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MATTRESS FIRM HOLDING CORP. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The discussion in this section contains forward-looking statements that involve risks and uncertainties. See "Cautionary Note Regarding Forward-Looking Statements" included elsewhere in this report for a discussion of important factors that could cause actual results to differ materially from those described or implied by the forward-looking statements contained herein. Unless the context otherwise requires, the terms "Mattress Firm®," "our company," "the Company," "we," "us," "our" and the like refer to Mattress Firm Holding Corp. and its consolidated subsidiaries. Unless otherwise indicated, (i) the term "our stores" refers to our company-operated stores and our franchised stores and (ii) when used in relation to our company, the terms "market" and "markets" refer to the metropolitan statistical area or an aggregation of the metropolitan statistical areas in which we or our franchisees operate. In this report, we refer to earnings before interest, taxes, depreciation and amortization and other adjustments (such as goodwill impairment charges, loss on store closings and acquisition expenses), or "Adjusted EBITDA." Adjusted EBITDA is not a performance measure under accounting principles generally accepted in the United States, or "U.S. GAAP." See "Adjusted EBITDA to Net Income Reconciliation" on page 30 for a definition of Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income. We report on the basis of a 52- or 53-week fiscal year, which ends on the Tuesday closest to January 31. Each fiscal year is described by the period of the calendar year that comprises the majority of the fiscal year period. For example, the fiscal year ending February 3, 2015 is described as "fiscal 2014." Fiscal 2014 contains 53 weeks. Executive Summary Net sales during the thirteen and twenty-six weeks ended July 29, 2014 improved $107.5 million and $165.0 million, respectively, from the comparable prior year levels as a result of the addition of new and acquired store units and an increase in comparable-store sales. We believe that our net sales growth is outpacing our competitors in most of the markets in which we operate and is resulting in increased market share. Key results for the thirteen and twenty-six weeks ended July 29, 2014 include: · Net income increased $0.2 million to $14.3 million for the thirteen weeks ended July 29, 2014, compared to $14.1 million for the comparable prior year period. Net income decreased $4.1 million to $22.0 million for the twenty-six weeks ended July 29, 2014, compared to $26.1 million for the comparable prior year period. · Income from operations for the thirteen weeks ended July 29, 2014 was $27.0 million. Excluding $11.0 million of acquisition-related expenses, enterprise resource planning ("ERP") system implementation costs and impairment and severance charges, adjusted income from operations was $38.0 million, and adjusted operating margin during the thirteen weeks ended July 29, 2014 increased 40 basis-points from 8.9% during the thirteen weeks ended July 30, 2013 to 9.3% during the thirteen weeks ended July 29, 2014. This operating margin increase on an adjusted basis (excluding acquisition-related, ERP system implementation costs and impairment and severance charges) is comprised of a ten basis-point increase in gross margin, a 70 basis-point improvement in sales and marketing expense leverage, offset by a 20 basis-point decrease from general and administration expense deleverage, and 20 basis-points of combined operating margin declines in other areas. Income from operations for the twenty-six weeks ended July 29, 2014 was $42.4 million. Excluding $15.6 million of acquisition-related expenses, ERP system implementation costs and impairment and severance charges, adjusted income from operations was $58.0 million, and adjusted operating margin during the twenty-six weeks ended July 29, 2014 decreased 100 basis-points from 8.8% during the twenty-six weeks ended July 30, 2013 to 7.8% during the twenty-six weeks ended July 29, 2014. This operating margin decrease on an adjusted basis (excluding acquisition-related, ERP system implementation costs and impairment and severance charges) is comprised of a 70 basis-point decline in gross margin, a 70 basis-point decrease from general and administration expense deleverage, offset by a 50 basis-point improvement in sales and marketing expense leverage, and ten basis-points of combined operating margin declines in other areas. Acquisition-related costs for purposes of management's discussion and analysis, which are included in the results of operations, consist of the acquisition-related costs as defined under U.S. GAAP, including advisory, 19 -------------------------------------------------------------------------------- Table of Contents legal, accounting, valuation, and other professional or consulting fees and, in addition, costs of integrating store and warehouse operations and corporate functions. ERP system implementation costs, which are included in the results of operations, consist primarily of training costs related to the roll-out of the Microsoft Dynamics AX for Retail ERP system. Impairment charges, which are included in results of operations, consist of an impairment of store assets. Severance expense, which is included in the results of operations, resulted from our realignment of our management structure at the beginning of the second fiscal quarter of fiscal 2014. (Adjusted income from operations is not a performance measure under U.S. GAAP. See "Reconciliation of Reported (U.S. GAAP) to Adjusted Statements of Operations Data" on page 32 for a reconciliation of net income as reported to adjusted net income.) · Adjusted EBITDA increased $13.2 million to $49.2 million for the thirteen weeks ended July 29, 2014, compared with $36.0 million for the comparable prior year period. Adjusted EBITDA as a percentage of net sales increased to 12.0% during the thirteen weeks ended July 29, 2014, compared with 11.9% for the comparable prior year period. Adjusted EBITDA increased $11.7 million to $79.9 million for the twenty-six weeks ended July 29, 2014, compared with $68.2 million for the comparable prior year period. Adjusted EBITDA as a percentage of net sales decreased to 10.8% during the twenty-six weeks ended July 29, 2014, compared with 11.8% for the comparable prior year period. See "Adjusted EBITDA to Net Income Reconciliation" on page 30 for a definition of Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income. · Net sales increased $107.5 million, or 35.5%, to $410.0 million for the thirteen weeks ended July 29, 2014, compared to $302.5 million for the comparable prior year period primarily as the result of an increase in the number of stores we operated and an increase in comparable-store sales. Comparable-store sales increased 9.7% during the thirteen weeks ended July 29, 2014. Net sales increased $165.0 million, or 28.5%, to $743.5 million for the twenty-six weeks ended July 29, 2014, compared to $578.5 million for the comparable prior year period primarily as the result of an increase in the number of stores we operated and an increase in comparable-store sales. Comparable-store sales increased 7.1% during the twenty-six weeks ended July 29, 2014. The components of the net sales increase for the thirteen and twenty-six weeks ended July 29, 2014 as compared to the thirteen and twenty-six weeks ended July 30, 2013 were as follows (in millions): Progression in Net Sales Thirteen Weeks Twenty-Six Weeks Ended July 29, Ended July 29, 2014 2014 Net sales for prior year period $ 302.5 $ 578.5 Increase (decrease) in net sales: Comparable-store sales 28.8 40.3 New stores 40.4 75.8 Acquired stores 43.1 58.9 Closed stores (4.8) (10.0) Increase in net sales, net 107.5 165.0 Net sales for current year period $ 410.0 $ 743.5 % increase 35.5% 28.5% 20 -------------------------------------------------------------------------------- Table of Contents The components of net sales by major category of product and services were as follows (in millions): Thirteen Weeks Ended Twenty-Six Weeks Ended July 30, % of July 29, % of July 30, % of July 29, % of 2013 Total 2014 Total 2013 Total 2014 Total Conventional mattresses $ 148.5 49.1 % $ 195.6 47.7 % $ 270.1 46.7 % $ 359.3 48.3 % Specialty mattresses 129.2 42.7 % 177.5 43.3 % 259.0 44.8 % 313.8 42.2 % Furniture and accessories 19.1 6.3 % 28.7 7.0 % 38.3 6.6 % 55.7 7.5 % Total product sales 296.8 98.1 % 401.8 98.0 % 567.4 98.1 % 728.8 98.0 % Delivery service revenues 5.7 1.9 % 8.2 2.0 % 11.1 1.9 % 14.7 2.0 % Total net sales $ 302.5 100.0 % $ 410.0 100.0 % $ 578.5 100.0 % $ 743.5 100.0 % The activity with respect to the number of company-operated store units was as follows: Thirteen Twenty-Six Weeks Weeks Ended Ended July 29, July 29, 2014 2014 Store units, beginning of period 1,365 1,225 New stores 53 109 Acquired stores 67 159 Closed stores (5) (13) Store units, end of period 1,480 1,480 ?Operating cash flows were $51.2 million and $58.3 million during the thirteen and twenty-six weeks ended July 29, 2014. ?On March 3, 2014, we acquired the leasehold interests, store assets, distribution center assets and related inventories, and assumed certain liabilities of Yotes, a franchisee of ours, relating to the operation of 34 mattress specialty retail stores located in Colorado and Kansas for a total purchase price of approximately $14.3 million, including working capital adjustments. ?On March 3, 2014, we acquired the Virginia leasehold interests and store assets, and assumed certain liabilities, of Southern Max, a franchisee of ours, relating to the operations of three mattress specialty retail stores located in Virginia for a total purchase price of approximately $0.5 million, including working capital adjustments. ?On April 3, 2014, we acquired one hundred percent of the outstanding partnership interests in Sleep Experts, related to the operations of 55 mattress specialty retail stores in Texas under the brand Sleep Experts, for a total purchase price of approximately $67.8 million, including working capital adjustments, subject to customary post-closing adjustments. The purchase price consisted of cash of $62.8 million (net of $1.6 million of cash acquired), and $3.4 million delivered in the form of 71,619 shares of common stock, par value $0.01 per share, of Mattress Firm Holding Corp. common stock as calculated in accordance with the terms of the purchase agreement. ?We funded the cash requirements of the Yotes and Southern Max acquisitions using cash reserves and revolver borrowings. We raised $100 million of incremental term borrowings under the 2012 Senior Credit Facility to fund the cash requirements of the Sleep Experts acquisition and to pay down outstanding revolver borrowings. The new incremental term borrowings mature in January 2016 and are subject to the same interest rate as the existing outstanding incremental borrowings under the 2012 Senior Credit Facility. ?On June 4, 2014, we acquired substantially all of the mattress specialty retail assets and operations of Mattress Liquidators, Inc., which operated Mattress King retail stores in Colorado and BedMart retail stores 21 -------------------------------------------------------------------------------- Table of Contents in Arizona. The acquisition was for an aggregate purchase price of approximately $32.9 million, giving effect to certain preliminary adjustments, and is subject to further customary adjustments, and relates to the operations of approximately 67 mattress specialty retail stores primarily in Denver, Colorado, Phoenix, Arizona and Tucson, Arizona. The purchase price consisted of cash of $29.4 million funded by cash reserves and revolver borrowings, as well as a $3.5 million seller note, payable in quarterly installments over two years. We currently operate Mattress Firm stores in these markets and intend to complete the rebranding of the acquired stores during the third fiscal quarter. · At July 29, 2014, there were no outstanding revolver borrowings, $1.6 million outstanding standby letters of credit, and additional borrowing capacity of $98.4 million under the 2012 Senior Credit Facility. General Definitions for Operating Results Net sales are recognized upon delivery and acceptance of mattresses and bedding products by our customers and include fees collected for delivery services, and are recorded net of estimated returns. Customer deposits collected prior to the delivery of merchandise are recorded as a liability. Net sales are recognized net of sales tax collected from customers and remitted to various taxing jurisdictions. Cost of sales consist of the following: · Costs associated with purchasing and delivering our products to our stores and customers, net of vendor incentives earned on the purchase of products subsequently sold; · Physical inventory losses; · Store and warehouse occupancy and depreciation expense of related facilities and equipment; · Store and warehouse operating costs, including warehouse (i) labor costs, (ii) utilities, (iii) repairs and maintenance, (iv) supplies and (v) store facilities; and · Estimated costs to provide for customer returns and exchanges and to service customer warranty claims. Gross profit from retail operations is net sales minus cost of sales. Franchise fees and royalty income represents initial franchise fees earned upon the opening of new franchisee stores and ongoing royalties based on a percentage of gross franchisee sales. Sales and marketing expenses consist of the following: · Advertising and media production; · Payroll and benefits for sales associates; and · Merchant service fees for customer credit and debit card payments, check guarantee fees and promotional financing expense. General and administrative expenses consist of the following: · Payroll and benefit costs for corporate office and regional management employees; · Stock-based compensation costs; · Occupancy costs of corporate facility; 22 -------------------------------------------------------------------------------- Table of Contents · Information systems hardware, software and maintenance; · Depreciation related to corporate assets; · Management fees; · Insurance; and · Other overhead costs. Loss on store closings and impairment of store assets consists of the following: · Estimated future costs to close locations at the time of closing including, as applicable, the difference between future lease obligations and anticipated sublease rentals; · The write off of unamortized fixed assets related to store leasehold costs on closed stores; and · Non-cash charges recognized for long-lived assets generally consisting of leasehold costs and related equipment resulting in a reduction of the carrying value to estimated fair value, based on our periodic assessment of whether projected future cash flows of individual stores are sufficient to recover the carrying value of the related assets. Income from operations consists of gross profit from retail operations plus franchise fees and royalty income, minus (i) sales and marketing expenses, (ii) general and administrative expenses and (iii) loss (gain) on store closings and impairment of store assets. Other expense, net includes interest income and interest expense. Interest expense includes interest on outstanding debt, amortization of debt discounts, and amortization of financing costs. Results of Operations The following table presents the consolidated historical financial operating data for our business for each period indicated (amounts in thousands). The historical results are not necessarily indicative of results to be expected for any future period. Thirteen Weeks Ended Twenty-Six Weeks Ended July 30, % of July 29, % of July 30, % of July 29, % of 2013 Sales 2014 Sales 2013 Sales 2014 Sales Net sales $ 302,541 100.0 % $ 409,951 100.0 % $ 578,498 100.0 % $ 743,453 100.0 % Costs of sales 182,096 60.2 % 246,547 60.1 % 353,611 61.1 % 459,199 61.8 % Gross profit from retail operations 120,445 39.8 % 163,404 39.9 % 224,887 38.9 % 284,254 38.2 % Franchise fees and royalty income 1,438 0.5 % 1,092 0.2 % 2,687 0.4 % 2,278 0.3 % Total gross profit 121,883 40.3 % 164,496 40.1 % 227,574 39.3 % 286,532 38.5 % Sales and marketing expenses 75,768 25.0 % 99,998 24.3 % 139,499 24.1 % 175,663 23.6 % General and administrative expenses 19,749 6.5 % 36,888 9.0 % 38,918 6.7 % 67,574 9.1 % Loss on store closings and impairment of store assets 483 0.2 % 648 0.2 % 744 0.1 % 906 0.1 % Income from operations 25,883 8.6 % 26,962 6.6 % 48,413 8.4 % 42,389 5.7 % Other expense, net 2,795 1.0 % 3,469 0.9 % 5,642 1.0 % 6,285 0.8 % Income before income taxes 23,088 7.6 % 23,493 5.7 % 42,771 7.4 % 36,104 4.9 % Income tax expense 8,965 2.9 % 9,194 2.2 % 16,639 2.9 % 14,085 1.9 % Net income $ 14,123 4.7 % $ 14,299 3.5 % $ 26,132 4.5 % $ 22,019 3.0 % 23 -------------------------------------------------------------------------------- Table of Contents Thirteen Weeks Ended July 29, 2014 Compared to Thirteen Weeks Ended July 30, 2013 Net sales. Net sales increased $107.5 million, or 35.5%, to $410.0 million during the thirteen weeks ended July 29, 2014, compared to $302.5 million during the thirteen weeks ended July 30, 2013 primarily as a result of an increase in the number of stores we operated and an increase in comparable-store sales. The components of the net sales increase for the thirteen weeks ended July 29, 2014 as compared to the thirteen weeks ended July 30, 2013 were as follows (in millions): Progression in Net Sales Thirteen Weeks Ended July 29, 2014 Net sales for prior year period $ 302.5 Increase (decrease) in net sales: Comparable-store sales 28.8 New stores 40.4 Acquired stores 43.1 Closed stores (4.8) Increase in net sales, net 107.5 Net sales for current year period $ 410.0 % increase 35.5% Comparable-store net sales increased 9.7%, which was primarily the result of a combination of an increase in unit sales, particularly driven by conventional mattress sales and a focus on keeping stock in the stores, and an increase in average ticket, driven primarily by specialty mattress sales. The increase in our net sales from new stores was the result of 182 new stores opened at various times during the fifty-two week period ended July 29, 2014, including 53 stores opened during the thirteen week period ended July 29, 2014, prior to their inclusion in the comparable-store sales calculation which begins with the thirteenth full fiscal period of operations. The increase in net sales from acquired stores was the result of the acquisitions of five former Mattress People stores in November 2013, 39 stores formerly operated by Perfect Mattress in December 2013, two former Mattress Expo stores in December 2013, 34 stores formerly operated by Yotes in March 2014, three stores formerly operated by Southern Max in March 2014, 55 Sleep Experts stores in April 2014 and 67 Mattress Liquidators, Inc. stores in June 2014. We closed 28 stores during the fifty-two week period ended July 29, 2014, including five stores during the thirteen week period ended July 29, 2014. We operated 1,480 stores at July 29, 2014, compared with 1,121 stores at July 30, 2013. Cost of sales. Cost of sales increased $64.5 million, or 35.4%, to $246.6 million during the thirteen weeks ended July 29, 2014, compared to $182.1 million during the thirteen weeks ended July 30, 2013. The major components of the increase in cost of sales are discussed below. Cost of sales as a percentage of net sales decreased to 60.1% during the thirteen weeks ended July 29, 2014, as compared to 60.2% for the comparable prior year period. Product costs increased by $41.9 million, or 37.6%, to $153.5 million during the thirteen weeks ended July 29, 2014, compared with $111.6 million during the thirteen weeks ended July 30, 2013. The increase in the amount of product costs is primarily the result of the corresponding increase in net sales. Product costs as a percentage of net sales increased to 37.5% during the thirteen weeks ended July 29, 2014 from 36.9% during the thirteen weeks ended July 30, 2013. The increase in product costs as a percentage of net sales is largely the result of the recent acquisitions which are experiencing higher product costs during the period of transitioning to the Company's typical product mix. In addition, some tightening of margins was seen in the specialty mattress lines. Store and warehouse occupancy costs, consisting primarily of lease related costs of rented facilities, increased $13.8 million, or 33.1%, to $55.7 million during the thirteen weeks ended July 29, 2014, compared to $41.9 million for the corresponding prior year period. The increase in the amount of store and warehouse occupancy costs during the thirteen weeks ended July 29, 2014 was mainly attributable to the increase in the number of stores we operated and the warehouse operations in a number of new markets opened or acquired. Store and warehouse occupancy costs as a percentage of net sales decreased to 13.6% during the thirteen weeks ended July 29, 2014, compared to 13.8% during the thirteen weeks ended July 30, 2013. The decrease in store and warehouse occupancy costs as a percentage of net sales during the thirteen weeks ended July 29, 2014 was primarily attributable to the leverage generated by comparable-store sales growth. 24 -------------------------------------------------------------------------------- Table of Contents Depreciation expense related to leasehold improvements and other fixed assets used in stores and warehouse operations increased $1.8 million, or 28.8%, to $8.2 million, during the thirteen weeks ended July 29, 2014, compared to $6.4 million during the thirteen weeks ended July 30, 2013. The increase in expense was primarily attributable to the increase in the number of stores we operated during the thirteen weeks ended July 29, 2014, as compared with the comparable prior year period. Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $6.8 million, or 30.5%, to $29.1 million during the thirteen weeks ended July 29, 2014, compared to $22.3 million during the thirteen weeks ended July 30, 2013, primarily as a result of the increase in net sales and in the increased number of stores we operated during the thirteen weeks ended July 29, 2014, as compared with the corresponding prior year period. Gross profit from retail operations. As a result of the above, gross profit from retail operations increased $43.0 million, or 35.7%, to $163.4 million during the thirteen weeks ended July 29, 2014, compared with $120.4 million during the thirteen weeks ended July 30, 2013. Gross profit from retail operations as a percentage of net sales increased to 39.9% during the thirteen weeks ended July 29, 2014, as compared to 39.8% during the thirteen weeks ended July 30, 2013, for the reasons discussed above. Franchise fees and royalty income. Franchise fees and royalty income decreased $0.3 million, or 24.1%, to $1.1 million during the thirteen weeks ended July 29, 2014, compared to $1.4 million during the thirteen weeks ended July 30, 2013, primarily as a result of our acquisitions of certain formerly franchised operations, as described above. Our franchisees operated 107 stores at July 29, 2014, compared with 167 stores at July 30, 2013. Sales and marketing expenses. Sales and marketing expenses increased $24.2 million, or 32.0%, to $100.0 million during the thirteen weeks ended July 29, 2014, compared to $75.8 million during the thirteen weeks ended July 30, 2013. Sales and marketing expenses as a percentage of net sales decreased to 24.3% during the thirteen weeks ended July 29, 2014, compared to 25.0% during the thirteen weeks ended July 30, 2013. The components of sales and marketing expenses are explained below. Advertising expense increased $8.0 million, or 26.3%, to $38.8 million during the thirteen weeks ended July 29, 2014, from $30.8 million during the thirteen weeks ended July 30, 2013. The increase in the amount of advertising spend was a result of our expansion into new markets from acquisitions and new store additions. Advertising expense as a percentage of net sales decreased to 9.5% during the thirteen weeks ended July 29, 2014, compared to 10.2% during the thirteen weeks ended July 30, 2013, primarily due to generating greater leverage from the increase in net sales in certain markets. We receive funds from time to time from certain vendors for the advertisement of their products, and we recognize these funds as a direct reduction of advertising expense. The amount of vendor advertising funds that were recognized as a reduction of advertising expense totaled $1.7 million during the thirteen weeks ended July 29, 2014, compared with $2.2 million during the thirteen weeks ended July 30, 2013. Other sales and marketing expenses, consisting mainly of salesman compensation costs, but also including costs incurred to accept payments from our customers, such as credit card and third party finance fees, increased $16.2 million, or 35.9%, to $61.2 million during the thirteen weeks ended July 29, 2014, compared to $45.0 million during the thirteen weeks ended July 30, 2013, primarily as a result of the increase in net sales during the period. Other sales and marketing expenses as a percentage of net sales was flat at 14.9% during the thirteen weeks ended July 29, 2014 and the thirteen weeks ended July 30, 2013. General and administrative expenses. General and administrative expenses increased $17.2 million, or 86.7%, to $36.9 million for the thirteen weeks ended July 29, 2014, compared to $19.7 million for the thirteen weeks ended July 30, 2013. The increase in general and administrative expenses was primarily a result of our growth, including a $7.7 million increase in wages, benefits and stock-based compensation resulting from employee additions to our corporate office, a $7.6 million increase in acquisition-related costs, a $0.8 million increase in ERP implementation training costs and a $1.1 million increase in various other general and administrative expense categories. General and administrative expenses as a percentage of net sales increased to 9.0% during the thirteen weeks ended July 29, 2014, compared to 6.5% for the comparable prior year period. The increase in general and administrative expenses as a percentage of net sales is primarily due to the increase in acquisition-related costs noted above, an increase in cost of administrative labor as a percentage of net sales and increases in various other areas. General and administrative expenses for the thirteen weeks ended July 29, 25 -------------------------------------------------------------------------------- Table of Contents 2014 and July 30, 2013 included $10.6 million and $1.0 million, respectively, of primarily acquisition-related costs, ERP implementation training costs, and impairment and severance charges. We expect to continue making investments in our corporate infrastructure commensurate with our growth strategy. Loss on store closings and impairment of store assets. Loss on store closings and impairment of store assets increased $0.1 million, or 34.2%, to $0.6 million for the thirteen weeks ended July 29, 2014, compared to $0.5 million for the thirteen weeks ended July 30, 2013, primarily as a result of an increase of $0.5 million in store-level fixed asset impairment charges over the prior year period, offset by a decrease of $0.4 million in the amount of remaining lease commitments on stores that we closed during the respective periods. Other expense, net. Other expense, net, for both periods consisted primarily of interest expense. Interest expense, net increased $0.7 million, or 24.2%, to $3.5 million for the thirteen weeks ended July 29, 2014, compared to $2.8 million for the thirteen weeks ended July 30, 2013, primarily as a result of an increase in term and revolver borrowings as compared to the prior year period. Income tax expense. We recognized $9.2 million of income tax expense during the thirteen weeks ended July 29, 2014, compared to $9.0 million of income tax expense during the thirteen weeks ended July 30, 2013. The effective tax rate was 39.1% during the thirteen weeks ended July 29, 2014 and 38.8% during the thirteen weeks ended July 30, 2013. Net income. As a result of the above, our net income was $14.3 million during the thirteen weeks ended July 29, 2014 compared to $14.1 million during the thirteen weeks ended July 30, 2013. Twenty-Six Weeks Ended July 29, 2014 Compared to Twenty-Six Weeks Ended July 30, 2013 Net sales. Net sales increased $165.0 million, or 28.5%, to $743.5 million during the twenty-six weeks ended July 29, 2014, compared to $578.5 million during the twenty-six weeks ended July 30, 2013 primarily as a result of an increase in the number of stores we operated and an increase in comparable-store sales. The components of the net sales increase for the twenty-six weeks ended July 29, 2014 as compared to the twenty-six weeks ended July 30, 2013 were as follows (in millions): Progression in Net Sales TwentySix Weeks Ended July 29, 2014 Net sales for prior year period $ 578.5 Increase (decrease) in net sales: Comparable-store sales 40.3 New stores 75.8 Acquired stores 58.9 Closed stores (10.0) Increase in net sales, net 165.0 Net sales for current year period $ 743.5 % increase 28.5% Comparable-store net sales increased 7.1%, which was primarily the result of an increase in unit sales driven by sales initiatives implemented during the second half of fiscal 2013 that encouraged our sales associates to improve sales productivity and an increase in average ticket for specialty mattress sales. The increase in our net sales from new stores was the result of 182 new stores opened at various times during the fifty-two week period ended July 29, 2014, including 109 stores opened during the twenty-six week period ended July 29, 2014, prior to their inclusion in the comparable-store sales calculation which begins with the thirteenth full fiscal period of operations. The increase in net sales from acquired stores was the result of the acquisitions of five former Mattress People stores in November 2013, 39 stores formerly operated by Perfect Mattress in December 2013, two former Mattress Expo stores in December 2013, 34 stores formerly operated by Yotes in March 2014, three stores formerly operated by Southern Max in March 2014, 55 Sleep Experts stores in April 2014 and 67 Mattress Liquidators, Inc. stores in June 2014. We closed 28 stores during the fifty-two week period ended July 29, 2014, including 13 stores during the thirteen week period ended July 29, 2014. 26 -------------------------------------------------------------------------------- Table of Contents Cost of sales. Cost of sales increased $105.6 million, or 29.9%, to $459.2 million during the twenty-six weeks ended July 29, 2014, compared to $353.6 million during the twenty-six weeks ended July 30, 2013. The major components of the increase in cost of sales are discussed below. Cost of sales as a percentage of net sales increased to 61.8% during the twenty-six weeks ended July 29, 2014, as compared to 61.1% for the comparable prior year period. Product costs increased by $65.1 million, or 30.4%, to $279.4 million during the twenty-six weeks ended July 29, 2014, compared with $214.3 million during the twenty-six weeks ended July 30, 2013. The increase in the amount of product costs was the result of the corresponding increase in net sales. Product costs as a percentage of net sales increased to 37.6% during the twenty-six weeks ended July 29, 2014 from 37.0% during the twenty-six weeks ended July 30, 2013. The increase of product costs as a percentage of net sales is largely the result of the significant product close-outs that occurred during the first quarter and the impact of the recent acquisitions experiencing higher product costs as the transition is made to the Company's typical product mix. Store and warehouse occupancy costs, consisting primarily of lease related costs of rented facilities, increased $22.8 million, or 27.6%, to $105.6 million during the twenty-six weeks ended July 29, 2014, compared to $82.8 million for the corresponding prior year period. The increase in the amount of store and warehouse occupancy costs during the twenty-six weeks ended July 29, 2014 was mainly attributable to the increase in the number of stores we operated and the warehouse operations in a number of new markets opened during the previous fifty-two week period. Store and warehouse occupancy costs as a percentage of net sales decreased to 14.2% during the twenty-six weeks ended July 29, 2014, compared to 14.3% during the twenty-six weeks ended July 30, 2013. The decrease in store and warehouse occupancy costs as a percentage of net sales during the twenty-six weeks ended July 29, 2014 was mostly attributable to leverage generated from comparable-store sales growth in our established markets, which was partially offset by less scale in some of our newer markets. Depreciation expense related to leasehold improvements and other fixed assets used in stores and warehouse operations increased $4.0 million, or 33.7%, to $15.8 million, during the twenty-six weeks ended July 29, 2014, compared to $11.8 million during the twenty-six weeks ended July 30, 2013. The increase in expense was primarily attributable to the increase in the number of stores we operated during the twenty-six weeks ended July 29, 2014, as compared to the comparable prior year period. Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $13.7 million, or 30.5%, to $58.4 million during the twenty-six weeks ended July 29, 2014, compared to $44.7 million during the twenty-six weeks ended July 30, 2013, primarily as a result of the increase in net sales and in the increase in the number of stores we operated during the twenty-six weeks ended July 29, 2014, as compared to the corresponding prior year period. Gross profit from retail operations. As a result of the above, gross profit from retail operations increased $59.4 million, or 26.4%, to $284.3 million during the twenty-six weeks ended July 29, 2014, compared with $224.9 million during the twenty-six weeks ended July 30, 2013. Gross profit from retail operations as a percentage of net sales decreased to 38.2% during the twenty-six weeks ended July 29, 2014, as compared to 38.9% during the twenty-six weeks ended July 30, 2013, for the reasons discussed above. Franchise fees and royalty income. Franchise fees and royalty income decreased $0.4 million, or 15.2%, to $2.3 million for the twenty-six weeks ended July 29, 2014, compared to $2.7 million during the corresponding prior year period. The decrease in income was primarily a result of our acquisitions of certain formerly franchised operations, as described above. Sales and marketing expenses. Sales and marketing expenses increased $36.2 million, or 25.9%, to $175.7 million during the twenty-six weeks ended July 29, 2014, compared to $139.5 million during the twenty-six weeks ended July 30, 2013. Sales and marketing expenses as a percentage of net sales decreased to 23.6% during the twenty-six weeks ended July 29, 2014, compared to 24.1% during the twenty-six weeks ended July 30, 2013. The components of sales and marketing expenses are explained below. Advertising expense increased $11.2 million, or 21.6%, to $63.3 million during the twenty-six weeks ended July 29, 2014, from $52.1 million during the twenty-six weeks ended July 30, 2013. The increase in the amount of advertising spend was mainly attributable to increased spending to enhance our market share in many of our established markets and, to a lesser extent, our expansion into new markets. Advertising expense as a percentage of net sales decreased to 8.5% 27 -------------------------------------------------------------------------------- Table of Contents during the twenty-six weeks ended July 29, 2014, compared to 9.0% during the twenty-six weeks ended July 30, 2013, primarily due to generating greater leverage from the increase in net sales in certain markets. We receive funds from time to time from certain vendors for the advertisement of their products, and we recognize these funds as a direct reduction of advertising expense. The amount of vendor advertising funds that were recognized as a reduction of advertising expense totaled $4.6 million during the twenty-six weeks ended July 29, 2014, compared with $3.6 million during the twenty-six weeks ended July 30, 2013. Other sales and marketing expenses, consisting mainly of salesman compensation costs, but also including costs incurred to accept payments from our customers, such as credit card and third party finance fees, increased $24.9 million, or 28.5%, to $112.3 million during the twenty-six weeks ended July 29, 2014, compared to $87.4 million during the twenty-six weeks ended July 30, 2013, primarily as a result of the increase in net sales during the period. Other sales and marketing expenses as a percentage of net sales remained flat at 15.1% during both the twenty-six weeks ended July 29, 2014 and July 30, 2013. General and administrative expenses. General and administrative expenses increased $28.7 million, or 73.6%, to $67.6 million for the twenty-six weeks ended July 29, 2014, compared to $38.9 million for the twenty-six weeks ended July 30, 2013. The increase in general and administrative expenses was primarily a result of our growth, including a $13.5 million increase in wages, benefits and stock-based compensation resulting from employee additions to our corporate office, a $10.3 million increase in acquisition-related costs, a $1.2 million increase in ERP implementation training costs and a $3.7 million increase in various other general and administrative expense categories. General and administrative expenses as a percentage of net sales increased to 9.1% during the twenty-six weeks ended July 29, 2014, compared to 6.7% for the comparable prior year period. The increase in general and administrative expenses as a percentage of net sales is primarily due to the increase in acquisition-related costs noted above, an increase in cost of administrative labor as a percentage of net sales and increases in various other areas. General and administrative expenses for the twenty-six weeks ended July 29, 2014 and July 30, 2013 included $15.1 million and $2.3 million, respectively, of acquisition-related costs, ERP implementation training costs, and impairment and severance charges. We expect to continue making investments in our corporate infrastructure commensurate with our growth strategy. Loss on store closings and impairment of store assets. Loss on store closings and impairment of store assets increased $0.2 million to $0.9 million during the twenty-six weeks ended July 29, 2014, compared to $0.7 million for the thirteen weeks ended July 30, 2013, primarily as a result of an increase of $0.5 million in store-level fixed asset impairment charges over the prior year period, offset by a decrease of $0.3 million in the amount of remaining lease commitments on stores that we closed during respective periods. Other expense, net. Other expense, net, for both periods consisted primarily of interest expense. Interest expense increased $0.7 million, or 11.4%, to $6.3 million during the twenty-six weeks ended July 29, 2014, compared to $5.6 million during the twenty-six weeks ended July 30, 2013, primarily as a result of an increase in term and revolver borrowings as compared to the prior year period. Income tax expense. We recognized $14.1 million of income tax expense during the twenty-six weeks ended July 29, 2014, compared to $16.6 million of income tax expense during the twenty-six weeks ended July 30, 2013. The effective tax rate was 39.0% during the twenty-six weeks ended July 29, 2014, compared to 38.9% during the twenty-six weeks ended July 30, 2013. Our estimated full year effective tax rate for Fiscal 2013 is 39.0%, which is above the federal statutory rate of 35.0% primarily due to state income taxes. Net income. As a result of the above, our net income was $22.0 million during the twenty-six weeks ended July 29, 2014 compared to $26.1 million during the twenty-six weeks ended July 30, 2013. Off-Balance Sheet Arrangements Except for a guarantee of approximately $0.7 million that we have provided with respect to one real estate lease of a franchisee, we do not have any "off-balance sheet arrangements" (as such term is defined in Item 303 of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. 28 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources The following table summarizes the principal elements of our cash flows (in thousands): Twenty-Six Weeks Ended July 30, July 29, 2013 2014 Total cash provided by (used in): Operating activities $ 40,664 $ 58,269 Investing activities (29,928) (141,566) Financing activities (18,922) 78,562 Net decrease in cash and cash equivalents (8,186) (4,735) Cash and cash equivalents, beginning of period 14,556 22,878 Cash and cash equivalents, end of period $ 6,370 $ 18,143 Operating cash flows. Net cash provided by operating activities was $58.3 million for the twenty-six weeks ended July 29, 2014, compared to $40.7 million for the twenty-six weeks ended July 30, 2013. The $17.6 million increase in cash flows from operating activities as compared to the prior year period was primarily due to changes in operating assets and liabilities related to normal fluctuations in the timing of cash collections and cash requirements which generated an additional $15.8 million in cash. Although net income decreased by $4.1 million from the twenty-six weeks ended July 29, 2014 compared to the twenty-six weeks ended July 30, 2013, the add-back of non-cash charges such as depreciation expense resulted in an additional $5.9 million increase resulting in a net increase to cash of $1.8 million. Investing cash flows. Net cash used in investing activities was $141.6 million for the twenty-six weeks ended July 29, 2014, compared to net cash used of $29.9 million for the twenty-six weeks ended July 30, 2013. The $111.7 million increase was primarily due to a $104.9 million increase in cash used for acquisitions during the twenty-six weeks ended July 29, 2014. In addition, capital expenditures increased $6.8 million primarily due to new store openings. We opened 109 new stores during the twenty-six weeks ended July 29, 2014, compared to 81 new stores in the twenty-six weeks ended July 30, 2013. Financing cash flows. Net cash provided by financing activities was $78.6 million for the twenty-six weeks ended July 29, 2014, compared to net cash used of $18.9 million for the twenty-six weeks ended July 30, 2013. The $97.5 million increase in cash provided by financing activities was primarily the result of net increased borrowings under the 2012 Senior Credit Facility of $96.2 million which were used to finance acquisitions, an increase of $0.8 million of cash provided by the exercise of common stock options, and a $0.5 million increase of cash provided by the excess tax benefits associated with stock-based awards. Covenant Compliance The 2012 Senior Credit Facility requires us to comply on a quarterly basis with financial covenants, including a maximum total leverage ratio and a minimum interest coverage ratio. These financial covenants are measured using, among other things, Adjusted EBITDA of Mattress Holding Corp. and its subsidiaries, as adjusted to include pro forma results of acquisitions. At July 29, 2014, there were no outstanding revolver borrowings under the 2012 Senior Credit Facility. There were standby letters of credit outstanding in the amount of $1.6 million and additional borrowing capacity of $98.4 million. For more information about the restrictive covenants imposed on us by the 2012 Senior Credit Facility, please see "Risk Factors" in our Fiscal 2013 Annual Report. We were in compliance with all of the financial covenants required under the 2012 Senior Credit Facility as of July 29, 2014. We believe that we will be able to maintain compliance with the various covenants required under our debt facilities for the next twelve months without amending the credit facility or requesting waivers from the lenders that are party to the agreement. 29 -------------------------------------------------------------------------------- Table of Contents Seasonality Our business is subject to seasonal fluctuations. We generally have experienced more sales and a greater portion of income during the second and third quarters of our fiscal year due to a concentration of summer season holidays, including Memorial Day, the Fourth of July and Labor Day, and other seasonal factors. Adjusted EBITDA to Net Income Reconciliation Adjusted EBITDA is defined as net income before income tax expense, interest income, interest expense, depreciation and amortization ("EBITDA"), without giving effect to non-cash goodwill and intangible asset impairment charges, gains or losses on store closings and impairment of store assets, gains or losses related to the early extinguishment of debt, financial sponsor fees and expenses, non-cash charges related to stock-based awards and other items that are excluded by management in reviewing the results of operations. We have presented Adjusted EBITDA because we believe that the exclusion of these items is appropriate to provide additional information to investors about our ongoing operating performance excluding certain non-cash and other items and to provide additional information with respect to our ability to comply with various covenants in documents governing our indebtedness and as a means to evaluate our period-to-period results. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed to imply that our future results will be unaffected by any such adjustments. We have provided this information to analysts, investors and other third parties to enable them to perform more meaningful comparisons of past, present and future operating results and as a means to evaluate the results of our ongoing operations. Management also uses Adjusted EBITDA to determine executive incentive compensation payment levels. In addition, our compliance with certain covenants under our 2012 Senior Credit Facility that are calculated based on similar measures and differ from Adjusted EBITDA primarily by the inclusion of pro forma results for acquired businesses in those similar measures. Other companies in our industry may calculate Adjusted EBITDA differently than we do. Adjusted EBITDA is not a measure of performance under U.S. GAAP and should not be considered as a substitute for net income prepared in accordance with U.S. GAAP. Adjusted EBITDA has significant limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under U.S. GAAP. Some of the additional limitations to the use of Adjusted EBITDA are: · Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments; · Adjusted EBITDA does not reflect interest expense or the cash requirements necessary to service interest or principal payments on our debt; · Adjusted EBITDA does not reflect tax expense or the cash requirements necessary to pay for tax obligations; · Although depreciation and amortization are non-cash charges, the asset being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements; · Adjusted EBITDA does not reflect the cash requirements of closing underperforming stores; and · Adjusted EBITDA does not reflect certain other costs that may recur in future periods. 30 -------------------------------------------------------------------------------- Table of Contents We compensate for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only as a supplemental measure. The following table contains a reconciliation of our net income determined in accordance with U.S. GAAP to EBITDA and Adjusted EBITDA for the periods indicated (in thousands): Thirteen Weeks Ended Twenty-Six Weeks Ended July 30, July 29, July 30, July 29, 2013 2014 2013 2014 Net income $ 14,123 $ 14,299 $ 26,132 $ 22,019 Income tax expense 8,965 9,194 16,639 14,085 Interest expense, net 2,795 3,469 5,642 6,285 Depreciation and amortization 7,231 9,509 13,441 18,201 Intangible assets and other amortization 612 848 1,153 1,611 EBITDA 33,726 37,319 63,007 62,201 Loss on store closings and impairment of store assets 483 648 744 906 Stock-based compensation 967 1,198 1,854 2,556 Vendor new store funds(a) 96 (346) 983 (443) Acquisition-related expenses(b) 124 7,193 450 9,757 Other(c) 607 3,184 1,188 4,970 Adjusted EBITDA $ 36,003 $ 49,196 $ 68,226 $ 79,947 -------------------------------------------------------------------------------- (a) We receive cash payments from certain vendors for each new incremental store that we open ("new store funds"). New store funds are initially recorded in other noncurrent liabilities when received and are then amortized as a reduction of cost of sales over 36 months in our financial statements. Historically, we have considered new store funds as a component of Adjusted EBITDA when received since new store funds are included in cash provided from operations. The adjustment includes the amount of new store funds received during the period presented and eliminates the non-cash reduction in cost of sales included in our results of operations. (b) Reflects both non-cash effects included in net income related to acquisition accounting adjustments made to inventories and other acquisition-related cash costs included in net income, such as direct acquisition costs and costs related to integration of acquired businesses. (c) Consists of various items that management excludes in reviewing the results of operations, including $1.6 million and $0.6 million of ERP system implementation costs incurred during the thirteen weeks ended July 29, 2014 and July 30, 2013, respectively, and $2.9 million and $1.2 million of cost incurred during the twenty-six weeks ended July 29, 2014 and July 30, 2013, respectively. 31 -------------------------------------------------------------------------------- Table of Contents Reconciliation of Reported (U.S. GAAP) to Adjusted Statements of Operations Data (In thousands, except share and per share amounts) The following table provides a reconciliation of our "As Adjusted" statements of operations data for the thirteen and twenty-six weeks ended July 30, 2013 and July 29, 2014 with the most directly comparable financial measures in our "As Reported", or U.S. GAAP, statements of operations data. Our "As Adjusted" data is considered a non-U.S. GAAP financial measure and is not in accordance with, or preferable to, "As Reported," or U.S. GAAP, financial data. However, we are providing this information as we believe it may enhance year-over-year comparisons for investors and financial analysts. Thirteen Weeks Ended July 30, 2013 July 29, 2014 Income Before Diluted Income Before Diluted Income From Income Net Weighted Income From Income Net Weighted Operations Taxes Income Shares Diluted EPS* Operations Taxes Income Shares Diluted EPS* As Reported $ 25,883 $ 23,088 $ 14,123 34,149,640 $ 0.41 $ 26,962 $ 23,493 $ 14,299 34,523,620 $ 0.41 % of sales 8.6 % 7.6 % 4.7 % 6.6 % 5.7 % 3.5 % Acquisition-related costs (1) 124 124 75 - 7,691 7,691 4,695 0.14 ERP system implementation costs (2) 894 894 547 0.02 1,738 1,738 1,060 0.03 Other (3) - - - - 1,636 1,636 999 0.03 Total adjustments 1,018 1,018 622 - 0.02 11,065 11,065 6,754 - 0.20 As Adjusted $ 26,901 $ 24,106 $ 14,745 34,149,640 $ 0.43 $ 38,027 $ 34,558 $ 21,053 34,523,620 $ 0.61 % of sales 8.9 % 8.0 % 4.9 % 9.3 % 8.4 % 5.1 % Twenty-Six Weeks Ended July 30, 2013 July 29, 2014 Income Before Diluted Income Before Diluted Income From Income Net Weighted Income From Income Net Weighted Operations Taxes Income Shares Diluted EPS* Operations Taxes Income Shares Diluted EPS* As Reported $ 48,413 $ 42,771 $ 26,132 34,076,567 $ 0.77 $ 42,389 $ 36,104 $ 22,019 34,464,038 $ 0.64 % of sales 8.4 % 7.4 % 4.5 % 5.7 % 4.9 % 3.0 % Acquisition-related costs (1) 450 450 276 0.01 10,701 10,701 6,540 0.19 ERP system implementation costs (2) 1,845 1,845 1,131 0.03 3,089 3,089 1,888 0.05 Other (3) - - - - 1,833 1,833 1,120 0.03 Total adjustments 2,295 2,295 1,407 - 0.04 15,623 15,623 9,548 - 0.28 As Adjusted $ 50,708 $ 45,066 $ 27,539 34,076,567 $ 0.81 $ 58,012 $ 51,727 $ 31,567 34,464,038 $ 0.92 % of sales 8.8 % 7.8 % 4.8 % 7.8 % 7.0 % 4.2 % -------------------------------------------------------------------------------- *Due to rounding to the nearest cent, totals may not equal the sum of the lines in the table above. (1) Acquisition-related costs, which are included in the "As Reported" results of operations, consist of acquisition-related costs as defined under U.S. GAAP, including advisory, legal, accounting, valuation, and other professional or consulting fees and, in addition, costs of integrating store and warehouse operations and corporate functions that are not expected to recur as acquisitions are absorbed. On May 2, 2012, we acquired all of the equity interests of MGHC Holding Corporation ("Mattress Giant"), including 181 mattress specialty retail stores. On September 25, 2012, we acquired the assets and operations of Mattress XPress, Inc. and Mattress XPress of Georgia, Inc. (collectively, "Mattress X-Press"), including 34 mattress specialty retail stores. On December 11, 2012, we acquired the assets and operations of Factory Mattress & Water Bed Outlet of Charlotte, Inc. ("Mattress Source"), including 27 mattress specialty retail stores. On June 14, 2013, we acquired the assets and operations of Olejo, Inc., an online retailer primarily focused on mattresses and bedding-related products. On November 13, 2013, we acquired the equity interests of NE Mattress People, LLC ("Mattress People"), including five mattress specialty retail stores. On December 10, 2013, we acquired the assets and operations of Perfect Mattress of Wisconsin, LLC ("Perfect Mattress"), including 39 mattress specialty retail stores. On December 31, 2013, we acquired the assets and operations of two mattress specialty retail stores in Houston, Texas ("Mattress Expo"). On March 3, 2014, we acquired the assets and operations of Yotes, Inc. ("Yotes"), including 34 mattress specialty retail stores. On March 3, 2014, we acquired the Virginia assets and operations of Southern Max LLC ("Southern Max"), including three mattress specialty retail stores. On April 3, 2014, we acquired the outstanding partnership interests in Sleep Experts Partners, L.P. ("Sleep Experts"), including 55 mattress specialty retail stores. On June 4, 2014, we acquired substantially all of the mattress specialty retail assets and operations of Mattress Liquidators, Inc., including 67 mattress specialty retail stores, which operated Mattress King retail stores in Colorado and BedMart retail stores in Arizona. Acquisition-related costs, consisting of direct transaction costs and integration cost,s are included in the results of operations as incurred. We incurred approximately $7.7 million and $0.1 million of acquisition-related costs during the thirteen weeks ended July 29, 2014 and July 30, 2013, respectively. We incurred approximately $10.7 million and $0.5 million of acquisition-related costs during the twenty-six weeks ended July 29, 2014 and July 30, 2013, respectively. (2) Reflects implementation costs included in the results of operations as incurred, consisting primarily of training-related costs, related to the roll-out of the Microsoft Dynamics AX for Retail ERP system. During the thirteen weeks ended July 29, 2014 and July 30, 2013, we incurred approximately $1.7 million and $0.9 million, respectively, of ERP system implementation costs. During the twenty-six weeks ended July 29, 2014 and July 30, 2013, we incurred approximately $3.1 million and $1.8 million, respectively, of ERP system implementation costs. (3) Reflects expensed legal fees relating to our February 2014 debt amendment and extension recorded in the thirteen weeks ended April 29, 2014, and an impairment of store assets and severance expense resulting from the Company's realignment of its management structure at the beginning of the second fiscal quarter recorded in the thirteen weeks ended July 29, 2014. . 32 -------------------------------------------------------------------------------- Table of Contents |