Change
Interest expense, net $ 20.1 $ 20.8 (3.4) %
Interest expense, net, decreased $0.7 million, or 3.4%. The decrease in interest expense, net, was primarily driven by reduced average levels of outstanding debt and lower interest rates on our variable rate debt.
INCOME TAX PROVISION
Three Months Ended September 30,
(in millions, except percentages) 2020 2019 % Change
Income tax provision $ 40.3 $ 26.1 54.4 %
Effective tax rate 25.2 % 26.5 %
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 income tax provision increased $14.2 million due to an increase in income before income taxes. Our effective tax rate for the three months ended September 30, 2020 as compared to the same prior year period decreased by 130 basis points. The effective tax rate as compared to the U.S. federal statutory tax rate for the three months ended September 30, 2020 and 2019 included a net favorable impact of discrete items.
32
Table of Contents
NINE MONTHS ENDED SEPTEMBER 30, 2020 COMPARED TO THE
NINE MONTHS ENDED SEPTEMBER 30, 2019
The following table sets forth the various components of our Condensed Consolidated Statements of Income, and expresses each component as a percentage of net sales:
Nine Months Ended September 30,
(in millions, except percentages and per share amounts) 2020 2019
Net sales $ 2,619.9 100.0 % $ 2,234.7 100.0 %
Cost of sales 1,466.7 56.0 1,278.9 57.2
Gross profit 1,153.2 44.0 955.8 42.8
Selling and marketing expenses 535.8 20.5 485.4 21.7
General, administrative and other expenses 288.1 11.0 218.7 9.8
Equity income in earnings of unconsolidated affiliates (9.6) (0.4) (10.4) (0.5)
Operating income 338.9 12.9 262.1 11.7
Other expense, net:
Interest expense, net 61.0 2.3 65.7 2.9
Loss on extinguishment of debt 0.9 — — —
Other expense (income), net 0.3 — (6.5) (0.3)
Total other expense, net 62.2 2.4 59.2 2.6
Income from continuing operations before income taxes 276.7 10.6 202.9 9.1
Income tax provision (73.2) (2.8) (58.8) (2.6)
Income from continuing operations 203.5 7.8 144.1 6.4
Income (loss) from discontinued operations, net of tax 1.3 — (0.8) —
Net income before non-controlling interests 204.8 7.8 143.3 6.4
Less: Net income attributable to non-controlling interests 0.7 — — —
Net income attributable to Tempur Sealy International, Inc. $ 204.1 7.8 % $ 143.3 6.4 %
Earnings per common share:
Basic
Earnings per share for continuing operations $ 3.89 $ 2.63
Earnings (loss) per share for discontinued operations 0.02 (0.01)
Earnings per share $ 3.91 $ 2.62
Diluted
Earnings per share for continuing operations $ 3.83 $ 2.57
Earnings (loss) per share for discontinued operations 0.03 (0.01)
Earnings per share $ 3.86 $ 2.56
Weighted average common shares outstanding:
Basic 52.2 54.7
Diluted 52.9 56.0
33
Table of Contents
NET SALES
Nine Months Ended September 30,
2020 2019 2020 2019 2020 2019
(in millions) Consolidated North America International
Net sales by channel
Wholesale $ 2,273.3 $ 1,958.2 $ 1,973.3 $ 1,632.5 $ 300.0 $ 325.7
Direct 346.6 276.5 250.9 181.6 95.7 94.9
Total net sales $ 2,619.9 $ 2,234.7 $ 2,224.2 $ 1,814.1 $ 395.7 $ 420.6
Net sales increased 17.2%, and on a constant currency basis increased 17.6%. The change in net sales was driven by the following:
• North America net sales increased $410.1 million, or 22.6%. Net sales in the Wholesale channel increased $340.8 million, or 20.9%, primarily driven by broad-based demand across both existing and new distribution. Net sales in the Direct channel increased $69.3 million, or 38.2%, primarily driven by growth from our e-commerce business.
• International net sales decreased $24.9 million, or 5.9%. On a constant currency basis, International net sales decreased 4.6% as a result of the global pandemic. Net sales in the Wholesale channel decreased 6.1% on a constant currency basis. Net sales in the Direct channel increased 0.7% on a constant currency basis.
GROSS PROFIT
Nine Months Ended September 30,
2020 2019
(in millions, except percentages) Gross Profit Gross Margin Gross Profit Gross Margin Margin Change
North America $ 932.0 41.9 % $ 731.2 40.3 % 1.6 %
International 221.2 55.9 % 224.6 53.4 % 2.5 %
Consolidated gross margin $ 1,153.2 44.0 % $ 955.8 42.8 % 1.2 %
Costs associated with net sales are recorded in cost of sales and include the costs of producing, shipping, warehousing, receiving and inspecting goods during the period, as well as depreciation and amortization of long-lived assets used in the manufacturing process.
Gross margin improved 120 basis points. The primary drivers of changes in gross margin by segment are discussed below:
• North America gross margin improved 160 basis points. The improvement in gross margin was primarily driven by fixed cost leverage and productivity on higher unit volume of 190 basis points, decreased floor model expenses of 70 basis points and lower commodity costs of 70 basis points. These improvements were partially offset by unfavorable product and brand mix of 170 basis points. Additionally, we incurred $4.0 million of incremental costs related to global pandemic relief efforts, sanitation supplies and services and other items and $0.6 million of operational expansion costs related to the opening of a Sealy manufacturing facility, which partially offset the improvement in gross margin.
• International gross margin improved 250 basis points. The improvement in gross margin was primarily driven by favorable mix of 110 basis points, fixed cost leverage and productivity on higher unit volumes of 60 basis points and lower commodity costs . Additionally, we incurred $0.5 million of incremental costs related to global pandemic relief efforts, sanitation supplies and services and other items, which partially offset the improvement in gross margin.
OPERATING EXPENSES
Selling and marketing expenses include advertising and media production associated with the promotion of our brands, other marketing materials such as catalogs, brochures, videos, product samples, direct customer mailings and point of purchase materials and sales force compensation. We also include in selling and marketing expense certain new product development costs, including market research and new product testing.
34
Table of Contents
General, administrative and other expenses include salaries and related expenses, information technology, professional fees, depreciation and amortization of long-lived assets not used in the manufacturing process, expenses for administrative functions and research and development costs.
Nine Months Ended September 30,
2020 2019 2020 2019 2020 2019 2020 2019
(in millions) Consolidated North America International Corporate
Operating expenses:
Advertising expenses $ 229.8 $ 203.0 $ 204.7 $ 174.6 $ 25.1 $ 28.4 $ — $ —
Other selling and marketing expenses 306.0 282.4 182.6 180.6 86.6 93.4 36.8 8.4
General, administrative and other expenses 288.1 218.7 142.4 111.8 38.1 33.3 107.6 73.6
Total operating expenses $ 823.9 $ 704.1 $ 529.7 $ 467.0 $ 149.8 $ 155.1 $ 144.4 $ 82.0
Operating expenses increased $119.8 million, or 17.0%, and decreased 10 basis points as a percentage of net sales. The primary drivers of changes in operating expenses by segment are explained below:
• North America operating expenses increased $62.7 million, or 13.4%, and decreased 190 basis points as a percentage of net sales. The increase in operating expenses was primarily driven by advertising and incremental bad debt expense primarily related to the bankruptcy of one department store in the U.S. Additionally, we recorded $11.7 million of customer-related charges in connection with the bankruptcy of Art Van Furniture, LLC and affiliates to fully reserve trade receivables and other assets associated with this account and $7.0 million of asset impairment charges related to the write-off of certain sales and marketing assets driven by the macro-economic environment.
• International operating expenses decreased $5.3 million, or 3.4%, and increased 100 basis points as a percentage of net sales. The decrease in operating expenses was primarily driven by lower advertising and other selling and marketing investments, partially offset by increased bad debt expense. Additionally, we incurred $3.8 million of restructuring costs associated with headcount reductions driven by the macro-economic environment and $2.6 million of incremental costs related to global pandemic relief efforts, sanitation supplies and services and other items.
• Corporate operating expenses increased $62.4 million, or 76.1%. The increase in operating expenses was primarily driven by $45.2 million of amortization for our long-term aspirational plan stock-based compensation. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards which became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020. Additionally, we expect to reach the maximum payout for our 2020 annual incentive and performance-based stock compensation plans, which increased operating expense in the third quarter of 2020. We will record additional amortization related to these compensation plans and the aspirational plan in the fourth quarter of 2020. This increase was partially offset by $4.1 million of professional fees recorded in the first half of 2019 related to the acquisition of Sleep Outfitters, which were not repeated in 2020. For information regarding our aspirational plan refer to Note 9, "Stock-Based Compensation," of the "Notes to Condensed Consolidated Financial Statements," under Part I, ITEM 1, "Financial Statements" of this Report.
Research and development expenses were $17.1 million for the nine months ended September 30, 2020 as compared to $16.8 million for the nine months ended September 30, 2019.
OPERATING INCOME
Nine Months Ended September 30,
2020 2019
(in millions, except percentages) Operating Income Operating Margin Operating Income Operating Margin Margin Change
North America $ 402.3 18.1 % $ 264.2 14.6 % 3.5 %
International 81.0 20.5 % 79.9 19.0 % 1.5 %
483.3 344.1
Corporate expenses (144.4) (82.0)
Total operating income $ 338.9 12.9 % $ 262.1 11.7 % 1.2 %
Operating income increased $76.8 million and operating margin improved 120 basis points. The primary drivers of changes in operating income and operating margin by segment are discussed below:
• North America operating income increased $138.1 million and operating margin improved 350 basis points. The improvement in operating margin was primarily driven by improved operating expense leverage of 310 basis points and the improvement in gross margin of 160 basis points. These improvements were offset by $11.7 million of customer-related charges in connection with the bankruptcy of Art Van Furniture, LLC and affiliates to fully reserve trade receivables and other assets associated with this account. Additionally, we recorded $7.0 million of asset impairment charges related to the write-off of certain sales and marketing assets driven by the macro-economic environment and incurred $4.1 million of incremental costs related to global pandemic relief efforts, sanitation supplies and services and other items.
• International operating income increased $1.1 million and operating margin improved 150 basis points. The improvement in operating margin was primarily driven by the improvement in gross margin of 250 basis points and improved operating expense leverage. These improvements were offset by $3.8 million of restructuring costs associated with headcount reductions driven by the macro-economic environment and $3.1 million of incremental costs related to global pandemic relief efforts, sanitation supplies and services and other items.
• Corporate operating expenses increased $62.4 million, which negatively impacted our consolidated operating margin by 240 basis points. The increase in operating expenses was primarily driven by $45.2 million of amortization for our long-term aspirational plan stock-based compensation. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards which became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020. Additionally, we expect to reach the maximum payout for our 2020 annual incentive and performance-based stock compensation plans, which increased operating expense in the third quarter of 2020. We will record additional amortization related to these compensation plans and the aspirational plan in the fourth quarter of 2020. This increase was partially offset by $4.1 million of professional fees recorded in the first half of 2019 related to the acquisition of Sleep Outfitters, which were not repeated in 2020. For information regarding our aspirational plan refer to Note 9, "Stock-Based Compensation," of the "Notes to Condensed Consolidated Financial Statements," under Part I, ITEM 1, "Financial Statements" of this Report.
INTEREST EXPENSE, NET
Nine Months Ended September 30,
(in millions, except percentages) 2020 2019 % Change
Interest expense, net $ 61.0 $ 65.7 (7.2) %
Interest expense, net, decreased $4.7 million, or 7.2%. The decrease in interest expense, net, was primarily driven by reduced average levels of outstanding debt and lower interest rates on our variable rate debt.
INCOME TAX PROVISION
Nine Months Ended September 30,
(in millions, except percentages) 2020 2019 % Change
Income tax provision $ 73.2 $ 58.8 24.5 %
Effective tax rate 26.5 % 29.0 %
Our income tax provision increased $14.4 million due to an increase in income before income taxes. Our effective tax rate for the nine months ended September 30, 2020 as compared to the same prior year period decreased 250 basis points. The effective tax rate as compared to the U.S. federal statutory rate for the nine months ended September 30, 2020 included a net unfavorable impact of discrete items, primarily related to the impact of the likelihood of realization of certain deferred tax assets. The effective tax rate as compared to the U.S. federal statutory rate for the for the nine months ended September 30, 2019 included a net unfavorable impact of discrete items primarily related to the sale of a certain interest in our Asia-Pacific joint venture and the impact of certain stock compensation.
35
Table of Contents
Liquidity and Capital Resources
Liquidity
Our principal sources of funds are cash flows from operations, borrowings made pursuant to our credit facilities and cash and cash equivalents on hand. Principal uses of funds consist of payments of principal and interest on our debt facilities, share repurchases, capital expenditures and working capital needs. As of September 30, 2020, we had net working capital of $121.4 million, including cash and cash equivalents of $229.2 million, as compared to $126.9 million, including cash and cash equivalents of $64.9 million, as of December 31, 2019.
At September 30, 2020, total cash and cash equivalents were $229.2 million, of which $186.3 million was held in the U.S. and $42.9 million was held by subsidiaries outside of the U.S. The amount of cash and cash equivalents held by subsidiaries outside of the U.S. and not readily convertible into the U.S. Dollar or other major foreign currencies is not material to our overall liquidity or financial position.
Cash Provided by (Used in) Continuing Operations
The table below presents net cash provided by (used in) operating, investing and financing activities from continuing operations for the periods indicated below:
Nine Months Ended September 30,
(in millions) 2020 2019
Net cash provided by (used in) continuing operations:
Operating activities $ 497.9 $ 201.7
Investing activities (111.4) (64.0)
Financing activities (228.5) (124.8)
Cash provided by operating activities from continuing operations increased $296.2 million in the nine months ended September 30, 2020 as compared to the same period in 2019. The increase in cash provided by operating activities was driven by strong operational performance in the period.
Cash used in investing activities from continuing operations increased $47.4 million in the nine months ended September 30, 2020 as compared to the same period in 2019. The increase in cash used in investing activities was primarily due to cash used to acquire the Sherwood Bedding business and planned capital expenditures.
Cash used in financing activities from continuing operations increased $103.7 million in the nine months ended September 30, 2020 as compared to the same period in 2019. For the nine months ended September 30, 2020, we had net repayments of $21.0 million on our credit facilities, as compared to net repayments of $76.0 million in 2019. During the nine months ended September 30, 2020 and 2019, respectively, we repurchased $187.5 million and $52.3 million of our common stock under our share repurchase program. In 2020, these repurchases were largely made in the first quarter prior to the impact of COVID-19 on our business. Additionally, we repurchased $12.1 million and $3.2 million of our common stock which was withheld to satisfy tax withholding obligations related to stock compensation during the nine months ended September 30, 2020 and 2019, respectively.
Cash Provided by (Used in) Discontinued Operations
Net cash provided by (used in) operating, investing and financing activities from discontinued operations for the periods ended September 30, 2020 and 2019 was not material.
Capital Expenditures
Capital expenditures totaled $73.6 million and $61.9 million for the nine months ended September 30, 2020 and 2019, respectively. We currently expect our 2020 capital expenditures to be approximately $110 to $115 million, which includes investments in our U.S. enterprise resource planning projects and domestic manufacturing facilities.
36
Table of Contents
Indebtedness
Our total debt decreased to $1,535.3 million as of September 30, 2020 from $1,547.0 million as of December 31, 2019. During the first quarter of 2020, we took initial actions to mitigate the impact of the material slowdown in business activity resulting from COVID-19 and to provide greater financial flexibility. As a result, we entered into a new $200.0 million 364-day term loan (the "364-Day Loan") in the second quarter of 2020. As industry trends improved in the third quarter of 2020, we generated record operating cash flow which allowed us to repay the 364-Day Loan referred to below. Total availability under our revolving senior secured credit facility was $424.9 million as of September 30, 2020, which matures in 2024.
As of September 30, 2020, our ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility, which is a non-GAAP financial measure, in accordance with our 2019 Credit Agreement was 1.92 times. Our leverage ratio as of September 30, 2020 was the lowest in our history. This ratio is within the terms of the financial covenants for the maximum consolidated total net leverage ratio as set forth in the 2019 Credit Agreement, which limits this ratio to 5.00 times. As of September 30, 2020, we were in compliance with all of the financial covenants in our debt agreements, and we do not anticipate material issues under any debt agreements based on current facts and circumstances.
Our debt agreements contain certain covenants that limit restricted payments, including share repurchases and dividends. The 2019 Credit Agreement, 2023 Senior Notes and 2026 Senior Notes contain similar limitations which, subject to other conditions, allow unlimited restricted payments at times when the ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility, which is a non-GAAP financial measure, remains below 3.5 times. In addition, these agreements permit limited restricted payments under certain conditions when the ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility is above 3.5 times. The limit on restricted payments under the 2019 Credit Agreement, 2023 Senior Notes and 2026 Senior Notes is in part determined by a basket that grows at 50% of adjusted net income each quarter, reduced by restricted payments that are not otherwise permitted.
On May 13, 2020, we entered into an amendment to the existing 2019 Credit Agreement, which provided for the $200.0 million 364-Day Loan. We used the proceeds of the 364-Day Loan to repay borrowings under the existing $425.0 million revolving credit facility and to pay fees and expenses in connection with the amendment. On September 14, 2020, we repaid the 364-Day Loan. Repayment of the 364-Day Loan lifted certain restrictions on dividends, share repurchases and our ability to make certain investments.
For additional information, refer to "Non-GAAP Financial Information" below for the calculation of the ratio of consolidated indebtedness less netted cash to adjusted EBITDA calculated in accordance with the 2019 Credit Agreement. Both consolidated indebtedness and adjusted EBITDA as used in discussion of the 2019 Credit Agreement are non-GAAP financial measures and do not purport to be alternatives to net income as a measure of operating performance or total debt.
Debt Securities Guaranteed by Subsidiaries
The $450.0 million and $600.0 million aggregate principal amount of 2023 Senior Notes and 2026 Senior Notes (collectively the "Senior Notes"), respectively, are general unsecured senior obligations of Tempur Sealy International and are fully and unconditionally guaranteed on a senior unsecured basis, jointly and severally, by all of Tempur Sealy International’s 100% directly or indirectly owned domestic subsidiaries (together, the "Obligor Group"). The foreign subsidiaries represent the foreign operations of the Company and do not guarantee the Senior Notes.
The Senior Notes rank equally with or senior to all debt of Tempur Sealy International and the Obligor Group, but are effectively junior to all secured debt, including obligations under the 2019 Credit Agreement, to the extent of the value of the assets securing such debt. Subject to certain restrictions, Tempur Sealy International and the restricted subsidiaries under the applicable indenture may incur additional secured debt. Claims of creditors of non-guarantor subsidiaries, including trade creditors, and creditors holding debt and guarantees issued by those subsidiaries, and claims of preferred stockholders (if any) of those subsidiaries generally will have priority with respect to the assets and earnings of those subsidiaries over the claims of creditors of the holders of the Senior Notes. The Senior Notes and each guarantee are therefore effectively subordinated to creditors (including trade creditors) and preferred stockholders (if any) of non-guarantor subsidiaries.
37
Table of Contents
Under the applicable indenture, each guarantee is limited to the maximum amount that would not render the subsidiary guarantor's obligations subject to avoidance under the applicable fraudulent conveyance provisions of the United States Bankruptcy Code or any comparable provision of state law. By virtue of this limitation, a subsidiary guarantor's obligation under its guarantee could be significantly less than amounts payable with respect to the Senior Notes, or could be reduced to zero, depending upon the amount of other obligations of such guarantor.
A subsidiary guarantor will be released from its obligations under the applicable indenture governing the Senior Notes when: (a) the subsidiary guarantor is sold or sells all or substantially all of its assets; (b) the subsidiary is declared "unrestricted" under the applicable indenture; (c) the subsidiary’s guarantee of indebtedness under the 2019 Credit Agreement (as it may be amended, refinanced or replaced) is released (other than a discharge through repayment); (d) the requirements for legal or covenant defeasance or discharge of the applicable indenture have been satisfied; (e) the subsidiary is liquidated or dissolved in accordance with the applicable indenture; or (f) the occurrence of any covenant suspension. The principal elimination entries relate to investments in subsidiaries and intercompany balances and transactions, including transactions with the Company’s wholly-owned subsidiary guarantors and non-guarantor subsidiaries. The Company has accounted for its investments in its subsidiaries under the equity method.
In March 2020, the SEC adopted final rules that amend the financial disclosure requirements for subsidiary issuers and guarantors of registered debt securities under Rule 3-10 of Regulation S-X, permitting registrants to disclose summarized financial information for such subsidiary issuers and guarantors. The rule is effective January 4, 2021; however, earlier compliance is permitted. We elected to early comply with this rule.
The summarized financial information for the Obligor Group follows.
Nine Months Ended
September 30, 2020
Obligor Group
(in millions)
Net sales to unrelated parties $ 2,089.1
Net sales to non-obligor subsidiaries $ 43.8
Gross profit $ 908.8
Income from continuing operations $ 147.1
Net income attributable to Tempur Sealy International, Inc. $ 146.4
38
Table of Contents
Obligor Group Obligor Group
September 30, 2020 December 31, 2019
(in millions)
ASSETS
Receivables due from non-obligor subsidiaries $ 17.4 $ 9.6
Other current assets 528.2 314.6
Total current assets 545.6 324.2
Loan receivable from non-obligor subsidiaries 250.0 310.1
Goodwill and other intangible assets, net 1,096.0 1,075.5
Other non-current assets 738.7 624.6
Total non-current assets 2,084.7 2,010.2
LIABILITIES
Payables due to non-obligor subsidiaries 18.4 11.4
Other current liabilities 650.7 490.5
Total current liabilities 669.1 501.9
Loan payable to non-obligor subsidiaries 23.8 8.3
Other non-current liabilities 1,892.6 1,832.8
Total non-current liabilities $ 1,916.4 $ 1,841.1
Share Repurchase Program
Our Board of Directors authorized a share repurchase program in 2016 pursuant to which we were authorized to repurchase shares of our common stock for a total repurchase price of not more than $800.0 million. During the nine months ended September 30, 2020, we repurchased 2.6 million shares for approximately $187.5 million. As of September 30, 2020, we had approximately $131.3 million remaining under our existing share repurchase authorization. In October 2020, the Board of Directors authorized an additional increase, of $168.7 million, to the existing share repurchase authorization of Tempur Sealy International's common stock to $300.0 million. Share repurchases under this program may be made through open market transactions, negotiated purchases or otherwise, at times and in such amounts as management deems appropriate. These repurchases may be funded by operating cash flows and/or borrowings under our debt arrangements. The timing and actual number of shares repurchased will depend on a variety of factors including price, financing and regulatory requirements and other market conditions. The program is subject to certain limitations under our debt agreements. The program does not require the purchase of any minimum number of shares and may be suspended, modified or discontinued at any time without prior notice. Repurchases may be made under a Rule 10b5-1 plan, which would permit shares to be repurchased when we might otherwise be precluded from doing so under federal securities laws.
In connection with the 364-Day Loan, we agreed to certain limitations on our ability to repurchase shares and make investments while the 364-Day Loan was outstanding. These limitations were lifted upon repayment of the 364-Day Loan in the third quarter of 2020. In the near term, subject to market conditions, we expect to repurchase at least 3% of shares outstanding per year. We will manage our share repurchase program based on current and expected cash flows, share price and alternative investment opportunities. For a complete description of our share repurchase program, please refer to ITEM 5 under Part II, "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities," in the 2019 Annual Report. Please also refer to "Issuer Purchases of Equity Securities" in ITEM 2(c) of Part II of this Report.
Future Liquidity Sources and Uses
As of September 30, 2020, we had $737.7 million of liquidity, including $229.2 million of cash on hand and $424.9 million available under our revolving senior secured credit facility. We also had availability of $83.6 million under our securitization facility. In addition, we expect to generate additional cash flow from operations in the fourth quarter of 2020. We believe that cash flow from operations, availability under our existing credit facilities and arrangements, current cash balances and the ability to obtain other financing, if necessary, will provide adequate cash funds for our foreseeable working capital needs, necessary capital expenditures and debt service obligations.
39
Table of Contents
Operating cash flow and liquidity exceeded our expectations in 2020. As a result, we have developed a new capital allocation plan to drive shareholder value over time. Our plan is focused on the following:
• Invest approximately $70 million annually for capital expenditures to invest in our people, products and processes.
• Initiate a quarterly cash dividend beginning in early 2021, subject to approval by the Board of Directors, targeting an annual distribution to our stockholders of approximately 15% of net income.
• Resume our share repurchase program and target to repurchase at least 3% of shares outstanding per year in the near-term, depending on market conditions.
• Evaluate acquisition opportunities with a focus on strategic acquisitions similar to those we have completed over the past few years.
• Execute a four-for-one stock split, which will be effected through a stock dividend in the fourth quarter of 2020, to make our common stock more accessible and improve trading liquidity.
As of September 30, 2020, we had $1,535.3 million in total debt outstanding and consolidated indebtedness less netted cash, which is a non-GAAP financial measure, of $1,335.3 million. Leverage based on the ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility, which is a non-GAAP financial measure, was 1.92 times for the trailing twelve months ended September 30, 2020, the lowest in our history. Our target range for our ratio of consolidated indebtedness less netted cash, which is a non-GAAP financial measure, is 2.0 to 3.0 times. Total cash interest payments related to our borrowings are expected to be approximately $75 to $80 million in 2020.
On October 8, 2020, we announced our election to conditionally redeem $200.0 million of our $450.0 million of our issued and outstanding 2023 Senior Notes on November 9, 2020 (the "Redemption Date"). The 2023 Senior Notes selected for redemption will be redeemed at 101.406% of their principal amount, plus the accrued and unpaid interest. The redemption is conditioned on the determination by our Chief Financial Officer, in his sole discretion, as of the second business day before the Redemption Date, that the redemption continues to be reasonably prudent and consistent with our objectives concerning liquidity, financing needs and funding costs.
Our debt service obligations could, under certain circumstances, have material consequences to our stockholders. Similarly, our cash requirements are subject to change as business conditions warrant and opportunities arise. The timing and size of any new business ventures or acquisitions that we may complete may also impact our cash requirements and debt service obligations. For information regarding the impact of COVID-19 on our business, including our liquidity and capital resources, please refer to "Risk Factors" in ITEM 1A of Part II of this Report.
Non-GAAP Financial Information
We provide information regarding adjusted net income, adjusted EPS, adjusted gross profit, adjusted gross margin, adjusted operating income (expense), adjusted operating margin, EBITDA, adjusted EBITDA per credit facility, consolidated indebtedness and consolidated indebtedness less netted cash, which are not recognized terms under GAAP and do not purport to be alternatives to net income, earnings per share, gross profit, gross margin, operating income (expense), operating margin or an alternative to total debt as a measure of liquidity. We believe these non-GAAP financial measures provide investors with performance measures that better reflect our underlying operations and trends, providing a perspective not immediately apparent from net income, gross profit, gross margin, operating income (expense) and operating margin. The adjustments we make to derive the non-GAAP financial measures include adjustments to exclude items that may cause short-term fluctuations in the nearest GAAP financial measure, but which we do not consider to be the fundamental attributes or primary drivers of our business.
We believe that exclusion of these items assists in providing a more complete understanding of our underlying results from continuing operations and trends, and we use these measures along with the corresponding GAAP financial measures to manage our business, to evaluate our consolidated and business segment performance compared to prior periods and the marketplace, to establish operational goals and to provide continuity to investors for comparability purposes. Limitations associated with the use of these non-GAAP measures include that these measures do not present all of the amounts associated with our results as determined in accordance with GAAP. These non-GAAP financial measures should be considered supplemental in nature and should not be construed as more significant than comparable financial measures defined by GAAP. Because not all companies use identical calculations, these presentations may not be comparable to other similarly titled measures of other companies. For more information about these non-GAAP financial measures and a reconciliation to the nearest GAAP financial measure, please refer to the reconciliations on the following pages.
40
Table of Contents
Adjusted Net Income and Adjusted EPS
A reconciliation of reported net income to adjusted net income and the calculation of adjusted EPS is provided below. We believe that the use of these non-GAAP financial measures provides investors with additional useful information with respect to the impact of various adjustments as described in the footnotes below.
The following table sets forth the reconciliation of our reported net income to adjusted net income and the calculation of adjusted EPS for the three months ended September 30, 2020 and 2019:
Three Months Ended
(in millions, except per share amounts) September 30, 2020 September 30, 2019
Net income $ 121.4 $ 73.3
Income from discontinued operations, net of tax (1)
(2.4) (0.8)
Aspirational plan amortization (2)
45.2 —
Loss on extinguishment of debt (3)
0.9 —
Accounting standard adoption (4)
0.8 —
Facility expansion costs (5)
0.6 —
Restructuring costs (6)
0.4 —
Tax adjustments (7)
(11.5) —
Adjusted net income $ 155.4 $ 72.5
Adjusted earnings per share, diluted $ 2.94 $ 1.30
Diluted shares outstanding 52.9 55.8
(1) Certain subsidiaries in the International business segment are accounted for as discontinued operations and have been designated as unrestricted subsidiaries in the 2019 Credit Agreement. Therefore, these subsidiaries are excluded from our adjusted financial measures for covenant compliance purposes.
(2) In the third quarter of 2020, we recognized $45.2 million of performance-based stock compensation amortization related to our long-term aspirational awards. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards that became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020.
(3) In the third quarter of 2020, loss on extinguishment of debt represents costs associated with the early repayment of the 364-Day Loan.
(4) In the third quarter of 2020, we recorded $0.8 million of charges related to the adoption of ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)". As permitted by the 2019 Credit Agreement, we elected to eliminate the effect of this accounting change within our covenant compliance calculation.
(5) In the third quarter of 2020, we recorded $0.6 million of costs related to the opening of a Sealy manufacturing facility.
(6) We incurred $0.4 million of restructuring costs associated with International headcount reductions driven by the macro-economic environment, in the third quarter of 2020.
(7) Adjusted income tax provision represents the tax effects associated with the aforementioned items and other discrete income tax events.
Adjusted Gross Profit and Gross Margin and Adjusted Operating Income (Expense) and Operating Margin
A reconciliation of gross profit and gross margin to adjusted gross profit and adjusted gross margin, respectively, and operating income (expense) and operating margin to adjusted operating income (expense) and adjusted operating margin, respectively, are provided below. We believe that the use of these non-GAAP financial measures provides investors with additional useful information with respect to the impact of various adjustments as described in the footnotes below.
41
Table of Contents
The following table sets forth the reconciliation of our reported gross profit and operating income (expense) to the calculation of adjusted gross profit and adjusted operating income (expense) for the three months ended September 30, 2020.
Three Months Ended September 30, 2020
(in millions, except percentages) Consolidated
Margin North America Margin International Margin Corporate
Net sales $ 1,132.3 $ 976.5 $ 155.8 $ —
Gross profit $ 530.2 46.8 % $ 438.6 44.9 % $ 91.6 58.8 % $ —
Adjustments:
Facility expansion costs (1)
0.6 0.6 — —
Adjusted gross profit $ 530.8 46.9 % $ 439.2 45.0 % $ 91.6 58.8 % $ —
Operating income (expense) $ 180.2 15.9 % $ 231.5 23.7 % $ 44.8 28.8 % $ (96.1)
Adjustments:
Aspirational plan amortization (2)
45.2 — — 45.2
Accounting standard adoption (3)
0.8 0.8 — —
Facility expansion costs (1)
0.6 0.6 — —
Restructuring costs (4)
0.4 — 0.4 —
Total adjustments 47.0 1.4 0.4 45.2
Adjusted operating income (expense) $ 227.2 20.1 % $ 232.9 23.9 % $ 45.2 29.0 % $ (50.9)
The following table sets forth our reported gross profit and operating income (expense) for the three months ended September 30, 2019. We had no adjustments to gross profit and operating income (expense) for the three months ended September 30, 2019.
Three Months Ended September 30, 2019
(in millions, except percentages) Consolidated Margin North America Margin International Margin Corporate
Net sales $ 821.0 $ 682.0 $ 139.0 $ —
Gross profit $ 360.6 43.9 % $ 286.8 42.1 % $ 73.8 53.1 % $ —
Operating income (expense) $ 120.6 14.7 % $ 119.8 17.6 % $ 27.3 19.6 % $ (26.5)
(1) In the third quarter of 2020, we recorded $0.6 million of costs related to the opening of a Sealy manufacturing facility.
(2) In the third quarter of 2020, we recognized $45.2 million of performance-based stock compensation amortization related to our long-term aspirational awards. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards that became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020.
(3) In the third quarter of 2020, we recorded $0.8 million of charges related to the adoption of ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)". As permitted by the 2019 Credit Agreement, we elected to eliminate the effect of this accounting change within our covenant compliance calculation.
(4) We incurred $0.4 million of restructuring costs associated with International headcount reductions driven by the macro-economic environment, in the third quarter of 2020.
EBITDA, Adjusted EBITDA per Credit Facility and Consolidated Indebtedness less Netted Cash
The following reconciliations are provided below:
• Net income to EBITDA and adjusted EBITDA per credit facility
• Ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility
• Total debt, net to consolidated indebtedness less netted cash
42
Table of Contents
We believe that presenting these non-GAAP measures provides investors with useful information with respect to our operating performance, cash flow generation and comparisons from period to period, as well as general information about our progress in reducing our leverage.
The 2019 Credit Agreement provides the definition of adjusted EBITDA (“adjusted EBITDA per credit facility”). Accordingly, we present adjusted EBITDA per credit facility to provide information regarding our compliance with requirements under the 2019 Credit Agreement.
The following table sets forth the reconciliation of our reported net income to the calculations of EBITDA and adjusted EBITDA per credit facility for the three months ended September 30, 2020 and 2019:
Three Months Ended
(in millions) September 30, 2020 September 30, 2019
Net income $ 121.4 $ 73.3
Interest expense, net 20.1 20.8
Loss on extinguishment of debt (1)
0.9 —
Income taxes 40.3 26.1
Depreciation and amortization 52.0 30.5
Aspirational plan amortization (2)
45.2 —
EBITDA $ 279.9 $ 150.7
Adjustments:
Income from discontinued operations, net of tax (3)
(2.4) (0.8)
Accounting standard adoption (4)
0.8 —
Facility expansion costs (5)
0.6 —
Restructuring costs (6)
0.4 —
Adjusted EBITDA per credit facility $ 279.3 $ 149.9
(1) In the third quarter of 2020, loss on extinguishment of debt represents costs associated with the early repayment of the 364-Day Loan.
(2) In the third quarter of 2020, we recognized $45.2 million of performance-based stock compensation amortization related to our long-term aspirational awards. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards that became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition which will lapse in December 2020.
(3) Certain subsidiaries in the International business segment are accounted for as discontinued operations and have been designated as unrestricted subsidiaries in the 2019 Credit Agreement. Therefore, these subsidiaries are excluded from our adjusted financial measures for covenant compliance purposes.
(4) In the third quarter of 2020, we recorded $0.8 million of charges related to the adoption of ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)". As permitted by the 2019 Credit Agreement, we elected to eliminate the effect of this accounting change within our covenant compliance calculation.
(5) In the third quarter of 2020, we recorded $0.6 million of costs related to the opening of a Sealy manufacturing facility.
(6) We incurred $0.4 million of restructuring costs associated with International headcount reductions driven by the macro-economic environment, in the third quarter of 2020.
43
Table of Contents
The following table sets forth the reconciliation of our net income to the calculations of EBITDA and adjusted EBITDA per credit facility for the trailing twelve months ended September 30, 2020:
Trailing Twelve Months Ended
(in millions) September 30, 2020
Net income $ 250.3
Interest expense, net 81.0
Loss on extinguishment of debt (1)
0.9
Income tax provision 89.1
Depreciation and amortization 145.5
Aspirational plan amortization (2)
45.2
EBITDA $ 612.0
Adjustments:
Income from discontinued operations, net of tax (3)
(0.7)
Customer-related charges (4)
41.5
Charitable stock donation and other (5)
9.6
COVID-19 charges (6)
7.9
Incremental operating costs (7)
7.2
Asset impairments (8)
7.0
Restructuring costs (9)
3.8
Accounting standard adoption (10)
3.6
Earnings from Sherwood prior to acquisition (11)
1.7
Facility expansion costs (12)
0.6
Adjusted EBITDA per credit facility $ 694.2
Consolidated indebtedness less netted cash $ 1,335.3
Ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility 1.92 times
44
Table of Contents
(1) In the third quarter of 2020, loss on extinguishment of debt represents costs associated with the early repayment of the 364-Day Loan.
(2) In the third quarter of 2020, we recognized $45.2 million of performance-based stock compensation amortization related to our long-term aspirational awards. The amount recognized represents the cumulative catch-up adjustment for the long-term aspirational awards that became probable of vesting during the third quarter of 2020. The awards are subject to a remaining service vesting condition through December 2020.
(3) Certain subsidiaries in the International business segment are accounted for as discontinued operations and have been designated as unrestricted subsidiaries in the 2019 Credit Agreement. Therefore, these subsidiaries are excluded from our adjusted financial measures for covenant compliance purposes.
(4) In the first quarter of 2020, we recorded $11.7 million of customer-related charges in connection with the bankruptcy of Art Van Furniture, LLC and affiliates to fully reserve trade receivables and other assets associated with this account. In the fourth quarter of 2019, we recorded $29.8 million of customer-related charges in connection with the bankruptcy of Mattress PAL Holding, LLC ("Mattress PAL") and resulting significant liquidity issues of Mattress PAL's affiliates to fully reserve trade receivables and other assets associated with this account.
(5) In 2019, we recorded a $9.6 million charge for charitable stock donation and other costs. These costs included an $8.9 million charge related to the donation of common stock at fair market value to certain public charities and $0.7 million of professional fees in connection with the amendment of the 2019 Credit Agreement.
(6) In the second quarter of 2020, adjusted EBITDA per credit facility excluded $7.9 million of COVID-19 charges associated with temporarily closed company-owned retail stores and sales force retention costs.
(7) In the second quarter of 2020, we recorded $4.9 million of incremental operating costs associated with the global pandemic. In the first quarter of 2020, we recorded $2.3 million of charges related to the global pandemic.
(8) In the second quarter of 2020, we recorded $7.0 million of asset impairment charges related to the write-off of certain sales and marketing assets driven by the macro-economic environment.
(9) We incurred $0.4 million and $3.4 million of restructuring costs associated with International headcount reductions driven by the macro-economic environment, in the third and second quarter of 2020, respectively.
(10) In the third quarter of 2020, we recorded $0.8 million of charges related to the adoption of ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)". In the first half of 2020, we recorded $2.8 million of charges related to the adoption. As permitted by the 2019 Credit Agreement, we elected to eliminate the effect of this accounting change within our covenant compliance calculation.
(11) We completed the acquisition of Sherwood Bedding on January 31, 2020 and designated this subsidiary as restricted under the 2019 Credit Agreement. For covenant compliance purposes, we included $1.7 million of EBITDA from this subsidiary for the four months prior to acquisition in our calculation of adjusted EBITDA per credit facility for the trailing twelve months ended September 30, 2020.
(12) In the third quarter of 2020, we recorded $0.6 million of costs related to the opening of a Sealy manufacturing facility.
Under the 2019 Credit Agreement, the definition of adjusted EBITDA (which we refer to as "adjusted EBITDA per credit facility") contains certain restrictions that limit adjustments to net income when calculating adjusted EBITDA. For the trailing twelve months ended September 30, 2020, our adjustments to net income when calculating adjusted EBITDA did not exceed the allowable amount under the 2019 Credit Agreement.
The ratio of consolidated indebtedness less netted cash to adjusted EBITDA per credit facility is 1.92 times for the trailing twelve months ended September 30, 2020. The 2019 Credit Agreement requires us to maintain a ratio of consolidated indebtedness less netted cash to adjusted EBITDA of less than 5.00:1.00 times.
The following table sets forth the reconciliation of our reported total debt to the calculation of consolidated indebtedness less netted cash as of September 30, 2020. "Consolidated Indebtedness" and "Netted Cash" are terms used in the 2019 Credit Agreement for purposes of certain financial covenants.
(in millions) September 30, 2020
Total debt, net $ 1,530.0
Plus: Deferred financing costs (1)
5.3
Consolidated indebtedness 1,535.3
Less: Netted cash (2)
200.0
Consolidated indebtedness less netted cash $ 1,335.3
(1) We present deferred financing costs as a direct reduction from the carrying amount of the related debt in the Condensed Consolidated Balance Sheets. For purposes of determining total debt for financial covenant purposes, we have added these costs back to total debt, net as calculated per the Condensed Consolidated Balance Sheets.
(2) Netted cash includes cash and cash equivalents for domestic and foreign subsidiaries designated as restricted subsidiaries in the 2019 Credit Agreement. For purposes of determining netted cash for financial covenant purposes under the 2019 Credit Agreement, the aggregate amount of netted cash is not permitted to exceed $200.0 million.
45
Table of Contents
Critical Accounting Policies and Estimates
For a discussion of our critical accounting policies and estimates, please refer to ITEM 7 under Part II, "Management’s Discussion and Analysis of Financial Condition and Results of Operations," in the 2019 Annual Report. There have been no material changes to our critical accounting policies and estimates in 2020.