10-Q 1 a2211139z10-q.htm 10-Q
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549



FORM 10-Q


ý

 

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

For the quarterly period ended: August 26, 2012

o

 

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

For the Transition Period from                to

Commission file number 001-08738



SEALY CORPORATION
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation)
  36-3284147
(I.R.S. Employer Identification No.)

Sealy Drive One Office Parkway
Trinity, North Carolina

(Address of principal executive offices)

 

27370
(Zip Code)

(336) 861-3500
Registrant's telephone number, including area code



        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý    No o

        Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer o   Accelerated filer ý   Non-accelerated filer o
(Do not check if a
smaller reporting company)
  Smaller reporting company o

        Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

        The number of shares of the registrant's common stock outstanding as of September 20, 2012 is approximately: 104,082,411.

   



PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements


SEALY CORPORATION

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

 
  Three Months Ended  
 
  August 26,
2012
  August 28,
2011
 

Net sales

  $ 365,434   $ 334,067  

Cost of goods sold

    217,229     197,067  
           

Gross profit

    148,205     137,000  

Selling, general and administrative expenses

   
120,632
   
104,127
 

Amortization expense

    73     73  

Royalty income, net of royalty expense

    (5,105 )   (5,021 )
           

Income from operations

    32,605     37,821  

Interest expense

   
20,929
   
21,935
 

Refinancing and extinguishment of debt

    416     28  

Other income, net

    (131 )   (130 )
           

Income before income taxes

    11,391     15,988  

Income tax provision

    12,156     9,556  

Equity in earnings of unconsolidated affiliates

    875     1,057  
           

Income from continuing operations

    110     7,489  

Loss from discontinued operations

    (307 )   (891 )
           

Net (loss) income

    (197 )   6,598  

Net loss attributable to noncontrolling interests

    91      
           

Net (loss) income attributable to common shareholders

  $ (106 ) $ 6,598  
           

Earnings (loss) per common share attributable to common shareholders—Basic

             

Income from continuing operations per common share

  $   $ 0.07  

Loss from discontinued operations per common share

         
           

Earnings (loss) per common share attributable to common shareholders—Basic

  $   $ 0.07  
           

Earnings (loss) per common share attributable to common shareholders—Diluted

             

Income from continuing operations per common share

  $   $ 0.04  

Loss from discontinued operations per common share

         
           

Earnings (loss) per common share attributable to common shareholders—Diluted

  $   $ 0.04  
           

Weighted average number of common shares outstanding:

             

Basic

    103,534     100,334  

Diluted

    109,800     308,566  

   

See accompanying notes to Condensed Consolidated Financial Statements.

1



SEALY CORPORATION

Condensed Consolidated Statements of Operations (Continued)

(in thousands, except per share data)

(unaudited)

 
  Nine Months Ended  
 
  August 26,
2012
  August 28,
2011
 

Net sales

  $ 989,755   $ 960,892  

Cost of goods sold

    592,155     580,314  
           

Gross profit

    397,600     380,578  

Selling, general and administrative expenses

   
327,254
   
315,308
 

Amortization expense

    217     217  

Royalty income, net of royalty expense

    (14,425 )   (14,796 )
           

Income from operations

    84,554     79,849  

Interest expense

   
65,554
   
65,309
 

Refinancing and extinguishment of debt

    3,341     1,264  

Other income, net

    (410 )   (337 )
           

Income before income taxes

    16,069     13,613  

Income tax provision

    14,821     7,779  

Equity in earnings of unconsolidated affiliates

    3,283     2,535  
           

Income from continuing operations

    4,531     8,369  

Loss from discontinued operations

    (1,814 )   (3,050 )
           

Net income

    2,717     5,319  

Net loss attributable to noncontrolling interests

    91      
           

Net income attributable to common shareholders

  $ 2,808   $ 5,319  
           

Earnings per common share attributable to common shareholders—Basic

             

Income from continuing operations per common share

  $ 0.05   $ 0.08  

Loss from discontinued operations per common share

    (0.02 )   (0.03 )
           

Earnings per common share attributable to common shareholders—Basic

  $ 0.03   $ 0.05  
           

Earnings per common share attributable to common shareholders—Diluted

             

Income from continuing operations per common share

  $ 0.04   $ 0.08  

Loss from discontinued operations per common share

    (0.02 )   (0.01 )
           

Earnings per common share attributable to common shareholders—Diluted

  $ 0.02   $ 0.07  
           

Weighted average number of common shares outstanding:

             

Basic

    101,849     98,725  

Diluted

    109,329     304,659  

   

See accompanying notes to Condensed Consolidated Financial Statements.

2



SEALY CORPORATION

Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)

(unaudited)

 
  August 26,
2012
  November 27,
2011
 

ASSETS

             

Current assets:

             

Cash and equivalents

  $ 88,833   $ 107,975  

Accounts receivable (net of allowance for doubtful accounts, discounts and returns, 2012—$31,390; 2011—$30,104)

    177,954     126,494  

Inventories

    70,819     57,002  

Other current assets

    21,345     29,275  

Deferred income tax assets

    21,770     21,349  
           

Total current assets

    380,721     342,095  
           

Property, plant and equipment

    418,124     406,115  

Less accumulated depreciation

    (253,445 )   (239,370 )
           

    164,679     166,745  
           

Goodwill

    363,305     361,026  

Intangible assets, net

    16,001     1,116  

Deferred income tax assets

    1,377     1,772  

Other assets, including debt issuance costs, net

    45,426     46,440  
           

    426,109     410,354  
           

Total assets

  $ 971,509   $ 919,194  
           

LIABILITIES AND STOCKHOLDERS' DEFICIT

             

Current liabilities:

             

Current portion—long-term obligations

  $ 2,324   $ 1,584  

Accounts payable

    96,184     68,774  

Accrued incentives and advertising

    29,267     26,038  

Accrued compensation

    26,224     17,601  

Accrued interest

    15,369     14,074  

Other accrued liabilities

    32,516     28,426  
           

Total current liabilities

    201,884     156,497  
           

Long-term obligations, net of current portion

    758,204     790,297  

Other liabilities

    51,927     52,415  

Deferred income tax liabilities

    326     549  

Redeemable noncontrolling interest

   
12,131
   
 

Stockholders' deficit:

             

Common stock, $0.01 par value; Authorized 600,000 shares Issued and outstanding: 2012—104,066; 2011—100,916

    1,043     1,010  

Additional paid-in capital

    953,598     935,512  

Treasury stock, at cost: 2012—102; 2011—0

    (180 )    

Accumulated deficit

    (1,013,769 )   (1,016,577 )

Accumulated other comprehensive income (loss), net

    6,345     (509 )
           

Total stockholders' deficit

    (52,963 )   (80,564 )
           

Total liabilities and stockholders' deficit

  $ 971,509   $ 919,194  
           

   

See accompanying notes to Condensed Consolidated Financial Statements.

3



SEALY CORPORATION

Condensed Consolidated Statement of Stockholders' Deficit

(in thousands)

(unaudited)

 
   
  Common Stock    
   
   
  Accumulated
Other
Comprehensive
Income (Loss)
   
 
 
  Comprehensive
Income (Loss)
  Additional
Paid-in
Capital
  Treasury
Stock
  Accumulated
Deficit
   
 
 
  Shares   Amount   Total  

Balance at November 27, 2011

          100,916   $ 1,010   $ 935,512   $   $ (1,016,577 ) $ (509 ) $ (80,564 )

Net income attributable to common shareholders

    2,808                             2,808           2,808  

Foreign currency translation adjustment

    7,623                                   7,623     7,623  

Adjustment to defined benefit plan liability, net of tax of $243

    335                                   335     335  

Change in fair value of cash flow hedges, net of tax of $704

    (1,104 )                                 (1,104 )   (1,104 )

Share-based compensation

                      6,566                       6,566  

Exercise of stock options

          40     2     62                       64  

Vesting of restricted share units, net

          3,110     31     (2,938 )                     (2,907 )

Treasury shares repurchased

                      180     (180 )                

Excess tax benefit on share based awards

                      (552 )                     (552 )

Beneficial conversion features on Convertible Paid in Kind Notes

                      14,768                       14,768  
                                   

Balance at August 26, 2012

  $ 9,662     104,066   $ 1,043   $ 953,598   $ (180 ) $ (1,013,769 ) $ 6,345   $ (52,963 )
                                   

   

See accompanying notes to Condensed Consolidated Financial Statements.

4



SEALY CORPORATION

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 
  Nine Months Ended  
 
  August 26,
2012
  August 28,
2011
 

Operating activities:

             

Net income

  $ 2,717   $ 5,319  

Adjustments to reconcile net income to cash provided by (used in) operating activities:

             

Depreciation and amortization

    18,753     18,001  

Deferred income taxes

    348     946  

Amortization of deferred gain on sale-leaseback

    (260 )   (515 )

Paid in kind interest on convertible notes

    17,064     14,551  

Amortization of discount on new senior secured notes

    1,250     1,101  

Amortization of debt issuance costs and other

    3,139     3,511  

Impairment charges

        288  

Share-based compensation

    6,566     9,239  

Loss (gain) on sale of assets

    197     (30 )

Write-off of debt issuance costs related to debt extinguishments

    1,862     643  

Loss on repurchase of senior notes

    1,050     300  

Dividends received from unconsolidated affiliates

    2,500     1,011  

Equity in earnings of unconsolidated affiliates

    (3,283 )   (2,535 )

Loss on disposition of subsidiary

        206  

Other, net

    (2,252 )   (532 )

Changes in operating assets and liabilities:

             

Accounts receivable

    (45,686 )   (29,787 )

Inventories

    (20,201 )   (1,224 )

Other current assets

    6,554     (2,750 )

Other assets

    482     2,361  

Accounts payable

    25,321     9,255  

Accrued expenses

    15,101     (20,338 )

Other liabilities

    180     (2,159 )
           

Net cash provided by operating activities

    31,402     6,862  
           

Investing activities:

             

Purchase of property, plant and equipment

    (10,011 )   (17,692 )

Acquisition of Comfort Revolution, inclusive of cash acquired of $159

    159      

Proceeds from sale of property, plant and equipment

    2,544     24  
           

Net cash used in investing activities

    (7,308 )   (17,668 )
           

Financing activities:

             

Proceeds from issuance of long-term obligations

    1,269     2,568  

Repayments of long-term obligations

    (9,009 )   (3,882 )

Repayment of senior secured notes, including premium of $1,050

    (36,050 )   (10,300 )

Repurchase of common stock associated with vesting of employee share-based awards

    (2,905 )   (3,674 )

Exercise of employee stock options

    62     621  

Debt issuance costs

    (1,120 )   (147 )

Other

        (34 )
           

Net cash used in financing activities

    (47,753 )   (14,848 )
           

Effect of exchange rate changes on cash

    4,517     2,333  
           

Change in cash and equivalents

    (19,142 )   (23,321 )

Cash and equivalents:

             

Beginning of period

    107,975     109,255  
           

End of period

  $ 88,833   $ 85,934  
           

Noncash investing transaction:

             

Investment in Comfort Revolution

  $ 10,000   $  

Inventory items transferred to property, plant and equipment

  $ 8,454   $  

   

See accompanying notes to Condensed Consolidated Financial Statements.

5



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1: Basis of Presentation and Significant Accounting Policies

        The interim Condensed Consolidated Financial Statements are unaudited, and certain related information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with Rule 10-01 of Regulation S-X. The accompanying interim Condensed Consolidated Financial Statements were prepared following the same policies and procedures used in the preparation of the annual financial statements and reflect all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position of Sealy Corporation and its subsidiaries (collectively, the "Company"). The results of operations for the interim periods are not necessarily indicative of the results for the fiscal year. Our third fiscal quarter sales are typically 5% to 15% higher than other fiscal quarters. These Condensed Consolidated Financial Statements should be read in conjunction with the annual consolidated financial statements for the year ended November 27, 2011 included within the Company's Annual Report on Form 10-K (File No. 001-08738).

        At August 26, 2012, affiliates of Kohlberg Kravis Roberts & Co. L.P. ("KKR") controlled approximately 44.8% of the issued and outstanding common stock of the Company.

        The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the amount of assets and liabilities and disclosures on contingent assets and liabilities at period end and the reported amounts of revenue and expenses during the reporting period. Actual results may differ from these estimates.

    Principles of Consolidation

        The Company evaluates, at inception, each investment to determine if it qualifies as a variable interest entity ("VIE") under the authoritative guidance for consolidations. A variable interest entity is an entity used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors who are not required to provide sufficient financial resources for the entity to support is activities without additional subordinated financial support. Upon the occurrence of certain events outlined in the FASB's consolidation guidance, the Company reassesses its initial determination of whether the investment is a VIE.

        The Company also evaluates whether it is the primary beneficiary of each VIE and consolidates the VIE if the Company has both (a) the power to direct the economically significant activities of the entity and (b) the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE. The Company considers the contractual agreement that define ownership structure, distribution of profits and losses, risks, responsibilities, indebtedness, voting rights and board representation of the respective parties in determining whether it qualifies as the primary beneficiary. The Company also considers all parties that have direct or implicit variable interests when determining whether it is the primary beneficiary. When the Company is determined to be the primary beneficiary, the VIE is consolidated. As required by the Financial Accounting Standard Board's (the "FASB") consolidation guidance, the assessment of whether the Company is the primary beneficiary of the VIE is continuously performed.

        On June 13, 2012, the Company acquired a 45% ownership interest in Comfort Revolution International, LLC ("Comfort Revolution"), a joint venture with Comfort Revolution, LLC ("CR

6



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 1: Basis of Presentation and Significant Accounting Policies (Continued)

Member"). Upon review of the FASB authoritative guidance for consolidation, the Company determined that Comfort Revolution constitutes a VIE for which the Company is considered to be the primary beneficiary due, primarily, to the Company's disproportionate share of the economic risk associated with its equity contribution and debt financing. As of August 26, 2012, the Company had recorded net assets of $9.9 million within the accompanying Condensed Consolidated Balance Sheets related to Comfort Revolution. These assets are only able to be used to settle obligations of Comfort Revolution. Further, the creditors of Comfort Revolution do not have recourse to the assets of the Company. Since the Company is considered to be the primary beneficiary, the financial statements of Comfort Revolution are consolidated herein.

        Due to the difference in Comfort Revolution's fiscal year, which ends on December 31, and the availability of financial statements from Comfort Revolution, the results of Comfort Revolution are presented on a two month lag. As such, for the three and nine month periods ended August 26, 2012, the results of Comfort Revolution are included from the acquisition date through June 30, 2012.

        The Company also invests in a group of joint ventures which were formed to develop markets for Sealy branded products in Asia, New Zealand and India. The Company has concluded that these entities do not qualify as VIEs and are accounted for as equity method investments since the Company is deemed to have significant influence but does not have effective control of the entities.

    Promotional Displays

        The Company invests in promotional displays in certain retail stores for certain products to demonstrate product features and specifications. These assets are owned by the Company and are considered to be productive assets which provide the benefits described above. The Company's investment in promotional displays is carried at cost less accumulated depreciation. Depreciation is provided by the straight line method for each display over a period of two years, which represents the estimated period of the benefit provided by these assets. Promotional displays of $9.8 million and related accumulated depreciation of $1.8 million as of August 26, 2012 were recognized as a component of property, plant and equipment and accumulated depreciation, respectively in the Condensed Consolidated Balance Sheets. Depreciation expense related to these displays for the three and nine months ended August 26, 2012 was $0.6 million and $1.0 million, respectively and is recorded as a component of selling, general and administrative expense in the Condensed Consolidated Statement of Operations.

        The Company's significant accounting policies are described in Note 1 to the annual consolidated financial statements for the year ended November 27, 2011 within the Company's Annual Report on Form 10-K.

Note 2: Recently Issued Authoritative Accounting Guidance

        In January 2010, the FASB issued authoritative guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The Company adopted the portion of this guidance that requires a gross reporting of purchases, sales, issuance and settlements of assets and liabilities measured using Level 3 fair value measurements in the first quarter of fiscal 2012. The

7



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 2: Recently Issued Authoritative Accounting Guidance (Continued)

adoption of this guidance did not have a significant impact on the financial statements due to the immateriality of the Company's assets and liabilities measured using a Level 3 fair value measurement.

        In December 2010, the FASB issued authoritative guidance that modifies the requirements of step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. The Company adopted this guidance in the first quarter of fiscal 2012. The adoption of this guidance did not have a significant impact on the financial statements of the Company due to the conclusion that it is more likely than not that the goodwill of reporting units with negative carrying values are not impaired.

        In May 2011, the FASB issued authoritative guidance to improve the consistency of fair value measurement and disclosure requirements between US GAAP and International Financial Reporting Standards ("IFRS"). The provisions of this guidance change certain of the fair value principles related to the highest and best use premise, the consideration of blockage factors and other premiums and discounts, the measurement of financial instruments held in a portfolio and instruments classified within shareholders' equity. Further, the guidance provides additional disclosure requirements surrounding Level 3 fair value measurements, the uses of nonfinancial assets in certain circumstances and identification of the level in the fair value hierarchy used for assets and liabilities which are not recorded at fair value, but where fair value is disclosed. The Company adopted this guidance in the second quarter of fiscal 2012. The adoption of this guidance did not have a significant impact on the Company's financial statements.

        In June 2011, the FASB issued authoritative guidance surrounding the presentation of comprehensive income, with an objective of increasing the prominence of items reported in other comprehensive income ("OCI"). This guidance provides entities with the option to present the total of comprehensive income, the components of net income and the components of OCI in either a single continuous statement of comprehensive income or in two separate but consecutive statements. In addition, entities must present on the face of the financial statement, items reclassified from OCI to net income in the section of the financial statement where the components of net income and OCI are presented, regardless of the option selected to present comprehensive income. The guidance is applicable retrospectively and is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. Early adoption is permitted. The Company will adopt this guidance in the first quarter of fiscal 2013, and is currently evaluating its options for the presentation of comprehensive income upon adoption.

        In September 2011, the FASB issued authoritative guidance that permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. The Company plans to adopt this guidance in the fourth quarter of fiscal 2012 in connection with its annual testing of goodwill for impairment.

        In September 2011, the FASB issued authoritative guidance that increases the Company's disclosures surrounding the multiemployer pension plans in which it participates by providing users with additional information to 1) assess the potential future cash flow implications relating to the Company's participation in these plans and 2) indicate the financial health of all of the significant plans in which the Company participates. The Company will adopt this guidance in the fourth quarter of fiscal 2012.

8



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 2: Recently Issued Authoritative Accounting Guidance (Continued)

The adoption of this guidance will increase the Company's disclosures surrounding its participation in multiemployer pension plans.

Note 3: Share-Based Compensation

        The Company maintains the 1998 Stock Option Plan ("1998 Plan") and the 2004 Stock Option Plan for Key Employees of Sealy Corporation and its Subsidiaries ("2004 Plan") which are collectively referred to as the "Option Plans". The Company accounts for all new share-based awards granted and outstanding using the fair value based method under FASB authoritative guidance surrounding share-based payments. Total share-based compensation recognized during the three and nine months ended August 26, 2012 and August 28, 2011 was $1.8 million and $6.6 million, respectively, for fiscal 2012 and $3.5 million and $9.2 million, respectively, for fiscal 2011.

Stock Option Awards

        During the three and nine months ended August 26, 2012 and August 28, 2011, the Company granted no new options to purchase shares of its common stock.

        A summary of outstanding options under the 1998 Plan as of August 26, 2012, is presented below:

 
  Shares Subject to Options   Weighted Average
Exercise Price Per Share
 

Outstanding November 27, 2011

    1,508,275   $ 0.99  

Exercised

    (12,002 )   1.40  

Forfeited

    (10,999 )   2.57  
             

Outstanding August 26, 2012 (all fully vested and exercisable)

    1,485,274   $ 0.97  

Weighted average remaining contractual term

   
1.6 years
       

Aggregate intrinsic value of in-the-money options at August 26, 2012 (in thousands)

  $ 1,094        

        A summary of outstanding options under the 2004 Plan as of August 26, 2012, is presented below:

 
  Shares Subject to Options   Weighted Average
Exercise Price Per Share
 

Outstanding November 27, 2011

    5,394,364   $ 5.43  

Exercised

    (28,000 ) $ 1.64  

Forfeited

    (90,872 ) $ 5.45  
             

Outstanding August 26, 2012

    5,275,492   $ 5.45  

Weighted average remaining contractual term

    2.8 years        

Aggregate intrinsic value of in-the-money options (in thousands)

  $ 48        

Exercisable at August 26, 2012

    4,648,431        

Weighted average remaining contractual term

    2.9 years        

Aggregate intrinsic value of in-the-money options (in thousands)

  $ 48        

9



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 3: Share-Based Compensation (Continued)

        As of August 26, 2012, the Company had approximately $0.3 million of unrecognized compensation expense related to stock option awards, which is expected to be recognized over a weighted average period of 1.4 years.

        The Company has granted stock options to employees that have accelerated vesting provisions which take effect if certain performance levels are achieved by the Company. If the Company does not meet these performance targets, then the vesting of the options occurs over the remainder of the requisite service period. As of August 26, 2012, the performance targets for certain of these stock options have not been met. As such, the related unrecognized compensation cost is being recognized over the remainder of the requisite service period.

Restricted Share Unit Awards

        During the three and nine months ended August 26, 2012 and August 28, 2011, the Company approved the following grants of time-based restricted stock units ("RSUs"):

 
  Three months   Nine months  
 
  August 26, 2012   August 28, 2011   August 26, 2012   August 28, 2011  

Number of awards granted

    76,000     50,000     587,456     2,120,156  

Weighted average grant date fair value

  $ 1.83   $ 2.31   $ 1.85   $ 2.64  

        The awards granted in fiscal 2012 and 2011 vest ratably over a requisite service period and do not contain an accretion factor. The fair value of the Company's RSU awards is based on the closing price of the Company's common stock as of the grant date. The Company has outstanding RSU awards of two types: 1) Time-based RSU awards that accrete in the number of RSUs at an annual rate of 8% payable semi-annually until the RSUs are vested or forfeited; and 2) Time-based RSU awards that vest ratably over a requisite service period. Certain of the Company's outstanding RSUs contain dividend participation rights and are considered participating securities for the purposes of calculating the Company's earnings per share. The unrecognized compensation expense for the outstanding unvested RSU awards as of August 26, 2012 is $3,569 (in thousands).

        A summary of restricted share unit award activity for the nine months ended August 26, 2012, is presented below:

 
  Unvested Restricted
Share Units
  Weighted Average Grant
Date Fair Value
 

Outstanding November 27, 2011

    10,728,028   $ 2.16  

Granted

    587,456     1.85  

Vested

    (4,820,324 )   2.03  

Forfeited

    (482,320 )   1.48  
             

Outstanding August 26, 2012

    6,012,840   $ 2.26  

Expected to vest August 26, 2012

    5,703,172     2.27  

Weighted average remaining vesting period

    4.5 years        

10



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 4: Inventories

        The major components of inventories were as follows (in thousands):

 
  August 26, 2012   November 27, 2011  

Raw materials

  $ 29,566   $ 25,635  

Work in process

    24,866     26,056  

Finished goods

    16,387     5,311  
           

  $ 70,819   $ 57,002  
           

Note 5: Warranty Costs

        The Company's warranty policy provides a 10-year non-prorated warranty service period on all currently manufactured Sealy Posturepedic, and Bassett bedding products and certain other Sealy branded products. In addition, the Company is beginning a 20 year, limited warranty (10 year non-prorated and 10 year additional warranty on certain components of its 2012 Optimum by Sealy Posturepedic and Stearns & Foster products. Also, the Company has a 20-year warranty on the major components of its TrueForm and MirrorForm visco-elastic products and its SpringFree latex product, the last ten years of which are prorated on a straight-line basis. Though discontinued in 2008, the Company also offered a 20-year limited warranty on its RightTouch product line which covered only certain parts of the product and will be prorated for part of the twenty years. The Company's policy is to accrue the estimated cost of warranty coverage at the time the sale is recorded. The estimate involves an average lag time in days between the sale of a bed and the date of its return, applied to the current rate of the warranty returns.

        The change in the Company's accrued warranty obligations for each of the nine months ended August 26, 2012 and August 28, 2011 was as follows (in thousands):

 
  August 26, 2012   August 28, 2011  

Accrued warranty obligations at beginning of period

  $ 13,606   $ 17,584  

Warranty claims

    (12,980 )   (11,823 )

Warranty provisions

    15,888     11,238  
           

Accrued warranty obligations at end of period

  $ 16,514   $ 16,999  
           

        As of August 26, 2012 and November 27, 2011, $9.3 million and $7.5 million are included as a component of other accrued liabilities and $7.2 million and $6.1 million are included as a component of other noncurrent liabilities within the accompanying Condensed Consolidated Balance Sheet, respectively. In estimating its warranty obligations, the Company considers the impact of recoverable salvage value on warranty cost in determining its estimate of future warranty obligations. Warranty claims and provisions shown above do not include estimated salvage recoveries that reduced cost of sales by $3.9 million and $3.8 million for the nine months ended August 26, 2012 and the nine months ended August 28, 2011, respectively.

11



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 6: Goodwill and Other Intangible Assets

        The Company performs an annual assessment of its goodwill for impairment as of the beginning of the fiscal fourth quarter. The Company also assesses its goodwill and other intangible assets for impairment when events or circumstances indicate that their carrying value may not be recoverable from future cash flows.

        The changes in the carrying amount of goodwill for the nine months ended August 26, 2012 are as follows (in thousands):

Balance as of November 27, 2011

  $ 361,026  

Additions due to acquisition of Comfort Revolution

    357  

Increase due to foreign currency translation

    1,922  
       

Balance as of August 26, 2012

  $ 363,305  
       

        The Company's intangible assets consist of the following (in thousands):

 
  August 26, 2012   November 27, 2011    
 
 
  Gross Carrying
Amount
  Accumulated
Amortization
  Net Carrying
Amount
  Gross Carrying
Amount
  Accumulated
Amortization
  Net Carrying
Amount
  Weighted
Average
Useful Life
 

Licenses

  $ 4,617   $ (3,716 ) $ 901   $ 4,617   $ (3,501 ) $ 1,116     15.0  

Trademarks

    3,100         3,100                 11.5  

Intellectual property

    3,300         3,300                 9.5  

Customer relationships

    8,700         8,700                 10.5  
                                 

Total intangible assets

  $ 19,717   $ (3,716 ) $ 16,001   $ 4,617   $ (3,501 ) $ 1,116     11.5  
                                 

        Intangible assets with determinable lives are amortized using a straight-line method. Costs to renew or extend the term of a recognized intangible asset are expensed as incurred. During each of the three and nine months ended August 26, 2012 and August 28, 2011, the Company recognized amortization expense associated with intangibles of $0.1 million and $0.2 million, for both fiscal 2011 and fiscal 2010. The Company expects to recognize amortization expense relating to these intangibles of $0.7 million for the remainder of 2012, $1.7 million in 2013, $1.7 million in 2014, $1.7 million in 2015, $1.4 million in 2016 and $8.6 million thereafter.

12



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 7: Debt Issuance Costs

Senior Note Redemptions

        During the nine months ended August 26, 2012 and August 28, 2011, the Company redeemed portions of the principal amount of its outstanding senior secured notes due April 2016 (the "Senior Notes") at a redemption price of 103% of the principal amount of the notes, plus accrued and unpaid interest to the redemption date. The Company did not redeem any of its outstanding Senior Notes during the three months ended August 26, 2012 and August 28, 2011.

 
  Nine Months Ended  
 
  August 26, 2012   August 28, 2011  

Principal amount redeemed

  $ 35,000   $ 10,000  
           

Premium paid to redeem the notes

  $ 1,050   $ 300  

Write-off of related debt issuance costs and original issue discount

    1,862     643  
           

  $ 2,912   $ 943  
           

ABL Revolver Amendment

        On May 9, 2012, the Company amended and restated its existing senior secured asset-based revolving credit facility to extend the stated maturity of this facility until May 2017 and amend certain other provisions. In connection with this amendment, the Company recorded fees of $1.0 million which were deferred and will be amortized over the life of the amended agreement. As of August 26, 2012, $0.3 million of these fees had not yet been paid and were recorded as a component of other accrued liabilities in the accompanying Condensed Consolidated Balance Sheets. In addition, the remaining unamortized debt issuance costs associated with the existing senior revolving credit facility will continue to be amortized over the life of the agreement, as amended, in accordance with the authoritative accounting guidance surrounding debtor's accounting for changes in line-of-credit or revolving-debt arrangements.

Note 8: Unconsolidated Affiliate Companies

        The Company is involved in a group of joint ventures to develop markets for Sealy branded products in Asia. Our ownership interest in these joint ventures is 50% and they are accounted for under the equity method. The Company's share of earnings is recorded in equity in earnings of unconsolidated affiliates in the Condensed Consolidated Statements of Operations.

13



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 8: Unconsolidated Affiliate Companies (Continued)

        Summarized statements of operations for these joint ventures for each of the three and nine month periods ended are as follows (in thousands):

 
  Three months   Nine months  
 
  August 26, 2012   August 28, 2011   August 26, 2012   August 28, 2011  

Revenues

  $ 17,186   $ 13,627   $ 49,066   $ 39,048  

Gross profit

    10,855     8,476     31,286     24,098  

Income from operations

    2,148     2,374     8,356     6,038  

Net income

    1,696     2,114     6,513     5,069  

Note 9: Long-Term Obligations

        Long-term obligations as of August 26, 2012 and November 27, 2011 consisted of the following (in thousands):

 
  August 26, 2012   November 27, 2011  

Asset-based revolving credit facility

  $   $  

Senior notes

    263,291     296,119  

Convertible notes(1)

    187,083     185,268  

Senior subordinated notes

    268,945     268,945  

Financing obligations

    40,288     41,225  

Other

    921     324  
           

    760,528     791,881  

Less current portion

    (2,324 )   (1,584 )
           

  $ 758,204   $ 790,297  
           

(1)
Includes paid in kind ("PIK") interest of $2.0 million from July 16, 2012 through August 26, 2012 for which the principal balance of the Convertible Notes has not yet been increased. This balance also includes the impact of unamortized beneficial conversion features recognized upon prior interest payment dates.

        The Company's outstanding debt as of August 26, 2012 primarily consists of the following: 1) a senior secured asset-based revolving credit facility (the "Amended ABL Revolver") which is discussed further below; 2) $270.0 million in aggregate principal amount of Senior Notes; 3) $221.1 million in aggregate principal amount of senior secured convertible PIK notes due June 2016 which are convertible into shares of the Company's common stock (the "Convertible Notes") and 4) $268.9 million aggregate principal amount of senior subordinated notes due June 2014, which bear interest at 8.25% per annum payable semi annually (the "2014 Notes").

Debt Refinancing

        On May 9, 2012, the Company amended its existing senior secured asset-based revolving credit facility to extend the stated maturity of this facility until May 2017 and amend certain other provisions. In addition to the extension of the maturity date, the amendment to the facility provides for an

14



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)

increase in the available accordion feature on the facility which, if exercised and additional commitments are obtained, can increase the total principal amount to $150.0 million. Further, the amendment provides an adjustment to the interest margins which both reduced the margin rates and provides a feature through which they adjust based on the availability under the facility. In connection with this amendment, the Company incurred charges of $1.0 million which have been recorded as a component of deferred debt issuance costs and will be amortized over the remaining maturity of the agreement as a component of interest expense (See Note 7).

Amended and Restated ABL Revolver

        The Company's Amended ABL Revolver provides for revolving credit financing of up to $100.0 million (or, if the accordion feature described above is exercised and additional commitments are obtained, $150.0 million), subject to borrowing base availability, and matures in May 2017. The borrowing base consists of the following: 1) 85% of the net amount of eligible accounts receivable and 2) the lesser of (i) 85% of the net orderly liquidation value of eligible inventory or (ii) 75% of the net amount of eligible inventory. These amounts are reduced by reserves deemed necessary by the security agents for the facility. Borrowings under the Amended ABL Revolver bear interest at the Company's choice of either a base rate (determined by reference to the highest of three rates as defined in the Amended ABL Revolver agreement) or a LIBOR rate for U.S. dollar deposits plus an applicable margin between 0.75% and 1.25% for base rate loans and 1.75% and 2.25% for LIBOR loans based on current availability. The Amended ABL Revolver also requires the Company to pay a commitment fee for the unused portion. As of August 26, 2012, there were no amounts outstanding under the Amended ABL Revolver. At August 26, 2012, the Company had approximately $77.7 million available under the Amended ABL Revolver which represents the calculated borrowing base reduced by outstanding letters of credit of $16.9 million.

        The obligations under the Company's Amended ABL Revolver are guaranteed by Sealy Mattress Corporation and all of its current and future domestic subsidiaries, and are also secured by substantially all of the assets of the Company and the assets of its current and future domestic subsidiaries through a first-priority security interest in the accounts receivable, inventory, cash, related general intangibles and instruments and proceeds of the foregoing, and a second-priority security interest in substantially all of the Company's material real property and equipment and all other assets of its current and future domestic subsidiaries that secure the Senior Notes on a first-priority basis.

        The Amended ABL Revolver agreement requires the Company to maintain a fixed charge coverage ratio in excess of 1.0 to 1.0 in periods of minimum availability under the facility where the availability for two consecutive calendar days is less than the greater of 1) 12.5% of the borrowing base under the Amended ABL Revolver and 2) $10.0 million. As of August 26, 2012, the Company was not in a minimum availability period under the Amended ABL Revolver.

        In accordance with FASB authoritative guidance, the Company will classify borrowings under its Amended ABL Revolver, which has a maturity date of more than one year from the balance sheet date, as a current liability since it includes both a lockbox arrangement and a subjective acceleration clause.

15



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)

Senior Notes

        The Senior Notes mature in April 2016 and bear interest at 10.875% per annum payable semi-annually in arrears on April 15 and October 15. The total proceeds received by the Company from the issuance of these notes was $335.9 million, resulting in an original issue discount ("OID") of $14.1 million which will be accreted over the life of the agreement with the related expense recognized as a component of interest expense in the Condensed Consolidated Statement of Operations. For each of the three and nine months ended August 26, 2012 and August 28, 2011, the Company recognized additional interest expense related to the accretion of the OID of $0.4 million and $1.3 million, respectively, for fiscal 2012 and $0.4 and $1.1 million, respectively, for fiscal 2011.

        As discussed in Note 7, during the nine months ended August 26, 2012 and August 28, 2011, the Company redeemed a portion of the principal amount of its outstanding Senior Notes at a redemption price of 103% of the principal amount of the notes, plus accrued and unpaid interest to the redemption date.

Convertible PIK Notes

        The Convertible Notes mature in July 2016 and bear interest at 8.00% per annum payable semi-annually in arrears on January 15 and July 15. The Company does not pay interest in cash related to the Convertible Notes, but instead increases the amount of the Convertible Notes by an amount equal to the interest payable for the interest period ending immediately prior. The amount of interest payable for each interest period is calculated on the basis of the accreted principal amount as of the first day of such interest period. The Convertible Notes are convertible into shares of the Company's common stock at an initial conversion price of $1.00 per share.

        During the three and nine months ended August 26, 2012, there were no conversions of Convertible Notes into common shares.

        The Company accounts for the PIK interest on the Convertible Notes in accordance with the applicable FASB authoritative guidance pertaining to convertible instruments and derivative financial instruments indexed to, and potentially settled in, a company's own stock. This guidance requires an allocation of a portion of the issuance amount to an embedded beneficial conversion feature based on the difference between the effective conversion price of the convertible debt of $1.00 and the fair value of the underlying common stock. Upon the January 15, 2012 interest payment date, the fair value of the underlying common stock was $1.87. Therefore, a beneficial conversion feature was recognized for 87% of the total PIK interest payment. Upon the July 15, 2012 interest payment date, the fair value of the underlying common stock was $1.90. Therefore, a beneficial conversion feature was recognized for 90% of the total PIK interest payment. Upon the January 15, 2011 and July 15, 2011 interest payment date, the fair value of the underlying common stock was more than double the conversion price of the Convertible Notes. Therefore, a beneficial conversion feature was recognized for the entire amount of

16



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)

the PIK interest payment. Details of the amounts recognized as beneficial conversion features for the three months ended August 26, 2012 and August 28, 2011 are as follows:

 
  Three Months Ended   Nine Months Ended  
 
  August 26, 2012   August 28, 2011   August 26, 2012   August 28, 2011  
 
  (in thousands)
  (in thousands)
 

January 15

  $   $   $ 7,114   $ 7,563  

July 15

    7,654     7,864     7,654     7,864  
                   

  $ 7,654   $ 7,864   $ 14,768   $ 15,427  
                   

        The outstanding balance of the Convertible Notes at August 26, 2012 was $187.1 million which includes accrued but unpaid interest as well as the total of the unamortized beneficial conversion features of $35.7 million which are recognized as a discount to the outstanding principal amount. The recognized discounts for the beneficial conversion features will be accreted through interest expense over the remaining term of the Convertible Notes.

        The indentures and agreements governing the Amended ABL Revolver, Senior Notes, Convertible Notes and the 2014 Notes also impose certain restrictions including, but not limited to, the payment of dividends or other equity distributions and the incurrence of debt or liens upon the assets of the Company or its subsidiaries. For instance, the agreement governing the Amended ABL Revolver contains restrictions on the ability of Sealy Corporation's subsidiaries to pay dividends or make other distributions to Sealy Corporation subject to specified exceptions including the satisfaction of a minimum fixed charge coverage ratio and average daily availability levels. Likewise, under the indentures governing the Senior Notes and 2014 Notes, Sealy Mattress Company is restricted from paying dividends or making other distributions to Sealy Corporation unless Sealy Mattress Company is able to satisfy certain requirements or use an available exception from the limitation. Although we meet the minimum fixed charge coverage ratio requirements contained in our Amended ABL Revolver agreement, the Company does not meet the minimum fixed charge coverage ratio levels under the note indentures as of August 26, 2012, therefore the Company is limited in its ability to incur new indebtedness and pay dividends and distributions, other than pursuant to specified exceptions in these agreements. As of August 26, 2012, Sealy Mattress Company is restricted in distributing the net assets of its subsidiaries in the amount of $230.4 million to its parent due to the provisions in its long-term debt agreements. However, $30.0 million would be available for distribution without restriction to the parent and to the common shareholders of Sealy Corporation. At August 26, 2012, the Company was in compliance with the covenants contained within the related note indentures and agreements.

Note 10: Acquisition

        On June 13, 2012, the Company obtained a 45% ownership interest in a newly formed company, Comfort Revolution, an investment with the CR Member for a contribution of $10.0 million. Upon formation, the CR Member contributed the assets and liabilities of its existing business. Comfort Revolution develops specialty foam and gel bedding products which are believed to complement the Company's product offerings and had net revenues of approximately $8.9 million for the fiscal year ended December 31, 2011.

17



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Acquisition (Continued)

        The Company's $10.0 million equity contribution to Comfort Revolution was used, in part, to retire and terminate an existing $8.1 million of debt and pay $0.4 million in legal and advisory fees. These amounts were paid to members of the acquired enterprise or their affiliates.

        In connection with the acquisition, the Company entered into a revolving credit facility arrangement with Comfort Revolution under which it is obligated to provide funding up to $20.0 million for the operations of this entity. This credit facility bears interest at a rate of 12.0% per annum and matures in June 2014. Further, Comfort Revolution will be obligated to pay royalties to the Company for its sales of Sealy and Stearns & Foster branded product under the terms of a licensing arrangement.

        The consolidated statements of operations include the results of Comfort Revolution since the date of acquisition. The assets acquired and liabilities assumed through this acquisition have been recorded at preliminary estimates of fair value based on information currently available and on current assumptions as to the future operations of Comfort Revolution. The Company will recognize additional assets or liabilities if new information is obtained during the measurement period about facts and circumstances that existed as of the acquisition date that, if known, would have resulted in the recognition of those assets and liabilities as of that date. The measurement period will not exceed one year from the acquisition date. These preliminary estimates are subject to change upon the completion of the acquisition accounting.

        The following is a summary of the preliminary fair values of the assets acquired and liabilities assumed based on the acquisition (amounts in thousands):

Assets acquired:

       

Current assets, including cash and equivalents of $10,159

  $ 16,010  

Property, plant and equipment

    481  

Goodwill

    357  

Intangible assets

    15,100  

Other assets

    35  
       

Total assets acquired

    31,983  
       

Liabilities assumed:

       

Current liabilities

    1,659  

Other long-term liabilities

    8,102  
       

Total liabilities assumed

    9,761  
       

Noncontrolling interest

    (12,222 )
       

Net assets acquired

  $ 10,000  
       

        The identifiable intangible assets acquired consist of trademarks, customer relationships and intellectual property of $3.1 million, $8.7 million and $3.3 million, respectively, with such amounts based on a preliminary assessment of the fair value. The fair value of the noncontrolling interest was determined using a market approach based on the Company's acquisition of its 45% ownership stake in Comfort Revolution as well as the enterprise values of comparable companies in the industry.

18



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Acquisition (Continued)

        Between the acquisition date and June 30, 2012, Comfort Revolution recognized revenues and a net loss of $1.1 million and $0.2 million, respectively. During the three and nine months ended August 26, 2012, we incurred acquisition related costs for Comfort Revolution of $0.2 million which have been recorded as a component of selling, general and administrative expense in the accompanying Condensed Consolidated Statements of Operations.

Note 11: Derivative Instruments and Hedging Strategies

        The Company uses hedging contracts to manage the risk of its overall exposure to changes in foreign currency exchange rates and commodity prices. All of the Company's designated hedging instruments are considered to be cash flow hedges.

Foreign Currency Exposure

        The Company is exposed to foreign currency risk related to purchases of materials and certain equipment made in a foreign currency. To manage the risk associated with fluctuations in foreign currencies, the Company enters into foreign currency forward and option contracts. As with its interest rate swap instruments, the Company designates certain of these contracts as hedging instruments and enters into some contracts that are considered to be economic hedges which are not designated as hedging instruments. Whether designated or undesignated, these contracts protect against the reduction in value of forecasted foreign currency cash flows resulting from payments in a foreign currency. The fair values of foreign currency agreements are estimated as described in Note 11, taking into consideration current interest rates and the current creditworthiness of the counterparties or the Company, as applicable. Details of the specific instruments used by the Company to hedge its exposure to foreign currency fluctuations are as follows:

        At August 26, 2012, the Company had outstanding 49 forward foreign currency contracts to sell a total of 31.5 million Canadian dollars and receive U.S. dollars at specified exchange rates with expiration dates ranging from September 2012 through August 2013. These hedges were entered into to protect against the fluctuation in the Canadian subsidiary's U.S. dollar denominated purchases of raw materials. The Company has formally designated these contracts as cash flow hedges, and they are expected to be highly effective in offsetting fluctuations in the forecasted purchases of these raw materials related to changes in the foreign currency exchange rates.

        The Company also enters into foreign currency contracts that are not designated as hedges for accounting purposes. The changes in fair value of these foreign currency hedges are included as a part of cost of goods sold in the Condensed Consolidated Statements of Operations. At August 26, 2012 and November 27, 2011, the Company did not have any outstanding foreign currency contracts that were not designated as hedges for accounting purposes.

        At August 26, 2012, the maximum length of time over which the Company is hedging its exposure to the reduction in value of forecasted foreign currency cash flows through foreign currency forward agreements is through August 2013. Over the next 12 months, the Company expects to reclassify $0.5 million of deferred losses from accumulated other comprehensive income to cost of goods sold as related forecasted foreign currency payments are made.

19



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 11: Derivative Instruments and Hedging Strategies (Continued)

        For the three and nine months ended August 26, 2012, the Company recognized foreign currency transaction losses of $0.2 million and $0.1 million, respectively, compared with gains of $0.1 million and $1.3 million for the three and nine months ended August 28, 2011, respectively. These amounts are recognized in cost of goods sold, selling, general and administrative expenses, or royalty income, net at the time they occur.

Commodity Price Exposure

        The Company is exposed to risk associated with fluctuations in the prices of diesel fuel used in the transportation of its finished product to its customers. To manage this risk, the Company enters into fixed price swap agreements. These agreements were entered into to protect against the fluctuations in the prices of diesel fuel purchased by certain of the Company's U.S. manufacturing facilities. The fair values of the fixed price swap agreements are estimated as described in Note 12, taking into consideration current interest rates and the current creditworthiness of the counterparties or the Company, as applicable. Details of the specific instruments used by the Company to hedge its exposure to foreign currency fluctuations are as follows:

        At August 26, 2012, the Company had outstanding fourteen fixed price swap contracts to purchase 2.1 million gallons of diesel fuel at specified prices from August 2012 through May 2013. Since these contracts were not formally designated as cash flow hedges, the $0.2 million change in fair value is recorded as a component of selling, general and administrative expense in the Condensed Consolidated Statements of Operations.

Embedded Derivatives

        The Company evaluates its outstanding debt arrangements in accordance with the FASB's authoritative guidance on derivative instruments and hedging, which requires bifurcation of embedded derivative instruments and measurement of fair value for accounting purposes. The Company concluded that the contingent redemption option upon a change of control or a qualifying asset sale within its Senior Notes qualifies as an embedded derivative instrument which should be bundled as a compound embedded derivative and bifurcated from the Senior Notes. Due to the low probability of the occurrence of the contingent events requiring redemption, the fair value of this embedded derivative instrument was determined to be immaterial.

        The Company concluded that the floor on the foreign exchange rate related to the payments to be made associated with the lease of its former Brazilian manufacturing facility and the related purchase option qualifies as an embedded derivative instrument that should be bifurcated from the lease agreement and recorded at fair value at the end of each reporting period. As of August 26, 2012 and November 27, 2011, the fair value of this derivative was an insignificant amount and is recorded as a component of debt issuance costs, net, and other assets in the Consolidated Balance Sheet. The initial fair value of the embedded derivative was recorded as deferred lease income and is being amortized over the term of the lease.

20



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 11: Derivative Instruments and Hedging Strategies (Continued)

        At August 26, 2012 and November 27, 2011, the fair value carrying amount of the Company's derivative instruments was recorded as follows (in thousands):

 
  Asset Derivatives   Liability Derivatives  
 
  August 26, 2012   August 26, 2012  
 
  Balance Sheet
Location
  Fair Value   Balance Sheet
Location
  Fair Value  

Derivatives designated as hedging instruments

                     

Foreign exchange contracts

  Other current assets   $   Other current liabilities   $ (474 )
                   

Total derivatives designated as hedging instruments

                (474 )
                     

Derivatives not designated as hedging instruments

                     

Commodity fixed price swap contracts

  Other current assets     132   Other current liabilities      
                   

Total derivatives not designated as hedging instruments

        132          
                   

Total derivatives

      $ 132       $ (474 )
                   

 

 
  Asset Derivatives   Liability Derivatives  
 
  November 27, 2011   November 27, 2011  
 
  Balance Sheet
Location
  Fair Value   Balance Sheet
Location
  Fair Value  

Derivatives designated as hedging instruments

                     

Foreign exchange contracts

  Other current assets   $ 1,368   Other current liabilities   $ (34 )
                   

Total derivatives designated as hedging instruments

        1,368         (34 )
                   

Total derivatives

      $ 1,368       $ (34 )
                   

        The effect of derivative instruments on the Consolidated Statement of Operations for the three and nine months ended August 26, 2012 and August 28, 2011 was not significant.

Note 12: Fair Value of Financial Instruments

        For assets and liabilities measured at fair value on a recurring basis during the period, the Company uses an income approach to value the assets and liabilities for outstanding foreign currency derivative contracts discussed above in Note 11. These contracts are valued using an income approach, which consists of a discounted cash flow model that takes into account the present value of future cash flows under the terms of the contracts by using current market information available as of the reporting date such as prevailing interest rates and foreign currency spot and forward rates. We mitigate derivative credit risk by transacting with highly rated counterparties. There were no non-financial assets or liabilities requiring initial measurement or subsequent remeasurement during the first nine months

21



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 12: Fair Value of Financial Instruments (Continued)

of fiscal 2012 or 2011. The following table provides a summary of the fair values of assets and liabilities (in thousands):

 
   
  Fair Value Measurements at August 26, 2012 Using  
 
  August 26, 2012   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant Other
Observable Inputs
(Level 2)
  Significant
Unobservable Inputs
(Level 3)
 

Foreign exchange and commodity derivative assets

  $ 132   $   $ 132   $  

Foreign exchange and commodity derivative liabilities

    (474 )       (474 )    
                   

Total

  $ (342 ) $   $ (342 ) $  
                   

 

 
   
  Fair Value Measurements at November 27, 2011 Using  
 
  November 27, 2011   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant Other
Observable Inputs
(Level 2)
  Significant
Unobservable Inputs
(Level 3)
 

Foreign exchange and commodity derivative assets

  $ 1,379   $   $ 1,379   $  

Foreign exchange and commodity derivative liabilities

    (34 )       (34 )    

Embedded foreign currency derivative in lease agreement

    56             56  
                   

Total

  $ 1,401   $   $ 1,345   $ 56  
                   

        Due to the short maturity of cash and equivalents, accounts receivable, accounts payable and accrued expenses, their carrying values approximate fair value. The fair value of long term debt which is valued using Level 1 inputs based on quoted market prices, at August 26, 2012 was as follows (in thousands):

Senior Secured Notes

  $ 293,625  

Convertible Notes

    398,370  

Senior Subordinated Notes

    268,273  

Note 13: Discontinued Operations

        In the fourth quarter of fiscal 2010, management divested the assets of its European manufacturing operations in France and Italy and ceased manufacturing operations in Brazil. These businesses have been accounted for as discontinued operations. During the three and nine months ended August 26, 2012, the Company continued the liquidation of certain of its assets related to its Brazil operations. The charges related to these activities were recorded as a component of discontinued operations. The remaining current assets and liabilities of the Brazilian operations reflected within the Consolidated

22



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 13: Discontinued Operations (Continued)

Balance Sheet at August 26, 2012 and November 27, 2011 were immaterial. The Company also recognized additional expenses related to the settlement of certain outstanding contingencies related to the sale of the European business unit which resulted in the recognition of an additional $0.9 million of expense relating to the disposition of its European manufacturing operations.

        The operating results of the discontinued operations in total are summarized below (in thousands):

 
  Three months ended   Nine months ended  
 
  August 26,
2012
  August 28,
2011
  August 26,
2012
  August 28,
2011
 

Net sales

  $   $   $   $  

Loss before income taxes

   
(173

)
 
(466

)
 
(665

)
 
(1,630

)

Income tax provision (benefit)

                 
                   

Loss from operations of discontinued operations

    (173 )   (466 )   (665 )   (1,630 )

Loss on disposition of business, net of tax of $0 and $164

    (134 )   (425 )   (1,149 )   (1,420 )
                   

Loss from discontinued operations

  $ (307 ) $ (891 ) $ (1,814 ) $ (3,050 )
                   

        In connection with the sale of the Company's European manufacturing operations, the Company made certain guarantees with respect to the existence of liabilities and deficiencies related to assets as of the closing date that were not reflected in the European business' financial statements as of the closing date. Further, certain guarantees were made with respect to losses or damages incurred by the purchaser related to any misrepresentations or warranties made by the Company, outstanding disputes or judicial proceedings. Such guarantees are limited to an aggregate amount of €1.8 million under the terms of the contract. During the three and nine months ended August 26, 2012, the Company settled certain outstanding claims related to these guarantees for €1.8 million.

23



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 14: Defined Benefit Pension Expense

        The components of net periodic pension cost recognized for the Company's defined benefit pension plans in the U.S. and Canada for the three and nine months ended August 26, 2012 and August 28, 2011 are as follows (in thousands):

 
  Three Months Ended   Nine Months Ended  
 
  August 26,
2012
  August 28,
2011
  August 26,
2012
  August 28,
2011
 

Service cost

  $ 240   $ 199   $ 721   $ 597  

Interest cost

    382     360     1,146     1,079  

Expected return on plan assets

    (388 )   (367 )   (1,165 )   (1,100 )

Amortization of unrecognized losses

    202     35     606     106  

Amortization of unrecognized prior service cost

    38     144     113     432  
                   

Net periodic pension cost*

  $ 474   $ 371   $ 1,421   $ 1,114  
                   

Cash contributions

  $ 426   $ 538   $ 426   $ 758  
                   

Weighted average expected return on plan assets

    7.50 %   7.85 %   7.50 %   7.85 %
                   

*
Net periodic pension cost recognized for the three and nine months ended August 26, 2012 is based upon preliminary estimates pending the final actuarial determination of such costs for fiscal 2012. Similarly, net periodic pension cost for the three and nine months ended August 28, 2011 is based upon preliminary estimates.

        The Company expects to make additional cash contributions to the defined benefit pension plans of approximately $1.3 million during the remainder of fiscal 2012.

Note 15: Income Taxes

        The Company's effective income tax rates regularly differ from the Federal statutory rate principally because of the effect of non-deductible interest on the Company's Convertible Notes, certain foreign tax rate differentials and state and local income taxes. The effective tax rate for the three and nine months ended August 26, 2012 was approximately 106.7% and 92.2%, respectively, compared to approximately 59.8% and 57.1%, respectively, for the three and nine months ended August 28, 2011. The effective rate for the three months ended August 26, 2012 was higher than the rate for the three months ended August 28, 2011, primarily due to the impact of the permanent tax differences, the most significant of which relates to the non-deductible interest on the Company's Convertible Notes.

        The Condensed Consolidated Balance Sheet as of August 26, 2012 includes accrued interest of $3.7 million and penalties of $1.7 million due to unrecognized tax benefits. As of November 27, 2011, the Company had recorded accrued interest of $3.7 million and penalties of $1.9 million due to unrecognized tax benefits.

        The Company expects the liability for uncertain tax positions to decrease by approximately $1.5 million within the succeeding twelve months due to expiration of income tax statutes of limitations. Federal years open to examination are fiscal year 2004 and forward. State and international jurisdictions remain open to examination for fiscal year 2000 and forward.

24



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 15: Income Taxes (Continued)

        Significant judgment is required in evaluating the Company's federal, state and foreign tax positions and in the determination of its tax provision. Despite the Company's belief that its liability for unrecognized tax benefits is adequate, it is often difficult to predict the final outcome or the timing of the resolution of any particular tax matter. The Company may adjust these liabilities as relevant circumstances evolve, such as guidance from the relevant tax authority, or resolution of issues in the courts. These adjustments are recognized as a component of income tax expense entirely in the period in which they are identified. The Company is currently undergoing examinations of certain of its corporate income tax returns by tax authorities. Issues related to certain of these reserves have been presented to the Company and the Company believes that such audits will not result in a material assessment or payment of taxes related to these positions during the one year period following August 26, 2012. The Company also cannot predict when or if any other future tax payments related to these tax positions may occur.

Note 16: Redeemable Noncontrolling Interest

        The Company is party to a put and call arrangement with respect to the common securities that represent the 55% noncontrolling interest from the acquisition of Comfort Revolution. The call arrangement may be exercised by the Company upon the fifth anniversary of the acquisition date. Likewise, the put arrangement may be exercised by the CR Member upon the sixth anniversary of the acquisition date. The redemption value of both the put and the call arrangement is equal to 7.5 times earnings before interest, taxes, depreciation and amortization ("EBITDA"), as defined in the related LLC agreement, of Comfort Revolution for the preceding 12 months, adjusted for net debt outstanding and multiplied by the 55% ownership interest held by the CR Member. Due to the existing put and call arrangements, the noncontrolling interest is considered to be redeemable in accordance with the related authoritative accounting guidance and is recorded on the balance sheet as a redeemable noncontrolling interest outside of permanent equity. The redeemable noncontrolling interest is recognized at the higher of 1) the accumulated earnings associated with the noncontrolling interest or 2) the redemption value as of the balance sheet date. At August 26, 2012, the redeemable noncontrolling interest was recorded based on the fair value upon acquisition and the accumulated losses of Comfort Revolution since the acquisition date. The redemption amount as of August 26, 2012 is an insignificant amount.

        A reconciliation of redeemable noncontrolling interests for the three and nine months ended August 26, 2012 is as follows (in thousands):

Balance, beginning of period

  $  

Acquisition of redeemable noncontrolling interest

    12,222  

Net loss attributable to noncontrolling interest

    (91 )
       

Balance, end of period

  $ 12,131  
       

Note 17: Comprehensive Income

        Comprehensive income for the three and nine months ended August 26, 2012 was $5.5 million and $9.7 million, respectively and for the three and nine months ended August 28, 2011 was $5.5 million and $9.0 million, respectively. The increase in comprehensive income for the three months ended

25



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 17: Comprehensive Income (Continued)

August 26, 2012 compared to the three months ended August 28, 2011, was driven primarily by the Company's stronger earnings performance coupled with higher gains related to the translation effects of foreign currencies in the third quarter of fiscal 2012. The increase in comprehensive income for the nine months ended August 26, 2012 compared to the nine months ended August 28, 2011 was driven by the Company's stronger earnings performance offset by lower gains related to the translation effects of foreign currencies in the first three quarters of fiscal 2012.

        The following table provides the components of accumulated other comprehensive income in the Condensed Consolidated Balance Sheets (in thousands):

 
  August 26,
2012
  November 27,
2011
 

Unrealized gain (loss) on cash flow hedges, net of tax of $(184) and $519, respectively

  $ (289 ) $ 815  

Unrealized actuarial loss and prior service credit for pension liability, net of tax of $6,370 and $6,623, respectively

    (10,103 )   (10,438 )

Accumulated foreign currency translation adjustment

    16,737     9,114  
           

  $ 6,345   $ (509 )
           

Note 18: Contingencies

        The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material effect on the Company's consolidated financial position, results of operations or cash flows.

Product Warranty Claims

        During the third quarter of fiscal 2012, the Company identified a manufacturing defect with respect to certain of its foundation units that were sold to certain customers during the 2008 through 2011 fiscal years. The Company plans to repair or replace these defective foundation units and is expected to incur costs of $1.1 million related to the replacement products, and charges for transportation and labor. This expense was recorded as a component of cost of goods sold in the accompanying Condensed Consolidated Statement of Operations.

Multi-employer Pension Liabilities

        The Company is currently involved in negotiations with representatives of its labor unions for employees of its Portland, Oregon facility with respect to a potential move of this facility to Lacey, Washington. Though a decision has not been reached regarding this move pending the results of these negotiations, if the Company relocates its operations, it is expected to incur charges of $1.8 million related to underfunded multiemployer pension plans. The payment of this liability is expected to occur over the next three years. As this liability is not considered probable as of August 26, 2012, an accrual for this liability has not been made.

26



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 18: Contingencies (Continued)

Legal Proceedings

        On July 19, 2012, a purported shareholder of the Company filed a shareholder derivative complaint in the Court of Chancery of the State of Delaware against the members of the Company's Board of Directors (the "Board"), styled Plourde, v. Rogers et al., Civ. Action No. 7709-VCP. The complaint alleges that since at least April 2009 the Board has breached its fiduciary duties and mismanaged the Company by paying certain fees to the Company's largest shareholder for services provided to the Company. The complaint further alleges that the Company has made false and misleading statements about the services provided by its largest shareholder and the payments the Company has made for such services. The Company understands that the Board expects to move to dismiss the complaint.

Environmental

        The Company is currently conducting an environmental cleanup at a formerly owned facility in South Brunswick, New Jersey pursuant to the New Jersey Industrial Site Recovery Act. The Company and one of its subsidiaries are parties to an Administrative Consent Order issued by the New Jersey Department of Environmental Protection. Pursuant to that order, the Company and its subsidiary agreed to conduct soil and groundwater remediation at the property. The Company does not believe that its manufacturing processes were the source of contamination. The Company sold the property in 1997. The Company and its subsidiary retained primary responsibility for the required remediation. The Company, with the approval of the New Jersey Department of Environmental Protection, has undertaken soil remediation on the site. During 2005, with the approval of the New Jersey Department of Environmental Protection, the Company removed and disposed of sediment in Oakeys Brook adjoining the site. The Company continues to monitor ground water at the site and also operates a groundwater remediation system on the site. During the remainder of 2012, the Company plans to remove additional contaminated soil from the site. The Company has recorded a reserve as a component of other accrued liabilities and other noncurrent liabilities in the accompanying Condensed Consolidated Balance Sheets as of August 26, 2012 for $1.5 million ($2.3 million prior to discounting at 4.75%) associated with this remediation project.

        The Company has also undertaken a remediation of soil and groundwater contamination at an inactive facility located in Oakville, Connecticut. Although the Company is conducting the remediation voluntarily, it obtained Connecticut Department of Environmental Protection approval of the remediation plan. The Company believes that it has essentially completed its remediation of the site. Accordingly, the Company has submitted a closure report to the Connecticut Department of Environmental Protection for the lower portion of the site and is preparing a closure report for the upper portion of the site. The Company has recorded a liability of approximately $0.1 million associated with the completion of these closure reports and the closure of the Company's remediation efforts at the site. The Company believes the contamination is attributable to the manufacturing operations of previous, unrelated, unaffiliated occupants of the facility.

        The Company cannot predict the ultimate timing or costs of the South Brunswick and Oakville environmental matters. Based on facts currently known, the Company believes that the accruals recorded are adequate and does not believe the resolution of these matters will have a material effect on the financial position or future operations of the Company. However, in the event of an adverse

27



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 18: Contingencies (Continued)

decision by the agencies involved, or an unfavorable result in the New Jersey natural resources damages matter, these matters could have a material effect.

        In 1998, the Company sold an inactive facility located in Putnam, Connecticut. Recently, the Company received a letter from the attorney for the current owner of that property claiming that Sealy may have some responsibility for an environmental condition on the property. The Company has requested additional information on this matter and is awaiting receipt of that information.

        During fiscal 2010, the Company was assessed $8.0 million by the Brazilian government for the failure to provide certain income tax filings. Due to the accumulated net operating losses in this jurisdiction, the Company's exposure is expected to be limited. At August 26, 2012, the Company has recorded a reserve of $1.0 million associated with this assessment related to the expected requirement to pay certain sales tax, fees and penalties. This amount is recorded as a component of accrued expenses in the accompanying Condensed Consolidated Balance Sheets.

Note 19: Related Party Transactions

        During the three and nine months ended August 26, 2012 and August 28, 2011, the Company incurred costs for consulting services rendered by KKR and Capstone Consulting LLC (a consulting company that works exclusively with KKR's portfolio companies) of an insignificant amount and $0.7 million, respectively for fiscal 2012 and $0.4 million and $1.2 million, respectively for fiscal 2011. As of August 26, 2012 and November 27, 2011, $0.1 million and $0.2 million, respectively, of the costs incurred for these services were accrued as a component of other accrued liabilities in the accompanying Condensed Consolidated Balance Sheets. The Company also participates in a lease arrangement with a KKR affiliate for our Clarion facility for a six month initial term with two six month renewal options available. The Company has received lease income on this property of an insignificant amount during the three months ended August 26, 2012 and August 28, 2011. Capstone Consulting LLC also provided general consulting services as well as specific services related to the Company's acquisition of Comfort Revolution during the three and nine months ended August 26, 2012 for which the Company did not pay fees.

        Sealy Holding LLC, an affiliate of KKR, holds an aggregate amount of $118.7 million of the Company's Convertible Notes. In connection with the PIK interest payment on the Convertible Notes on January 15, 2012 and July 15, 2012, the par value of the notes held by KKR was increased by $4.4 million and $4.6 million, respectively.

        During the three and nine months ended August 26, 2012, the Company's Asian joint ventures made a distribution to the Company of $1.5 million and $2.5 million, respectively. During the three and nine months ended August 28, 2011, the Company's Asian joint ventures made a distribution of $1.0 million. These amounts have been reflected as a reduction of the investment in these joint ventures in the accompanying Condensed Consolidated Balance Sheets as of August 26, 2012 and November 27, 2011.

28



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 20: Revenue by Product and Geographical Information

Domestic Revenue by Product

        The Company produces sleep sets across a range of technologies, including innerspring, latex foam and visco-elastic "memory foam". The U.S. mattress industry groups these products in categories based on innerspring and specialty technologies. The products for international locations are aggregated as they are substantially similar and the international markets do not have similar product categorization. In the domestic market the Company's net revenue by product type for the three and nine months ended August 26, 2012 and August 28, 2011 was as follows (in thousands):

 
  Three months ended   Nine months ended  
 
  August 26,
2012
  August 28,
2011
  August 26,
2012
  August 28,
2011
 

Net sales—Domestic innerspring bedding

  $ 241,610   $ 232,328   $ 672,914   $ 672,558  

Net sales—Domestic specialty bedding

    37,724     20,498     75,331     62,507  
                   

Total bedding sales

    279,334     252,826     748,245     735,065  

Other revenue(1)

    6,866     4,467     18,507     14,415  
                   

Net sales

  $ 286,200   $ 257,293   $ 766,752   $ 749,480  
                   

(1)
Other revenue includes external sales of Comfort Revolution and the Company's components and U.S. latex businesses.

Geographical Information

        Net sales by geographic area are as follows (in thousands):

 
  Three Months Ended   Nine Months Ended  
 
  August 26,
2012
  August 28,
2011
  August 26,
2012
  August 28,
2011
 

United States

  $ 286,200   $ 257,293   $ 766,752   $ 749,480  

Canada

    50,729     52,433     143,572     140,518  

Other International

    28,505     24,341     79,431     70,894  
                   

Total

  $ 365,434   $ 334,067   $ 989,755   $ 960,892  
                   

Total International

  $ 79,234   $ 76,774   $ 223,003   $ 211,412  

        Long lived assets (principally property, plant and equipment) outside the United States were $37.0 million and $35.4 million as of August 26, 2012 and November 27, 2011, respectively.

29



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 21: Earnings per Share

        The following table sets forth the computation of basic and diluted earnings per share for the three months ended:

 
  Three Months Ended   Nine Months Ended  
 
  August 26,
2012
  August 28,
2011
  August 26,
2012
  August 28,
2011
 
 
  (in thousands)
  (in thousands)
 

Numerator:

                         

Net income from continuing operations, as reported

  $ 201   $ 7,489   $ 4,622   $ 8,369  

Net income attributable to participating securities

    (1 )   (4 )   (12 )   (7 )

Interest on convertible notes

        5,239         14,551  
                   

Net income from continuing operations available to common shareholders

  $ 200   $ 12,724   $ 4,610   $ 22,913  
                   

Denominator:

                         

Denominator for basic earnings per share—weighted average shares

    103,534     100,334     101,849     98,725  

Effect of dilutive securities:

                         

Convertible debt

        200,455         196,576  

Stock options

    679     747     693     811  

Restricted share units

    4,977     6,561     6,213     8,117  

Other

    610     469     574     430  
                   

Denominator for diluted earnings per share—adjusted weighted average shares and assumed conversions

    109,800     308,566     109,329     304,659  
                   

        For the three and nine months ended August 26, 2012, 4,109 options and share units (in thousands) were not included in the computation of diluted earnings per share because their impact is antidilutive. Additionally, for the three and nine months ended August 26, 2012, a weighted average 216,620 and 212,521 shares (in thousands), respectively of the outstanding Convertible Notes were excluded from the computation of diluted earnings per share since their inclusion would be antidilutive. For the three and nine months ended August 28, 2011, 4,142 and 3,985 options and share units (in thousands), respectively, were not included in the computation of diluted earnings per share because their impact is antidilutive.

Note 22: Subsequent Event

        On September 26, 2012, the Company entered into a Merger Agreement with Tempur-Pedic International, Inc. pursuant to which a wholly-owned subsidiary of Tempur-Pedic International, Inc. will merge with and into the Company, resulting in the Company becoming a subsidiary of Tempur-Pedic International, Inc. (the "Merger"). In connection with the Merger, each issued and outstanding share of the Company's common stock immediately prior to the Merger will be converted into the right to receive $2.20 per share in cash (the "Merger Consideration"). As part of the transaction it is anticipated that the Company's outstanding Senior and Subordinated Notes will also be redeemed in accordance with the provisions of the related note indentures.

30



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 22: Subsequent Event (Continued)

        Completion of the Merger is subject to several conditions, including (i) the adoption of the Merger Agreement by the affirmative vote or written consent of the holders of at least a majority of the outstanding shares of the Company's common stock; (ii) the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; (iii) the absence of a material adverse effect on the Company; and (iv) other customary closing conditions.

        The Merger Agreement may be terminated under certain customary circumstances, including by Tempur-Pedic International, Inc. if their Board of Directors withdraws or changes its recommendation in support of the Offer, or by the Company if the Company's Board of Directors decides to accept a Superior Proposal (as defined in the Merger Agreement). In the case of such termination, Tempur-Pedic International, Inc. would be entitled to a break-up fee of $25.0 million.

        In the event that the Merger is not consummated because the HSR approval is not obtained, Tempur-Pedic International, Inc. is required to pay the Company a reverse break-up fee of $90.0 million or $40.0 million, depending on the circumstances of such termination.

        The indenture governing the Company's outstanding Convertible Notes contain provisions pursuant to which (i) a holder of Convertible Notes will be entitled following completion of the Merger to convert the Convertible Notes into the Merger Consideration at a more favorable "make whole" conversion rate for a 35 trading day period and (ii) the Company will be required to make an offer to holders of Convertible Notes following completion of the Merger to purchase the Convertible Notes at a price equal to 100% of the outstanding principal amount thereof. The indentures governing the Company's outstanding Senior and Subordinated Notes contain a provision which requires the Company to make an offer to holders of such notes following completion of the Merger to purchase such notes at a price equal to 101% of the outstanding principal amount thereof.

        Upon completion of the Merger, all of the Company's outstanding stock options, restricted share units and equity share units, whether vested or unvested, will become fully vested and exercisable and converted into a right to receive a cash payment based upon the Merger Consideration and value of such awards.

Note 23: Guarantor/Non-Guarantor Financial Information

        Sealy Corporation, Sealy Mattress Corporation (a 100% owned subsidiary of Sealy Corporation) and each of the subsidiaries of Sealy Mattress Company (the "Issuer") that guarantee the Senior Notes, the Convertible Notes and the 2014 Notes (the "Guarantor Subsidiaries"), and are 100% owned subsidiaries of the Issuer, have fully and unconditionally guaranteed, on a joint and several basis, the obligation to pay principal and interest with respect to the Senior Notes, the Convertible Notes and the 2014 Notes (collectively, the "Guaranteed Notes") of the Issuer. Substantially all of the Issuer's operating income and cash flow is generated by its subsidiaries. As a result, funds necessary to meet the Issuer's debt service obligations are provided, in part, by distributions or advances from its subsidiaries. Under certain circumstances, contractual and legal restrictions, as well as the financial condition and operating requirements of the Issuer's subsidiaries, could limit the Issuer's ability to obtain cash from its subsidiaries for the purpose of meeting its debt service obligations, including the payment of principal and interest on the Guaranteed Notes. Although holders of the Guaranteed Notes will be direct creditors of the Issuer's principal direct subsidiaries by virtue of the guarantees, the Issuer

31



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

has subsidiaries ("Non-Guarantor Subsidiaries") that are not included among the Guarantor Subsidiaries, and such subsidiaries will not be obligated with respect to the Guaranteed Notes. As a result, the claims of creditors of the Non-Guarantor Subsidiaries will effectively have priority with respect to the assets and earnings of such companies over the claims of creditors of the Issuer, including the holders of the Guaranteed Notes.

        The following supplemental Condensed Consolidating Financial Statements present:

    1.
    Condensed Consolidating Balance Sheets as of August 26, 2012 and November 27, 2011, Condensed Consolidating Statements of Operations for the three months ended August 26, 2012 and August 28, 2011, and Condensed Consolidating Statements of Cash Flows for the three months ended August 26, 2012 and August 28, 2011.

    2.
    Sealy Corporation, who became a guarantor of the 2014 Notes effective May 25, 2006 and who is guarantor of the Senior Notes and a co-issuer of the Convertible Notes (as "Guarantor Parent"), Sealy Mattress Corporation (a guarantor), the Issuer, combined Guarantor Subsidiaries and combined Non-Guarantor Subsidiaries with their investments in subsidiaries accounted for using the equity method (see Note 1).

    3.
    Elimination entries necessary to consolidate the Guarantor Parent and all of its subsidiaries.

32



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Balance Sheets

August 26, 2012

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Assets

                                           

Current assets:

                                           

Cash and equivalents

  $ 155   $   $ 237   $ 16,230   $ 72,211   $   $ 88,833  

Accounts receivable, net

                113,377     64,577         177,954  

Inventories

            1,419     57,191     12,324     (115 )   70,819  

Other current assets and deferred income taxes

    1,380         666     36,456     4,613         43,115  
                               

Total current assets

    1,535         2,322     223,254     153,725     (115 )   380,721  

Property, plant and equipment, at cost

   
   
   
10,391
   
369,577
   
38,156
   
   
418,124
 

Less accumulated depreciation

            (6,122 )   (225,007 )   (22,316 )       (253,445 )
                               

            4,269     144,570     15,840         164,679  

Other assets:

                                           

Goodwill

            24,741     301,942     36,622         363,305  

Intangible assets, net

                872     15,129         16,001  

Net investment in subsidiaries

    (186,459 )   230,358     362,500     316,933         (723,332 )    

Due from (to) affiliates

    319,044     (416,817 )   545,815     (168,532 )   (91,915 )   (187,595 )    

Debt issuance costs, net and other assets

   
   
   
13,784
   
21,587
   
21,432
   
(10,000

)
 
46,803
 
                               

    132,585     (186,459 )   946,840     472,802     (18,732 )   (920,927 )   426,109  
                               

Total assets

  $ 134,120   $ (186,459 ) $ 953,431   $ 840,626   $ 150,833   $ (921,042 ) $ 971,509  
                               

Liabilities and Stockholders' (Deficit) Equity

                                           

Current liabilities:

                                           

Current portion—long-term obligations

  $   $   $   $ 1,413   $ 911   $   $ 2,324  

Accounts payable

            210     69,124     26,850         96,184  

Accrued customer incentives and advertising

                21,851     7,416         29,267  

Accrued compensation

            377     21,759     4,088         26,224  

Accrued interest

            1,365     14,004             15,369  

Other accrued liabilities

            1,662     25,783     5,071         32,516  
                               

Total current liabilities

            3,614     153,934     44,336         201,884  

Long-term obligations

   
187,083
   
   
719,320
   
38,884
   
   
(187,083

)
 
758,204
 

Other liabilities

                45,266     6,661         51,927  

Deferred income tax liabilities

            139     (139 )   326         326  

Redeemable noncontrolling interest

                    12,131         12,131  

Stockholders' equity (deficit)

    (52,963 )   (186,459 )   230,358     602,681     87,379     (733,959 )   (52,963 )
                               

Total liabilities and stockholders' equity (deficit)

  $ 134,120   $ (186,459 ) $ 953,431   $ 840,626   $ 150,833   $ (921,042 ) $ 971,509  
                               

33



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Balance Sheets

November 27, 2011

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Assets

                                           

Current assets:

                                           

Cash and equivalents

  $ 1,655   $   $ 9,123   $ 50,170   $ 47,027   $   $ 107,975  

Accounts receivable, net

                69,345     57,149         126,494  

Inventories

            1,476     47,391     8,293     (158 )   57,002  

Other current assets and deferred income taxes

    9,153         1,154     34,427     5,890         50,624  
                               

Total current assets

    10,808         11,753     201,333     118,359     (158 )   342,095  

Property, plant and equipment, at cost

            10,174     359,908     36,033         406,115  

Less accumulated depreciation

            (5,902 )   (213,043 )   (20,425 )       (239,370 )
                               

            4,272     146,865     15,608         166,745  

Other assets:

                                           

Goodwill

            24,741     301,942     34,343         361,026  

Intangible assets, net

                1,088     28         1,116  

Net investment in subsidiaries

    (196,903 )   219,918     368,983     161,796     (1 )   (553,793 )    

Due from (to) affiliates

    290,797     (416,821 )   546,305     (143,182 )   (91,275 )   (185,824 )    

Debt issuance costs, net and other assets

            16,649     12,654     18,909         48,212  
                               

    93,894     (196,903 )   956,678     334,298     (37,996 )   (739,617 )   410,354  
                               

Total assets

  $ 104,702   $ (196,903 ) $ 972,703   $ 682,496   $ 95,971   $ (739,775 ) $ 919,194  
                               

Liabilities and Stockholders' (Deficit) Equity

                                           

Current liabilities:

                                           

Current portion—long-term obligations

  $   $   $   $ 1,286   $ 298   $   $ 1,584  

Accounts payable

            186     45,985     22,603         68,774  

Accrued customer incentives and advertising

                18,014     8,024         26,038  

Accrued compensation

            392     14,416     2,793         17,601  

Accrued interest

            1,271     12,803             14,074  

Other accrued liabilities

    (2 )       465     21,997     5,966         28,426  
                               

Total current liabilities

    (2 )       2,314     114,501     39,684         156,497  

Long-term obligations

    185,268         750,332     39,965         (185,268 )   790,297  

Other liabilities

                46,086     6,329         52,415  

Deferred income tax liabilities

            139     72     338         549  

Stockholders' equity (deficit)

    (80,564 )   (196,903 )   219,918     481,872     49,620     (554,507 )   (80,564 )
                               

Total liabilities and stockholders' equity (deficit)

  $ 104,702   $ (196,903 ) $ 972,703   $ 682,496   $ 95,971   $ (739,775 ) $ 919,194  
                               

34



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Three Months Ended August 26, 2012

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net sales

  $   $   $ 24,849   $ 260,700   $ 78,493   $ 1,392   $ 365,434  

Cost and expenses:

                                           

Cost of goods sold

            13,163     155,963     46,738     1,365     217,229  

Selling, general and administrative

            2,118     97,385     21,129         120,632  

Amortization expense

                73             73  

Royalty (income) expense, net

                (5,105 )           (5,105 )
                               

Income from operations

            9,568     12,384     10,626     27     32,605  

Interest expense

        79     19,917     600     333         20,929  

Refinancing and extinguishment of debt

            416                 416  

Other (income) expense, net

            40     (1 )   (170 )       (131 )

Loss (income) from equity investees

    (189 )   (266 )   8,343             (7,888 )    

Loss (income) from non- guarantor equity investees

                (7,404 )       7,404      

Capital charge and intercompany interest allocation

            (18,163 )   17,437     726          
                               

Income (loss) before income taxes

    189     187     (985 )   1,752     9,737     511     11,391  

Income tax provision (benefit)

    297     (2 )   (1,251 )   10,163     2,992     (43 )   12,156  

Equity in earnings of unconsolidated affiliates

                    875         875  
                               

Income (loss) from continuing operations

    (108 )   189     266     (8,411 )   7,620     554     110  

Loss from discontinued operations

                    (307 )       (307 )

Net income (loss)

    (108 )   189     266     (8,411 )   7,313     554     (197 )
                               

Net loss attributable to noncontrolling interests

                    91         91  
                               

Net income (loss) attributable to common shareholders

  $ (108 ) $ 189   $ 266   $ (8,411 ) $ 7,404   $ 554   $ (106 )
                               

35



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Three Months Ended August 28, 2011

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net sales

  $   $   $ 20,729   $ 243,403   $ 75,231   $ (5,296 ) $ 334,067  

Cost and expenses:

                                           

Cost of goods sold

            11,319     147,516     43,510     (5,278 )   197,067  

Selling, general and administrative

            1,943     81,847     20,337         104,127  

Amortization expense

                73             73  

Royalty (income) expense, net

                (5,021 )           (5,021 )
                               

Income from operations

            7,467     18,988     11,384     (18 )   37,821  

Interest expense

        76     20,979     493     387         21,935  

Refinancing and extinguishment of debt

            28                 28  

Other (income) expense, net

                (7 )   (123 )       (130 )

Loss (income) from equity investees

    (6,598 )   (6,758 )   4,480             8,876      

Loss (income) from non- guarantor equity investees

                (7,988 )       7,988      

Capital charge and intercompany interest allocation

            (19,248 )   18,641     607          
                               

Income (loss) before income taxes

    6,598     6,682     1,228     7,849     10,513     (16,882 )   15,988  

Income tax provision (benefit)

        84     (5,530 )   12,400     2,691     (89 )   9,556  

Equity in earnings of unconsolidated affiliates

                    1,057         1,057  
                               

Income (loss) from continuing operations

    6,598     6,598     6,758     (4,551 )   8,879     (16,793 )   7,489  

Loss from discontinued operations

                    (891 )       (891 )
                               

Net income (loss)

  $ 6,598   $ 6,598   $ 6,758   $ (4,551 ) $ 7,988   $ (16,793 ) $ 6,598  
                               

36



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Nine Months Ended August 26, 2012

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net sales

  $   $   $ 68,095   $ 712,322   $ 219,278   $ (9,940 ) $ 989,755  

Cost and expenses:

                                           

Cost of goods sold

            36,909     435,361     129,868     (9,983 )   592,155  

Selling, general and administrative

            6,169     259,777     61,308         327,254  

Amortization expense

                217             217  

Royalty (income) expense, net

                (14,425 )           (14,425 )
                               

Income from operations

            25,017     31,392     28,102     43     84,554  

Interest expense

        234     62,399     1,868     1,053         65,554  

Refinancing and extinguishment of debt

            3,341                 3,341  

Other (income) expense, net

            40     (5 )   (445 )       (410 )

Loss (income) from equity investees

    (3,467 )   (3,694 )   14,344             (7,183 )    

Loss (income) from non- guarantor equity investees

                (19,903 )       19,903      

Capital charge and intercompany interest allocation

            (56,747 )   54,873     1,874          
                               

Income (loss) before income taxes

    3,467     3,460     1,640     (5,441 )   25,620     (12,677 )   16,069  

Income tax provision (benefit)

    661     (7 )   (2,054 )   8,987     7,277     (43 )   14,821  

Equity in earnings of unconsolidated affiliates

                    3,283         3,283  
                               

Income (loss) from continuing operations

    2,806     3,467     3,694     (14,428 )   21,626     (12,634 )   4,531  

Loss from discontinued operations

                    (1,814 )       (1,814 )

Net income (loss)

   
2,806
   
3,467
   
3,694
   
(14,428

)
 
19,812
   
(12,634

)
 
2,717
 
                               

Net loss attributable to noncontrolling interests

                    91         91  
                               

Net income (loss) attributable to common shareholders

  $ 2,806   $ 3,467   $ 3,694   $ (14,428 ) $ 19,903   $ (12,634 ) $ 2,808  
                               

37



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Nine Months Ended August 28, 2011

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net sales

  $   $   $ 64,850   $ 704,880   $ 206,785   $ (15,623 ) $ 960,892  

Cost and expenses:

                                           

Cost of goods sold

            36,327     439,723     120,068     (15,804 )   580,314  

Selling, general and administrative

            6,059     252,262     56,987         315,308  

Amortization expense

                217             217  

Royalty (income) expense, net

                (14,796 )           (14,796 )
                               

Income from operations

            22,464     27,474     29,730     181     79,849  

Interest expense

        230     62,411     1,595     1,073         65,309  

Refinancing and extinguishment of debt

            1,264                 1,264  

Other (income) expense, net

                (7 )   (330 )       (337 )

Loss (income) from equity investees

    (5,319 )   (5,586 )   12,595             (1,690 )    

Loss (income) from non- guarantor equity investees

                (18,720 )       18,720      

Capital charge and intercompany interest allocation

            (56,876 )   53,800     3,076          
                               

Income (loss) before income taxes

    5,319     5,356     3,070     (9,194 )   25,911     (16,849 )   13,613  

Income tax provision (benefit)

        37     (2,516 )   3,255     7,032     (29 )   7,779  

Equity in earnings of unconsolidated affiliates

                    2,535         2,535  
                               

Income (loss) from continuing operations

    5,319     5,319     5,586     (12,449 )   21,414     (16,820 )   8,369  

Loss from discontinued operations

                (356 )   (2,694 )       (3,050 )
                               

Net income (loss)

  $ 5,319   $ 5,319   $ 5,586   $ (12,805 ) $ 18,720   $ (16,820 ) $ 5,319  
                               

38



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Cash Flows

Nine Months Ended August 26, 2012

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-
Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net cash provided by (used in) operating activities

  $   $   $ 42,908   $ (29,258 ) $ 17,752   $   $ 31,402  
                               

Investing activities:

                                           

Purchase of property, plant and equipment

            (436 )   (8,266 )   (1,309 )       (10,011 )

Proceeds from the sale of property, plant, and equipment

            90     2,220     234         2,544  

Acquisition of Comfort Revolution

                    159         159  

Net activity in investment in and advances from (to) subsidiaries and affiliates

    (1,562 )       (14,278 )   5,223     10,617          
                               

Net cash provided by (used in) investing activities

    (1,562 )       (14,624 )   (823 )   9,701         (7,308 )

Financing activities:

                                           

Equity received upon exercise of stock including related excess tax benefits

    62                         62  

Repurchase of common stock

                (2,905 )           (2,905 )

Proceeds from issuance of long term obligations

                    1,269         1,269  

Repayments of long-term obligations

                (954 )   (8,055 )       (9,009 )

Repayment of senior secured notes

            (36,050 )               (36,050 )

Debt issuance costs

            (1,120 )               (1,120 )

Other

                             
                               

Net cash provided by (used in) financing activities

    62         (37,170 )   (3,859 )   (6,786 )       (47,753 )
                               

Effect of exchange rate changes on cash

                    4,517         4,517  
                               

Change in cash and equivalents

    (1,500 )       (8,886 )   (33,940 )   25,184         (19,142 )

Cash and equivalents:

                                           

Beginning of period

    1,655         9,123     50,170     47,027         107,975  
                               

End of period

  $ 155   $   $ 237   $ 16,230   $ 72,211   $   $ 88,833  
                               

39



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Cash Flows

Nine Months Ended August 28, 2011

(in thousands)

 
  Sealy
Corporation
  Sealy
Mattress
Corporation
  Sealy
Mattress
Company
  Combined
Guarantor
Subsidiaries
  Combined
Non-Guarantor
Subsidiaries
  Eliminations   Consolidated  

Net cash provided by (used in) operating activities

  $   $   $ 39,015   $ (39,104 ) $ 6,951   $   $ 6,862  
                               

Investing activities:

                                           

Purchase of property, plant and equipment           

            (160 )   (16,612 )   (920 )       (17,692 )

Proceeds from the sale of property, plant, and equipment

                2     22         24  

Net activity in investment in and advances from (to) subsidiaries and affiliates           

    24         (28,374 )   26,372     1,978          
                               

Net cash provided by (used in) investing activities

    24         (28,534 )   9,762     1,080         (17,668 )

Financing activities:

                                           

Equity received upon exercise of stock including related excess tax benefits

    621                         621  

Repurchase of common stock

                (3,674 )           (3,674 )

Proceeds from issuance of long term obligations

                    2,568         2,568  

Repayments of long-term obligations

                (1,214 )   (2,668 )       (3,882 )

Repayment of senior secured notes

            (10,300 )               (10,300 )

Debt issuance costs

            (147 )               (147 )

Other

            (34 )               (34 )
                               

Net cash provided by (used in) financing activities

    621         (10,481 )   (4,888 )   (100 )       (14,848 )
                               

Effect of exchange rate changes on cash

                    2,333         2,333  
                               

Change in cash and equivalents

    645             (34,230 )   10,264         (23,321 )

Cash and equivalents:

                                           

Beginning of period

    1,010         9,234     59,108     39,903         109,255  
                               

End of period

  $ 1,655   $   $ 9,234   $ 24,878   $ 50,167   $   $ 85,934  
                               

40



SEALY CORPORATION

Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations

        The following management's discussion and analysis is provided as a supplement to, and should be read in conjunction with, our Condensed Consolidated Financial Statements and accompanying notes included in this Quarterly Report on Form 10-Q as well as our management's discussion and analysis included in our Annual Report on Form 10-K (File No. 001-08738). Except where the context suggests otherwise, the terms "we," "us" and "our" refer to Sealy Corporation and its subsidiaries.

        We have reclassified the financial data for all periods presented below to reflect the operations of our European manufacturing operations in France and Italy and our operations in Brazil as discontinued operations. See "Results of Operations—Discontinued Operations" later in this Item 2 for more information. Unless otherwise noted, discussions below pertain to our continuing operations.

BUSINESS OVERVIEW

        Our mattress and foundation products include the Sealy, Sealy Posturepedic, Optimum by Sealy Posturepedic, Embody by Sealy, Stearns & Foster, and Bassett brands. We produce a variety of innerspring, visco-elastic (memory foam) and latex foam products.

        The bedding market continued to see revenue, unit and average unit selling price growth in the third quarter of fiscal 2012. There is also strength in the market with respect to queen size set retail price points above $1,000. As such, we have focused our recent product introductions on these areas to take advantage of this increased market activity. Specifically, we continued shipping new products in the third quarter of fiscal 2012 including our Optimum by Sealy Posturepedic line which targets the luxury price points of the specialty bedding market and includes Opticool gel memory foam which is designed to provide a cooler feel than more traditional memory foam mattresses. Additionally, we completed the rollout of our 2012 Sealy Brand collection which targets the value price points of the bedding market as this sector of the market continues to be more resilient.

        We are exposed to inflationary pressures which can significantly impact the results of our operations. We particularly experience volatility related to the prices of steel, and petroleum-based polyurethane foam. We have experienced recent decreases in the prices of steel as manufacturers are reducing inventories. This trend is expected to reverse in the beginning of fiscal 2013 as demand for steel products increases. The primary components of polyurethane foam, TDI and Polyol, continue to experience price increases due to the strength of demand in the market as well as supply constraints due to the shift from oil to natural gas production as the price of oil rises.

THIRD QUARTER 2012 HIGHLIGHTS

        Revenues for the third quarter of fiscal 2012 were $365.4 million, with income from operations of $32.6 million and net income from continuing operations of $0.1 million. These results were impacted by the following key items:

    Our U.S. operations experienced a net sales increase of 11.2% while gross profit margins declined 0.3 percentage points as a percentage of net sales. These results were driven by increased sales of our Optimum by Sealy Posturepedic product line, premium-priced Next Generation Stearns & Foster product line and Sealy Brand collection, and premium-priced Next Generation Stearns & Foster product line and were partially offset by lower sales of our Posturepedic product line. In continuing with the trend of higher price point products, we introduced the Optimum pillow top product to the market during the third quarter of fiscal 2012.

    Our International operations experienced net sales increases of approximately 3.2%, coupled with gross profit margin decreases of 1.3 percentage points as a percentage of net sales. The

41


      increase in sales was primarily due to increased sales in Mexico and Argentina, partially offset by lower sales in Canada in US dollars. We also experienced gross margin erosion in the Canadian market which was partially offset by gross margin improvement in Argentina and Mexico.

    Selling, general, and administrative expenses increased $16.5 million to $120.6 million for the third quarter of fiscal 2012. As a percentage of net sales, these expenses increased to 33.0% of net sales in the third quarter of fiscal 2012 compared to 31.2% of net sales for the third quarter of fiscal 2011. Approximately $6.4 million of this increase was due to increased national advertising messaging surrounding the Independence and Labor Day holidays in the U.S. market.

    As part of the Optimum rollout during the third quarter of fiscal 2012, we further utilized company owned promotional displays in retail stores to demonstrate Optimum's product features and specifications. These displays are capitalized and amortized over the expected product life. During the first nine months of fiscal 2012, $8.5 million of promotional displays were transferred to various retailers.

    During the third quarter of fiscal 2012, we obtained a 45% ownership interest in a newly formed company, Comfort Revolution International, LLC ("Comfort Revolution"), a joint venture with Comfort Revolution, LLC, for a contribution of $10.0 million. Upon formation, Comfort Revolution, LLC contributed the assets and liabilities of its existing business. Comfort Revolution develops specialty foam and gel bedding products which are believed to complement our existing product offerings. Due to the difference in Comfort Revolution's fiscal year, which ends on December 31, and the availability of financial statements from Comfort Revolution, the results of Comfort Revolution are presented on a two month lag. Between June 13, 2012, the acquisition date, and June 30, 2012, the Company recognized revenues and a net loss for Comfort Revolution of $1.1 million and $0.2 million, respectively.

42


RESULTS OF OPERATIONS

    Tabular Information—Current Fiscal Quarter

        The following table sets forth our summarized results of operations for the three months ended August 26, 2012 and August 28, 2011, expressed in thousands of dollars, as well as a percentage of each period's net sales:

 
  For the three months ended:  
 
  August 26, 2012   August 28, 2011  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

Net sales

  $ 365,434     100.0 % $ 334,067     100.0 %

Cost of goods sold

    217,229     59.4     197,067     59.0  
                   

Gross profit

    148,205     40.6     137,000     41.0  

Selling, general and administrative expenses

    120,632     33.0     104,127     31.2  

Amortization expense

    73         73      

Royalty income, net of royalty expense

    (5,105 )   (1.4 )   (5,021 )   (1.5 )
                   

Income from operations

    32,605     9.0     37,821     11.3  

Interest expense

    20,929     5.7     21,935     6.6  

Refinancing and extinguishment of debt

    416     0.1     28      

Other income, net

    (131 )       (130 )    
                   

Income before income taxes

    11,391     3.2     15,988     4.7  

Income tax provision

    12,156     3.3     9,556     2.9  

Equity in earnings of unconsolidated affiliates

    875     0.2     1,057     0.3  
                   

Income (loss) from continuing operations

    110         7,489     2.2  

Loss from discontinued operations

    (307 )   (0.1 )   (891 )   (0.3 )
                   

Net (loss) income

    (197 )   (0.1 )   6,598     1.9  

Net loss attributable to noncontrolling interests

    91              
                   

Net (loss) income attributable to common shareholders

  $ (106 )   (0.1 )% $ 6,598     1.9 %
                   

Effective tax rate

    106.7 %         59.8 %      

        The following table indicates the percentage distribution of our net sales in U.S. dollars throughout our global operations:

 
  Three Months Ended:  
 
  August 26,
2012
  August 28,
2011
 

United States

    78.3 %   77.0 %

Canada

    13.9     15.7  

Other

    7.8     7.3  
           

Total

    100.0 %   100.0 %
           

43


        The following table shows our net sales and margin profitability for the major geographic regions of our operations, including local currency results for the significant international operations:

 
  For the three months ended  
 
  August 26, 2012   August 28, 2011  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

United States (U.S. Dollars):

                         

Net sales

    286,200     100.0     257,293     100.0  

Cost of goods sold

    170,173     59.5     152,429     59.2  
                   

Gross profit

    116,027     40.5     104,864     40.8  

Total International (U.S. Dollars):

                         

Net sales

    79,234     100.0     76,774     100.0  

Cost of goods sold

    47,056     59.4     44,638     58.1  
                   

Gross profit

    32,178     40.6     32,136     41.9  

Canada:

                         

U.S. Dollars:

                         

Net sales

    50,729     100.0     52,433     100.0  

Cost of goods sold

    30,311     59.8     30,100     57.4  
                   

Gross profit

    20,418     40.2     22,333     42.6  

Canadian Dollars:

                         

Net sales

    51,507     100.0     50,898     100.0  

Cost of goods sold

    30,760     59.7     29,217     57.4  
                   

Gross profit

    20,747     40.3     21,681     42.6  

Other International (U.S. Dollars):

                         

Net sales

    28,505     100.0     24,341     100.0  

Cost of goods sold

    16,745     58.7     14,538     59.7  
                   

Gross profit

    11,760     41.3     9,803     40.3  

    Quarter Ended August 26, 2012 compared with Quarter Ended August 28, 2011

        Net Sales.    Our consolidated net sales for the quarter ended August 26, 2012, were $365.4 million, an increase of $31.4 million, or 9.4%, from the quarter ended August 28, 2011. This increase was driven by increased sales volumes in both our domestic and international markets.

        Domestic—Total U.S. net sales were $286.2 million for the third quarter of fiscal 2012, an increase of 11.2% from the third quarter of fiscal 2011. The U.S. net sales increase, excluding the effects of third party sales from our component plants and the Comfort Revolution joint venture, was attributable to a 7.6% increase in wholesale average unit selling price and a 2.7% increase in wholesale unit volume. The increase in our average unit selling price was driven primarily by increases in all major innerspring lines and improved product mix related to the newly introduced Next Generation Stearns & Foster product line. The increase in unit volume is attributable to increased sales volume for our Optimum by Sealy Posturepedic, Stearns & Foster and, Sealy branded, product lines partially offset by lower sales volumes for our Posturepedic beds.

        Our Next Generation Stearns & Foster product line continues to perform strongly and drove growth in our innerspring sales which experienced a 4.0% increase from the third quarter of fiscal 2011. The success of our recently introduced Optimum by Sealy Posturepedic product line drove an 84.0% increase in the sales of our specialty products for the third quarter of fiscal 2012.

44


        International—International net sales increased $2.5 million, or 3.2%, from the third quarter of fiscal 2011 to $79.2 million. This increase was primarily due to increased sales in Mexico and Argentina partially offset by lower sales in Canada. In Canada, local currency sales increases of 1.2% translated into decreases of 3.2% in U.S. dollars due to a decline in value of the Canadian dollar. Local currency sales performance in Canada was driven by a 3.8% increase in average unit selling price, offset by a 2.5% decrease in unit volume. The increase in average unit selling price was attributable to a shift in the mix of product sold to higher priced product due to strategic promotional events featuring products at these price points. The decline in unit volume resulted from our strategic decision to focus on higher priced product that typically experiences lower unit volume.

        Gross Profit.    Our consolidated gross profit for the quarter was $148.2 million, an increase of $11.2 million from the comparable prior year period. As a percentage of net sales, gross profit decreased 0.4 percentage points to 40.6%. The decrease in percentage of net sales was primarily due to decreases in gross profit margin in our Canadian and U.S. operations, partially offset by increases in gross profit margin in our Argentina and Mexico operations. U.S. gross profit margin decreased 0.3 percentage points to 40.5% of net sales. An increase in customer incentives and certain warranty expenses reduced the U.S. gross profit percentage by 2.3 percentage points. These were partially offset by improvements in operating efficiencies as well as a shift in the mix of our product sales to higher priced products in the third quarter of fiscal 2012. In local currency, the gross profit margin in Canada was 40.3% as a percentage of net sales, which represents a decrease of 2.3 percentage points. This decrease was primarily driven by the impact of higher raw material costs.

        Selling, General, and Administrative.    Selling, general, and administrative expenses increased $16.5 million to $120.6 million for the third quarter of fiscal 2012 compared to $104.1 million for the third quarter of fiscal 2011. As a percentage of net sales, selling, general, and administrative expenses were 33.0% for the third quarter of fiscal 2012 compared with 31.2% for the third quarter of fiscal 2011. The primary changes in selling, general and administrative expenses between the third quarter of fiscal 2012 and 2011 were as follows:

 
  (Increase) /
Decrease
 

Outbound delivery

  $ (0.2 )

Cooperative advertising/promotional costs

    1.1  

Bad debt

    (0.2 )
       

Volume driven variable expenses

    0.7  

Operational fixed expenses

   
(5.6

)

Product launch costs

    (1.3 )

National advertising

    (6.6 )

Incentive compensation and defined contribution expense

    (5.5 )
       

Fixed operating expenses

    (19.0 )

Non-cash compensation

   
1.7
 

Other

    0.1  
       

Total selling, general and administrative expense change

  $ (16.5 )
       

        During the third quarter of fiscal 2012, the Company increased its level of spending for national advertising in connection with the promotion of its new Optimum by Sealy Posturepedic line of products in connection with the Independence and Labor Day holidays in the U.S., which drove increases in the related expense. The increase in operational fixed expenses is due to higher compensation and product development costs. Additionally, incentive compensation and defined contribution expense increased based on the change in our projected achievement of the associated incentive targets relative to the

45


prior year. The increases have been partially offset by decreases in non-cash compensation and promotional costs in fiscal 2012.

        Royalty income, net of royalty expense.    Our consolidated royalty income, net of royalty expenses, was $5.1 million for the three months ended August 26, 2012, which is relatively consistent with the royalty income for the three months ended August 28, 2011.

        Interest Expense.    Our consolidated interest expense for the third quarter of fiscal 2012 remained relatively consistent with the comparable prior year period. Our net weighted average borrowing cost was 11.0% and 11.2% for the three months ended August 26, 2012 and August 28, 2011, respectively. Our net weighted average borrowing cost was favorably impacted by the redemptions of our outstanding Senior Notes in the first and second quarters of fiscal 2012.

        We recognize non-cash interest related to the PIK interest on our outstanding Convertible Notes and the accretion or amortization of original issue discount and deferred debt issuance costs. The table below provides a breakout of cash and non-cash interest for the three month periods ended August 26, 2012 and August 28, 2011:

 
  Three Months Ended:  
 
  August 26,
2012
  August 28,
2011
 

Cash interest expense

  $ 14,061   $ 15,161  

Non-cash interest expense

    6,868     6,774  
           

  $ 20,929   $ 21,935  
           

        Income Tax.    Our effective income tax rates regularly differ from the Federal statutory rate principally because of the effect of non-deductible paid in kind interest, certain foreign tax rate differentials and state and local income taxes. Our effective tax rate for the three months ended August 26, 2012 was 106.7% compared to 59.8% for the three months ended August 28, 2011. The effective rate for the third quarter of fiscal 2012 period was higher than the tax rate for the third quarter of fiscal 2011 primarily due to the impact of the permanent tax differences. The most significant permanent tax difference relates to the non-deductible interest on the Company's Convertible Notes.

        Equity in Earnings of Unconsolidated Affiliates.    Earnings related to our joint ventures remained relatively consistent with that of the third quarter of fiscal 2011.

        Discontinued Operations.    During the fourth quarter of fiscal 2010, we divested the assets of our European manufacturing operations in France and Italy. Also during the fourth quarter of fiscal 2010, we discontinued our operations in Brazil and transitioned to a license arrangement with third parties in this market. We accounted for these businesses as discontinued operations, and accordingly, we have reclassified the results of operations and any losses resulting from disposition for all periods presented to reflect them as such.

46


    Tabular Information—Year to Date

 &nbs