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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 29, 2010

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 o    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 21, 2010 was approximately: 97,494,390.



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 29,
2010
  August 30,
2009
 

Net sales

  $ 346,181   $ 349,573  

Cost of goods sold

    208,616     203,508  
           
 

Gross profit

    137,565     146,065  

Selling, general and administrative expenses

   
107,498
   
110,256
 

Asset impairment loss

    22,963      

Amortization expense

    68     842  

Royalty income, net of royalty expense

    (4,535 )   (4,216 )
           
   

Income from operations

    11,571     39,183  

Interest expense

    21,784     22,127  

Loss on rights for convertible notes

        1,820  

Refinancing and extinguishment of debt and interest rate derivatives

        39  

Other income, net

    (57 )   (14 )
           
   

(Loss) income before income taxes

    (10,156 )   15,211  

Income tax provision

    6,379     3,155  

Equity in earnings of unconsolidated affiliates

    712      
           
   

Net (loss) income

  $ (15,823 ) $ 12,056  
           

(Loss) earnings per common share—Basic

  $ (0.16 ) $ 0.13  
           

(Loss) earnings per common share—Diluted

  $ (0.16 ) $ 0.05  
           

Weighted average number of common shares outstanding:

             
 

Basic

    97,043     91,884  
 

Diluted

    97,043     279,156  

See accompanying notes to Condensed Consolidated Financial Statements.

1



SEALY CORPORATION

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

 
  Nine Months Ended  
 
  August 29,
2010
  August 30,
2009
 

Net sales

  $ 1,002,336   $ 958,004  

Cost of goods sold

    596,413     572,353  
           
 

Gross profit

    405,923     385,651  

Selling, general and administrative expenses

   
323,636
   
302,533
 

Asset impairment loss

    22,963      

Amortization expense

    522     2,435  

Restructuring expenses including related asset impairment

        1,448  

Royalty income, net of royalty expense

    (12,343 )   (12,186 )
           
   

Income from operations

    71,145     91,421  

Interest expense

   
65,890
   
56,551
 

Loss on rights for convertible notes

        4,549  

Refinancing and extinguishment of debt and interest rate derivatives

    3,759     17,461  

Gain on sale of subsidiary stock

        (1,292 )

Other income, net

    (161 )   (60 )
           
   

Income before income taxes

    1,657     14,212  

Income tax provision

    13,619     3,201  

Equity in earnings of unconsolidated affiliates

    2,702      
           
   

Net (loss) income

  $ (9,260 ) $ 11,011  
           

(Loss) earnings per common share—Basic

  $ (0.10 ) $ 0.12  
           

(Loss) earnings per common share—Diluted

  $ (0.10 ) $ 0.07  
           

Weighted average number of common shares outstanding:

             
 

Basic

    95,384     91,836  
 

Diluted

    95,384     153,602  

See accompanying notes to Condensed Consolidated Financial Statements.

2



SEALY CORPORATION

Condensed Consolidated Balance Sheets

(in thousands, except per share amounts)

(unaudited)

 
  August 29,
2010
  November 29,
2009
 

ASSETS

             

Current assets:

             
 

Cash and equivalents

  $ 82,510   $ 131,427  
 

Accounts receivable, less allowances for bad debts, cash discounts and returns

    181,758     156,850  
 

Inventories

    68,634     56,810  
 

Other current assets

    19,910     21,080  
 

Deferred income tax assets

    15,375     20,222  
           

Total current assets

    368,187     386,389  
           

Property, plant and equipment—at cost

    416,354     446,989  

Less accumulated depreciation

    (246,468 )   (239,508 )
           

    169,886     207,481  
           

Goodwill

    360,878     360,583  

Intangible assets, net

    1,517     1,937  

Deferred income tax assets

    9,601     6,874  

Other assets, including debt issuance costs, net

    54,814     52,206  
           

    426,810     421,600  
           

Total assets

  $ 964,883   $ 1,015,470  
           

LIABILITIES AND STOCKHOLDERS' DEFICIT

             

Current liabilities:

             
 

Current portion—long-term obligations

  $ 7,634   $ 13,693  
 

Accounts payable

    89,229     88,971  
 

Accrued incentives and advertising

    33,215     31,804  
 

Accrued compensation

    26,466     43,105  
 

Accrued interest

    17,616     15,230  
 

Other accrued liabilities

    32,617     36,436  
           

Total current liabilities

    206,777     229,239  
           

Long-term obligations, net of current portion

    794,658     833,766  

Other liabilities

    58,004     59,625  

Deferred income tax liabilities

    875     832  

Stockholders' deficit:

             
 

Common stock, $0.01 par value; Authorized shares: 2010 and 2009—600,000 Issued and outstanding: 2010—97,477; 2009—94,417

    977     947  
 

Additional paid-in capital

    908,446     885,064  
 

Accumulated deficit

    (1,002,210 )   (992,950 )
 

Accumulated other comprehensive income, net

    (2,644 )   (1,053 )
           

Total shareholders' deficit

    (95,431 )   (107,992 )
           

Total liabilities and shareholders' deficit

  $ 964,883   $ 1,015,470  
           

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
  Accumulated
Deficit
   
 
 
  Shares   Amount   Total  

Balance at November 29, 2009

  $ 32,143     94,417   $ 947   $ 885,064   $ (992,950 ) $ (1,053 ) $ (107,992 )

Net loss

    (9,260 )                     (9,260 )         (9,260 )

Foreign currency translation adjustment

    (1,982 )                           (1,982 )   (1,982 )

Adjustment to defined benefit plan liability, net of tax of $191

    461                             461     461  

Change in fair value of cash flow hedges, net of tax of $43

    (70 )                           (70 )   (70 )

Share-based compensation

                      12,759                 12,759  

Exercise of stock options

          261     3     156                 159  

Vesting of restricted share units

          2,593     26     (4,531 )               (4,505 )

Vesting of restricted shares

          112     1     (207 )               (206 )

Excess tax benefit on share based awards

                      942                 942  

Beneficial conversion feature on Convertible paid-in-kind Notes

                      14,263                 14,263  
                               

Balance at August 29, 2010

  $ (10,851 )   97,383   $ 977   $ 908,446   $ (1,002,210 ) $ (2,644 ) $ (95,431 )
                               

See accompanying notes to Condensed Consolidated Financial Statements.

4



SEALY CORPORATION

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

 
  Nine Months Ended  
 
  August 29,
2010
  August 30,
2009
 

Operating activities:

             
 

Net (loss) income

  $ (9,260 ) $ 11,011  
 

Adjustments to reconcile net income to cash provided by operating activities:

             
   

Depreciation and amortization

    21,813     24,655  
   

Deferred income taxes

    4,259     (7,565 )
   

Impairment charges

    22,963     1,326  
   

Amortization of deferred gain on sale-leaseback

    (490 )   (485 )
   

Paid in kind interest on convertible notes

    10,830     1,820  
   

Amortization of discount on new senior secured notes

    1,702     351  
   

Amortization of debt issuance costs and other

    4,191     2,925  
   

Loss on rights for convertible notes

        4,549  
   

Share-based compensation

    12,759     7,381  
   

Excess tax benefits from share-based payment arrangements

    (942 )    
   

Loss on sale of assets

    246     383  
   

Write-off of debt issuance costs related to debt extinguishments

    2,709     2,113  
   

Loss on repurchase of senior notes

    1,050     15,232  
   

Payment to terminate interest rate swaps

        (15,232 )
   

Gain on sale of subsidiary stock

        (1,292 )
   

Other, net

    (1,635 )   (2,458 )
 

Changes in operating assets and liabilities:

             
   

Accounts receivable

    (28,724 )   (27,628 )
   

Inventories

    (13,984 )   5,684  
   

Other current assets

    (1,279 )   14,080  
   

Other assets

    (5,314 )   (1,434 )
   

Accounts payable

    3,822     5,195  
   

Accrued expenses

    (14,239 )   6,752  
   

Other liabilities

    386     (7,150 )
           
     

Net cash provided by operating activities

    10,863     40,213  
           

Investing activities:

             
 

Purchase of property, plant and equipment

    (11,369 )   (8,669 )
 

Proceeds from sale of property, plant and equipment

    67     10,385  
 

Net proceeds from sale of subsidiary stock

        1,237  
 

Investments in and loans to unconsolidated affiliate

        (2,322 )
           
     

Net cash (used in) provided by investing activities

    (11,302 )   631  
           

Financing activities:

             
 

Proceeds from issuance of long-term obligations

    2,784     3,343  
 

Repayments of long-term obligations

    (10,204 )   (15,668 )
 

Repayment of senior term loans

        (377,181 )
 

Proceeds from issuance of new senior secured notes

        335,916  
 

Proceeds from issuance of related party notes

        177,132  
 

Repayment of related party notes

        (83,284 )
 

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

    (36,050 )    
 

Proceeds from issuance of convertible notes, net

        83,284  
 

Borrowings under revolving credit facilities

        140,904  
 

Repayments under revolving credit facilities

        (205,304 )
 

Repurchase of common stock

    (4,711 )    
 

Exercise of employee stock options, including related excess tax benefits

    1,101     (330 )
 

Debt issuance costs

        (27,421 )
 

Other

    (8 )    
           
     

Net cash (used in) provided by financing activities

    (47,088 )   31,391  
           

Effect of exchange rate changes on cash

    (1,390 )   1,009  
           

Change in cash and equivalents

    (48,917 )   73,244  

Cash and equivalents:

             
 

Beginning of period

    131,427     26,596  
           
 

End of period

  $ 82,510   $ 99,840  
           

See accompanying notes to Condensed Consolidated Financial Statements.

5



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements

(unaudited)

Note 1: Basis of Presentation

        The accompanying 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 29, 2009 included within the Company's Annual Report on Form 10-K (File No. 001-08738).

        At August 29, 2010, affiliates of Kohlberg Kravis Roberts & Co. L.P. ("KKR") controlled approximately 48.2% 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.

Note 2: Recently Issued Accounting Pronouncements

        In December 2007, the Financial Accounting Standards Board ("FASB") issued authoritative guidance on noncontrolling interests in consolidated financial statements. This guidance establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The Company adopted this guidance in the first quarter of fiscal 2010, and it did not have a material impact on its financial statements.

        In December 2007, the FASB issued authoritative guidance on business combinations, which significantly changes the principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The FASB also issued guidance for recognizing and measuring goodwill acquired in a business combination and what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The Company adopted this guidance in the first quarter of fiscal 2010, and it did not have a material impact on its financial statements.

        In April 2008, the FASB issued authoritative guidance on the determination of the useful lives of intangible assets, which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of an intangible asset. The Company adopted this guidance in the first quarter of fiscal 2010, and it did not have a material impact on its financial statements.

        In June 2008, the FASB issued authoritative guidance which addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to

6



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 2: Recently Issued Accounting Pronouncements (Continued)


be included in the earnings allocation in computing earnings per share. The Company adopted this guidance in the first quarter of fiscal 2010 and retrospectively restated its earnings per share for previous periods in accordance with this guidance. The adoption did not have a material impact on the current or prior period financial statements presented herein.

        In November 2008, the Emerging Issues Task Force ("EITF") of the FASB issued authoritative guidance which clarifies the accounting for certain transactions involving equity method investments. The Company adopted this guidance in the first quarter of fiscal 2010, and it did not have a material impact on its financial statements.

        In December 2008, the FASB issued authoritative guidance on employers' disclosures about plan assets of a defined benefit pension or other postretirement plan. This interpretation is effective for financial statements issued for fiscal years ending after December 15, 2009. The Company will adopt this interpretation in the fourth quarter of fiscal 2010. The adoption of this interpretation will increase the disclosures in the financial statements related to the assets of the Company's defined benefit pension plans.

        In June 2009, the FASB issued authoritative guidance on the consolidation of variable interest entities ("VIE"). This new guidance significantly affects the overall consolidation analysis. The Company adopted this guidance in the first quarter of fiscal 2010. The Company has evaluated the guidance and does not have a VIE for which it is currently required to evaluate whether it is the primary beneficiary. As such, the adoption of this guidance did not have a material impact on the Company's financial statements.

        In January 2010, the FASB issued authoritative guidance to amend the disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 and Level 2 of the fair value measurement hierarchy, including the reasons and timing of the transfers, which the Company adopted in the second quarter of fiscal 2010. Additionally, the guidance requires a rollforward of activities related to the purchases, sales, issuance and settlements of assets and liabilities measured using Level 3 fair value measurements. The Company will adopt this guidance in the first quarter of fiscal 2012. The adoption of this guidance will increase the level of disclosures in the financial statements related to fair value measurements.

        In January 2010, the FASB issued authoritative guidance to amend the accounting and reporting requirements for decreases in ownership of a subsidiary. This guidance requires that a decrease in the ownership interest of a subsidiary that does not result in a change of control be treated as an equity transaction. The guidance also expands the disclosure requirements about the deconsolidation of a subsidiary. The Company adopted this guidance in the first quarter of fiscal 2010 and it did not have a material impact on its financial statements.

        In July 2010, the FASB issued authoritative guidance which requires expanded disclosures about the credit quality of an entity's financing receivables and its allowance for credit losses on a disaggregated basis. The Company will adopt the portion of this guidance which pertains to disclosures as of the end of a reporting period in the first quarter of fiscal 2011. The Company will adopt the portion of this guidance which pertains to the activity that occurs during a reporting period in the second quarter of fiscal 2011. The adoption of this guidance will increase the level of disclosures in the

7



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 2: Recently Issued Accounting Pronouncements (Continued)


financial statements related to the credit quality of its financing receivables and allowance for credit losses.

Note 3: Restatement of Previous Periods

        During the year-end financial close process of fiscal 2009, the Company discovered an error related to the depreciation of the assets acquired through the purchase of certain of its European subsidiaries in fiscal 2001. The Company also discovered an error related to the deferred income tax liabilities recorded on these assets. The errors, which were immaterial to the prior periods, resulted in an understatement of depreciation expense, recorded as a component of cost of goods sold and an overstatement of the income tax provision in the Condensed Consolidated Statements of Operations for prior periods. The recorded balances of accumulated depreciation and deferred tax liabilities were, likewise, understated and overstated, respectively in the Condensed Consolidated Balance Sheets for prior periods. The Company evaluated the effects of these errors on prior periods' consolidated financial statements, individually and in the aggregate, in accordance with the guidance provided by SEC Staff Accounting Bulletin ("SAB") No. 108, codified as Topic 1.N, "Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements," and concluded that no prior period is materially misstated. However, in accordance with the provisions of this SAB Topic, the Company is restating its Condensed Consolidated Financial Statements for the nine months ended August 30, 2009 as follows (in thousands):

 
  Condensed Consolidated Statements of
Operation Information
 
 
  Nine Months Ended
August 30, 2009
 
 
  As Previously
Reported
  Adjustments   Restated  

Cost of goods sold

  $ 571,538   $ 815   $ 572,353  

Gross profit

    386,466     (815 )   385,651  

Income from operations

    92,236     (815 )   91,421  

Income before income taxes

    15,027     (815 )   14,212  

Income tax provision

    3,463     (262 )   3,201  

Net income

    11,564     (553 )   11,011  

Eanrings per common share—Basic

    0.13         0.12  

Earnings per common share—Diluted

    0.09         0.07  

Basic shares

   
91,836
         
91,836
 

Diluted shares

    153,602           153,602  

8



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 3: Restatement of Previous Periods (Continued)

 

 
  Condensed Consolidated Statements of
Cash Flow Information for the
Nine Months Ended
August 30, 2009
 
 
  As Previously
Reported
  Adjustments   Restated  

Net income

  $ 11,564   $ (553 ) $ 11,011  

Adjustments to reconcile net income to cash provided by operating activities:

                   

Depreciation and amortization

    23,840     815     24,655  

Deferred income taxes

    (7,303 )   (262 )   (7,565 )

Net cash provided by operating activities

    40,213         40,213  

Note 4: 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 stock options granted and outstanding options 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 29, 2010 was $3.5 million and $12.8 million, respectively, and $5.2 million and $7.4 million, respectively, for the three and nine months ended August 30, 2009.

Modification of Awards

        During the third quarter of fiscal 2009, the Company undertook a modification to the terms of its outstanding share-based compensation awards to give effect to the dilution caused by the issuance of rights to purchase notes convertible into shares of common stock. For outstanding stock option awards granted under the 1998 Plan, the number of awards was increased by 32.7696%, and the strike price of the awards was reduced by 24.6815%. For awards granted under the 2004 Plan, the number of awards outstanding was not adjusted, but the strike price of the outstanding awards was reduced by 24.6815%. The increase to the number of outstanding awards has been treated as an additional grant of stock options under the 1998 Plan as disclosed below.

        The Company also modified the terms of its outstanding restricted share unit ("RSU") awards by increasing the number of awards by 32.7696%. This modification resulted in an additional 112,856 awards being granted. However, since the Company's restricted shares outstanding as of the modification date participated in the rights offering, there was no modification of the restricted share awards.

        The number of units outstanding under the Sealy Corporation Directors' Deferred Compensation Plan was also increased by 32.7696% as part of this modification, resulting in an additional 62,953 awards being granted at a grant date fair value of $2.00 per unit.

        In connection with the modification of its outstanding share-based compensation awards, the Company will recognize additional compensation expense of $2.1 million, which will be recorded as a component of selling, general and administrative expenses in the Condensed Consolidated Statements

9



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 4: Share-Based Compensation (Continued)


of Operations. Of this amount, $1.6 million was recognized in the three and nine months ended August 30, 2009 which primarily represents the additional compensation cost related to awards that were vested at the date of the modification.

        Assumptions used in valuing stock options modified in the third quarter of fiscal 2009 were as follows:

Expected volatility

    60 %

Expected dividend yield

    0.00 %

Expected term (in years)

    0.00 - 7.47  

Risk-free rate

    0.52% - 3.46 %

Stock Option Awards

        During the three and nine months ended August 29, 2010, the Company granted no new options to purchase shares of common stock. During the nine months ended August 30, 2009, the Company granted options to purchase 58,487 shares of common stock, in addition to those granted through the modification, to newly hired and promoted employees and recognized an insignificant amount of compensation expense associated with these grants during the nine months ended August 30, 2009. The options granted during the third quarter of fiscal 2009 had a weighted average grant-date fair value of $3.09 per option.

        The Company valued these stock option grants using the trinomial lattice valuation model with the following assumptions:

 
  Three Months
Ended
August 29, 2009
 

Expected volatility

    40 %

Expected dividend yield

    0.00 %

Expected term (in years)

    5.71 - 6.31  

Risk-free rate

    3.48 %

        Due to the lack of sufficient historical trading information with respect to its own shares, the Company estimated expected volatility based on its own shares weighted with a portfolio of selected stocks of companies believed to have market and economic characteristics similar to its own. The expected dividend yield is assumed to be zero based on restrictions to pay a dividend under the provisions of the Company's debt agreements. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected term is based on an analysis of the early exercise behavior of employees.

10



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 4: Share-Based Compensation (Continued)

        A summary of option activity under the 1998 Plan for the nine months ended August 29, 2010, is presented below:

 
  Shares Subject to Options   Weighted Average
Exercise Price Per Share
 

Outstanding November 29, 2009

    2,102,162   $ 1.09  
 

Exercised

    (228,888 )   0.49  
             

Outstanding August 29, 2010 (all fully vested and exercisable)

    1,873,274   $ 1.16  
 

Weighted average remaining contractual term

   
3.6 years
       
 

Aggregate intrinsic value of in-the-money options at August 29, 2010 (in thousands)

  $ 2,383        

        A summary of option activity under the 2004 Plan for the nine months ended August 29, 2010, is presented below:

 
  Shares Subject to Options   Weighted Average
Exercise Price Per Share
 

Outstanding November 29, 2009

    9,568,777   $ 5.20  
 

Exercised

    (28,068 ) $ 1.64  
 

Forfeited

    (2,639,385 ) $ 4.62  
             

Outstanding August 29, 2010

    6,901,324   $ 5.44  
 

Weighted average remaining contractual term

    4.7 years        
 

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

  $ 1,283        

Exercisable at August 29, 2010

    4,660,413        
 

Weighted average remaining contractual term

    4.7 years        
 

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

  $ 756        

        As of August 29, 2010, the Company had approximately $2.0 million of unrecognized compensation expense related to stock option awards, which is expected to be recognized over a weighted average period of 3.4 years.

        The Company has granted to employees stock options 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 29, 2010, it is the Company's expectation that the performance targets for these stock options will not be met. As such, the related unrecognized compensation cost is being recognized over the remainder of the requisite service period for those options that vest over the remaining service period. Further, the Company has not recognized compensation cost in the current period for certain options to purchase 667,532 shares of common stock that do not vest unless the performance targets are achieved. Total unrecognized compensation cost related to these options is $1.3 million.

11



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 4: Share-Based Compensation (Continued)

Restricted Shares

        At August 29, 2010, the Company had outstanding 97,324 restricted shares that are considered to be non-vested shares, and have the same rights as the Company's outstanding common shares, including dividend participation rights, except that they cannot be sold by the holder until the end of the vesting period. During the three and nine months ended August 29, 2010, 194,647 of the outstanding restricted shares vested. The restricted shares that vested were settled on a net basis which provided for the repurchase and cancellation of 82,628 shares as a means to cover the required minimum withholding tax payments. A total of 112,019 common shares were delivered to the holder of these awards. As of August 29, 2010, the remaining unrecognized compensation cost related to restricted stock awards was $0.6 million which is expected to be recognized over the remaining vesting period of 0.9 years. As the restricted shares outstanding participated in the rights offering, there was no modification of these awards as part of the 2009 modification.

Restricted Share Unit ("RSU") Awards

        As of August 29, 2010, the Company had outstanding 440,660 RSUs which vest based on the attainment of certain performance targets that are tied to the Company's earnings performance and a three-year service requirement. None of these RSUs were granted in the three or nine months ended August 29, 2010. If the performance targets are not met, then the RSUs will not vest. As of August 29, 2010, the first of the related performance targets has been met indicating that one-third of the awards will vest upon the completion of the service requirement.

        As of August 29, 2010, the Company also had outstanding 12,802,144 time-based RSUs that vest based on the passage of time and which do not contain performance requirements. The awards granted prior to the three and nine months ended August 30, 2009 accrete in the number of RSUs at an annual rate of 8% payable semi-annually until the RSUs are vested or forfeited. The number of awards outstanding above gives effect to this accretion.

        During the three and nine months ended August 29, 2010, the Company approved grants of 525,000 and 775,000 RSUs, respectively, that vest ratably over three years and do not contain an accretion factor. The RSUs granted during the three months ended August 29, 2010 have a grant date fair value of $2.68 per unit based on the closing price of the Company's common stock as of the grant date.

        During the three and nine months ended August 30, 2009, the Company approved grants of 16,251,433 and 16,595,833 RSUs, respectively. The RSUs granted in the third quarter of fiscal 2009 have a weighted average grant date fair value of $2.00 based on the closing price of the Company's common stock as of the grant date. The RSUs granted during the third quarter of fiscal 2009 vest based on the passage of time and do not contain performance requirements. The RSU award amount accretes in the number of RSUs at an annual rate of 8% payable semi-annually until the RSUs are vested or forfeited. The grants discussed above give effect to this accretion.

12



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 4: Share-Based Compensation (Continued)

        In connection with the modification of share-based compensation awards discussed above, the RSUs outstanding as of June 12, 2009, which were all performance-based awards, were modified to increase the number of awards by 32.7696%. This modification resulted in an additional 112,856 awards being granted and additional compensation cost of $0.2 million which will be recognized based on the forecasted attainment of the performance targets over time. The additional awards granted as part of this modification are included as RSUs granted as disclosed below.

        None of the Company's outstanding RSUs contain dividend participation rights.

        A summary of restricted share unit award activity for the nine months ended August 29, 2010, is presented below:

 
  Unvested Restricted
Share Units
  Weighted Average Grant
Date Fair Value
 

Outstanding November 29, 2009

    16,954,906   $ 2.02  
 

Granted

    775,000     3.00  
 

Vested

    (4,075,166 )   1.98  
 

Forfeited

    (411,936 )   1.97  
             

Outstanding August 29, 2010

    13,242,804   $ 2.08  
 

Weighted average remaining vesting period

    1.9 years        

        As of August 29, 2010, the remaining unrecognized compensation cost related to the total outstanding RSUs was $13.1 million which will be recognized based on the Company's forecasted attainment of the performance targets or over time depending upon the vesting criteria of the award. As of August 29, 2010, it is the Company's expectation that the performance targets for RSUs with performance targets will be met.

Note 5: Inventories

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

 
  August 29, 2010   November 29, 2009  

Raw materials

  $ 31,333   $ 29,700  

Work in process

    24,574     19,158  

Finished goods

    12,727     7,952  
           

  $ 68,634   $ 56,810  
           

Note 6: Warranty Costs

        The Company's warranty policy provides a 10-year non-prorated warranty service period on all currently manufactured Sealy Posturepedic, Stearns & Foster and Bassett bedding products and certain other Sealy-branded products. In addition, 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. The Company also offers a 20-year limited

13



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 6: Warranty Costs (Continued)


warranty on its RightTouch product line which covers only certain parts of the product and is prorated for part of the twenty years. The RightTouch line was discontinued in the third quarter of fiscal 2008. 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 29, 2010 and August 30, 2009 was as follows (in thousands):

 
  August 29, 2010   August 30, 2009  

Accrued warranty obligations at beginning of period

  $ 16,464   $ 16,487  

Warranty claims

    (14,443 )   (13,379 )

Warranty provisions

    15,871     13,354  
           

Accrued warranty obligations at end of period

  $ 17,892   $ 16,462  
           

        As of August 29, 2010 and November 29, 2009, respectively, $11.0 million and $10.6 million was included as a component of other accrued liabilities and $6.9 million and $5.9 million was 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 $4.5 million and $4.4 million for the nine months ended August 29, 2010 and the nine months ended August 30, 2009, respectively.

Note 7: 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, which relates entirely to the Americas segment, for the nine months ended August 29, 2010 were as follows (in thousands):

Balance as of November 29, 2009

  $ 360,583  

Increase due to foreign currency translation

    295  
       

Balance as of August 29, 2010

  $ 360,878  
       

        Total other intangibles of $1.5 million (net of accumulated amortization of $3.1 million) as of August 29, 2010 consisted primarily of licenses, which are amortized using a straight-line method over periods ranging from 5 to 15 years. Costs to renew or extend the term of a recognized intangible asset are expensed as incurred. The Company recognized amortization expense associated with intangibles of $0.1 million and $0.5 million, respectively, for the three and nine months ended August 29, 2010 and $0.8 and $2.4 million, respectively for the three and nine months ended August 30, 2009. The Company expects to recognize amortization expense relating to these intangibles of $0.1 million for the remainder

14



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 7: Goodwill and Other Intangible Assets (Continued)


of 2010, $0.3 million in 2011, $0.3 million in 2012, $0.3 million in 2013, $0.3 million in 2014 and $0.3 million thereafter.

Note 8: Debt Issuance Costs

        On March 16, 2010, the Company redeemed 10%, or $35.0 million, 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. In connection with the repurchase, the Company recognized charges of $1.1 million related to the premium paid to repurchase the notes and $2.7 million related to write-off of related debt issuance costs and original issue discount. These charges were recorded as a component of refinancing and extinguishment of debt and interest rate derivatives in the Condensed Consolidated Statements of Operations.

        The Company capitalizes costs associated with the issuance of debt and amortizes them as additional interest expense over the lives of the debt on a straight-line basis which approximates the effective interest method. In connection with the refinancing of the Company's senior secured credit facilities in May 2009, the Company recorded fees in the amount of $27.6 million which were deferred and will be amortized over the life of the new agreements. Since the previously existing senior secured term loans were considered terminated under the provisions of the applicable authoritative accounting guidance, the remaining unamortized debt issuance costs of $2.1 million were expensed and recognized as a component of debt extinguishment and refinancing expenses in the Condensed Consolidated Statements of Operations. The remaining unamortized debt issuance costs of $0.4 million associated with the previously existing senior revolving credit facility will continue to be amortized over the life of the Company's new asset-based revolving credit facility in accordance with the provisions of the applicable authoritative accounting guidance.

Note 9: Long-Term Obligations

        Long-term obligations as of August 29, 2010 and November 29, 2009 consisted of the following (in thousands):

 
  August 29, 2010   November 29, 2009  

Asset-based revolving credit facility

  $   $  

Senior secured notes

    303,978     336,625  

Convertible notes(1)

    177,320     180,109  

Senior subordinated notes

    268,945     268,945  

Financing obligations

    40,237     41,296  

Other

    11,812     20,484  
           

    802,292     847,459  

Less current portion

    (7,634 )   (13,693 )
           

  $ 794,658   $ 833,766  
           

(1)
Includes PIK interest of $2.0 million and $5.3 million for which the principal balance of the Convertible Notes has not yet been increased at August 29, 2010 and November 29, 2009, respectively.

15



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)

Debt Refinancing

        On May 13, 2009, the Company announced a comprehensive plan to refinance its existing senior secured credit facilities and replace them with indebtedness that has longer-dated maturities and eliminates quarterly financial ratio based maintenance covenants (the "Refinancing"). Through the Refinancing, the Company has: 1) entered into a new asset-based revolving credit facility (the "ABL Revolver") which provides commitments of up to $100.0 million maturing in May 2013; 2) issued $350.0 million in aggregate principal amount of senior secured notes due April 2016 (the "Senior Notes"); and 3) issued $177.1 million in aggregate principal amount of senior secured convertible paid in kind ("PIK") notes due July 2016 which are convertible into shares of the Company's common stock (the "Convertible Notes").

        At May 31, 2009, the rights offering (discussed below) related to the Convertible Notes had not yet expired, and therefore, none of the Convertible Notes were issued as of this date. However, the Company had entered into a forward purchase agreement with a related party, Sealy Holding LLC (the "Purchaser"), an affiliate of KKR, in connection with the distribution of the subscription rights through which the Purchaser provided $177.1 million in cash to support its obligation to exercise its rights as well as an oversubscription for those rights that are not exercised by other common shareholders.

        The proceeds from the Refinancing were used to repay all of the outstanding amounts due under the Company's previously existing senior secured credit facilities, which consisted of a $125 million senior revolving credit facility and senior secured term loans, and to increase cash for general operating purposes.

ABL Revolver

        The ABL Revolver provides for revolving credit financing of up to $100.0 million, subject to borrowing base availability, and matures in May 2013. As of August 29, 2010, there were no amounts outstanding under the ABL Revolver. At August 29, 2010, the Company had approximately $67.7 million available under the ABL Revolver which represents the calculated borrowing base reduced by outstanding letters of credit of $16.1 million.

        The ABL Revolver agreement requires the Company to maintain a fixed charge coverage ratio in excess of 1.1 to 1.0 in periods of minimum availability where the availability for two consecutive calendar days is less than the greater of 1) 15% of the total commitment under the ABL Revolver and 2) $15.0 million. As of August 29, 2010, the Company was not in a minimum availability period under the ABL Revolver.

Senior Secured Notes

        On May 29, 2009, the Company issued $350.0 million aggregate principal amount of Senior Notes maturing April 2016 bearing 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 the three and nine months ended August 29, 2010, the Company recognized additional interest expense of $0.3 million and

16



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)


$1.1 million, respectively, related to the accretion of the OID. For both the three and nine months ended August 30, 2009, the additional interest expense recognized related to the accretion of the OID was $0.4 million.

        As discussed further in Note 8, on March 16, 2010, the Company redeemed 10%, or $35.0 million, 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

        On May 13, 2009, the Company announced a rights offering pursuant to which rights to subscribe for Convertible Notes were issued at no charge to all holders of the Company's common stock at the close of business on May 26, 2009 at a rate of one right per share of common stock. Every 13 rights entitled its holder to purchase a Convertible Note at a subscription price of $25.00, and each Convertible Note was initially convertible into 25 shares of common stock. The rights offering expired on July 2, 2009, and the related Convertible Notes were issued on July 10, 2009.

        The issuance of the 92,116,369 rights to purchase the Convertible Notes was considered a non-reciprocal transfer with owners and was therefore treated as a dividend of $188.8 million in the second quarter of fiscal 2009. The amount recorded as a dividend was calculated based on the initial fair value of the rights issued of $2.05 per right based on the initial trading value of the rights on the active market on which they traded. See Note 11. The rights were considered to constitute written options which are accounted for as derivative instruments and were adjusted, prior to exercise or expiration, to fair value through earnings. See Note 10.

        On May 15, 2009, the Company entered into a forward purchase agreement (the "Forward Contract") with the Purchaser in connection with the distribution of the subscription rights discussed above. The Forward Contract required the Purchaser to purchase up to $177.1 million aggregate principal amount of Convertible Notes which represented the maximum number of Convertible Notes that the Purchaser could have been obligated to purchase. The Forward Contract was settled upon the expiration of the rights offering. Upon settlement, the Company delivered to the Purchaser the Convertible Notes that were not subscribed for by the Company's shareholders (other than the Purchaser) and cash in an amount equal to the purchase price of the Convertible Notes that were subscribed to by the Company's shareholders (other than the Purchaser) along with accrued interest. In consideration of the Forward Contract, the Purchaser posted cash of $177.1 million on May 29, 2009 which bore interest during the rights offering period at the rate of LIBOR plus 3.00%. On July 10, 2009, the forward contract was settled resulting in a repayment to the Purchaser of $84.0 million which represented $83.3 million related to rights exercised by shareholders other than the Purchaser and an interest payment of $0.7 million. Under the terms of the Forward Contract, the Company paid the Purchaser a forward contract payment of $1.0 million which was recorded as a component of debt issuance costs, net, and other assets in the Condensed Consolidated Balance Sheet as of November 29, 2009 and is being amortized as a component of interest expense within the Condensed Consolidated Statements of Operations.

        Due to the agreement by the Purchaser to exercise all of the rights distributed to it under the terms of the Forward Contract, the 46,625,921 rights allocable to the Purchaser have been considered

17



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)


to be exercised at issuance of the rights. The fair value of these rights was considered to represent a substantial premium related to the issuance of the Convertible Notes. As such, $95.6 million of this premium was recorded as a component of additional paid-in capital upon issuance of the rights. The amount of the premium recognized was based upon the $2.05 initial fair value of the rights. The 45,490,448 rights issued to the Company's other shareholders remained outstanding through the rights period and were adjusted to their fair value (See Note 13) until the issuance of the Convertible Notes on July 10, 2009 as the rights were considered to be written options and were accounted for as derivative liabilities while they were outstanding. Upon issuance of the Convertible Notes, the current fair value of these rights was also considered to represent a substantial premium related to the issuance of the Convertible Notes and $97.8 million of premium was recorded as a component of additional paid-in capital within the Condensed Consolidated Balance Sheets.

        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 and the fair value of the underlying common stock. Upon each of the January 15, 2010 and July 15, 2010 interest payment dates, 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 the PIK interest payment of $7.0 million and $7.3 million, respectively. The recognition of these beneficial conversion features resulted in the recognition of a discount of $14.3 million, which was reflected as a reduction of the balance of the Convertible Notes with an offsetting increase to additional paid-in capital. The recognized discount will be accreted through interest expense over the remaining term of the Convertible 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 29, 2010, there were an insignificant number of conversions of Convertible Notes into common shares.

        The indentures and agreements governing the 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 Sealy Mattress Company's 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 our Senior Notes and the 2014 Notes, we are restricted from paying dividends or making other distributions to Sealy Corporation unless we are able to satisfy certain requirements or

18



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 9: Long-Term Obligations (Continued)


use an available exception from the limitation. As of August 29, 2010, the net assets of Sealy Mattress Company and its subsidiaries of $234.0 million were restricted from being distributed to its parent due to the provisions in its long-term debt agreements. However, these agreements would allow $32.6 million of these assets to be distributed without restriction as restricted payments. At August 29, 2010, the Company was in compliance with the covenants contained within the related note indentures and agreements.

Note 10: Derivative Instruments and Hedging Strategies

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

Interest Rate Risk

        The Company is exposed to interest rate risk associated with fluctuations in the interest rates on its variable interest rate debt. In order to manage this risk, the Company has entered into several interest rate swap agreements that convert the debt's variable interest rate to a fixed interest rate. These swap agreements are either designated as hedging instruments or are considered to be economic hedges which are not designated as hedging instruments. The gains and losses on both designated and undesignated swap agreements will offset losses and gains on the transactions being hedged. The Company formally documents qualifying hedged transactions and hedging instruments. The Company assesses, both at inception of the contract and on an ongoing basis, whether the hedging instruments are effective in offsetting changes in cash flows of the hedged transaction. The fair values of the interest rate agreements are estimated as described in Note 10, 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 interest rate fluctuations are as follows:

        Prior to the Refinancing, the Company had three interest rate swap agreements related to term debt under our preexisting senior credit facility which were formally designated as cash flow hedges. These interest rate swaps consisted of: 1) an agreement fixing the floating portion of the interest rate at 5.495% on $242 million of the outstanding balance through November 2008, declining to $240 million from December 2008 through November 2009, and further declining to $180 million from December 2009 through November 2010; 2) an agreement fixing the floating portion of the interest rate at 1.952% on $20.0 million of the outstanding balance through November 4, 2009; and 3) an agreement fixing the floating portion of the interest rate at 1.991% on $107.0 million of the outstanding balance through February 4, 2010. In connection with the Refinancing, the Company paid $15.2 million to terminate these interest rate swap agreements which was recorded as refinancing expense in the second quarter of fiscal 2009.

        Additionally, the Company has three interest rate swaps outstanding for notional amounts of 2.3 million Euros, 2.9 million Euros and 3.5 million Euros which fix the floating interest rates on the Company's debt of its Europe segment at 4.92%, 4.85% and 4.50%, respectively. The notional amounts of these contracts amortize over the life of the agreement and the agreements expire in May 2019,

19



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)


January 2013 and October 2013. The Company has not formally documented these interest rate swaps as hedges.

        As of August 29, 2010, the total notional amount of the Company's interest rate swap agreements was $11.0 million, which relates to agreements that have not been designated as hedging instruments. The maximum length of time over which the Company is hedging its exposure to the variability of future cash flows related to forecasted interest payments through interest rate swap agreements is through May 2019.

Foreign Currency Exposure

        The Company is exposed to foreign currency risk related to purchases of materials and royalty payments 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 certain foreign currency fluctuations are as follows:

        At August 29, 2010, the Company had 35 forward foreign currency contracts and 7 foreign currency option contracts to sell Canadian dollars and receive a total of 32.9 million U.S. dollars at specified exchange rates with expiration dates ranging from September 15, 2010 through June 15, 2011. At August 30, 2009, the Company had three forward foreign currency contracts and three foreign currency option contracts to sell Canadian dollars and receive a total of 10.2 million U.S. dollars at specified exchanges rates with expiration dates ranging from September 15, 2009 through November 15, 2009. 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 or selling, general and administrative expenses in the Condensed Consolidated Statements of Operations. At August 29, 2010, the Company had one outstanding foreign currency contract that was not designated as a hedge for accounting purposes. This contract had a fair value of an insignificant amount. At November 29, 2009, the Company did not have any outstanding foreign currency contracts that were not designated as hedges for accounting purposes.

20



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)

        At August 30, 2009, the Company had two forward foreign currency contracts outstanding to purchase a total of 0.9 million Euros with expiration dates ranging from September 30, 2009 through December 31, 2009. These hedges were entered into to protect against the fluctuation in the Euro denominated royalty payments related to a third party license held by the Company. The Company formally designated these contracts as cash flow hedges, and they were expected to be highly effective in offsetting fluctuations in these royalty payments related to changes in the foreign currency exchange rates. These hedges were no longer outstanding at August 29, 2010.

        At August 29, 2010, the maximum length of time over which the Company is hedging its exposure to the reduction in value of certain forecasted foreign currency cash flows through foreign currency forward agreements is through June 15, 2011. Over the next 12 months, the Company expects to reclassify $0.8 million of deferred gains from accumulated other comprehensive income to selling, general and administrative expense as related forecasted foreign currency payments are made.

        For the three and nine months ended August 29, 2010, the Company recognized foreign currency transaction (losses) of $(0.6 million) and $(2.4 million), respectively, compared with (losses) of $(2.4 million) and $(3.2 million), respectively, for the three and nine months ended August 30, 2009. These amounts are recognized in cost of goods sold or selling, general and administrative expenses 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. The Company designates these fixed price swap contracts as hedging instruments. These contracts protect against the reduction in value of forecasted cash flows resulting from the purchases of diesel fuel. The fair values of the fixed price swap 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 diesel price fluctuations are as follows:

        At August 29, 2010, the Company had five fixed price swap contracts outstanding to purchase 0.6 million gallons of diesel fuel at specified prices with expiration dates ranging from September 30, 2010 through January 31, 2011. These hedges 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 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 diesel fuel related to changes in the underlying diesel fuel prices.

21



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)

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.

Rights to Purchase Convertible Notes

        During the second quarter of fiscal 2009, the Company issued rights to holders of its common stock at the close of business on May 26, 2009. As described in Note 11, these rights entitled holders to purchase the Company's Convertible Notes issued in connection with the Refinancing. These rights were considered to be written options and therefore were treated as derivatives and were adjusted, after issuance, to fair value through earnings. Based on the terms of the forward purchase agreement with the Purchaser, the rights related to the Purchaser's then approximate 50.6% ownership were considered to be exercised as of the date of the issuance of the right.

        The fair value of the rights attributable to the Purchaser, which was $95.6 million at May 27, 2009, was recorded as additional paid-in capital upon issuance. The rights issued to other shareholders remained outstanding through the issuance of the Convertible Notes on July 10, 2009, and were adjusted to their market value through that date. The Company recognized losses on these rights of $1.8 million and $4.5 million for the three and nine months ended August 30, 2009, respectively. At the expiration of the rights, the fair value of the rights issued to other shareholders of $97.8 million was recorded as additional paid-in capital.

22



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)

        At August 29, 2010 and November 29, 2009, the fair value carrying amount of the Company's derivative instruments was recorded as follows (in thousands):

 
  Asset Derivatives   Liability Derivatives  
 
  August 29, 2010   August 29, 2010  
 
  Balance Sheet
Location
  Fair Value   Balance Sheet
Location
  Fair Value  

Derivatives designated as hedging instruments

                     
 

Foreign exchange contracts

  Other current assets   $ 799   Other current liabilities   $  
 

Commodity fixed price swap contracts

  Other current assets     10   Other current liabilities     (12 )
                   

Total derivatives designated as hedging instruments

        809         (12 )

Derivatives not designated as hedging instruments

                     
 

Interest rate contracts

  Other noncurrent assets     532   Other noncurrent liabilities      
                     
 

Foreign exchange contracts

  Other current assets     5   Other current liabilities      
                   

Total derivatives not designated as hedging instruments

        537          
                   

Total derivatives

      $ 1,346       $ (12 )
                   

 

 
  Asset Derivatives   Liability Derivatives  
 
  November 29, 2009   November 29, 2009  
 
  Balance Sheet
Location
  Fair Value   Balance Sheet
Location
  Fair Value  

Derivatives designated as hedging instruments Foreign exchange contracts

  Other current assets   $ 1,133   Other current liabilities   $  
                   

Total derivatives designated as hedging instruments

        1,133          

Derivatives not designated as hedging instruments Interest rate contracts

  Other noncurrent assets     475   Other noncurrent liabilities      
                   

Total derivatives not designated as hedging instruments

        475          
                   

Total derivatives

      $ 1,608       $  
                   

23



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)

        The effect of derivative instruments on the Condensed Consolidated Statement of Operations for the three and nine months ended August 29, 2010 and August 30, 2009, was as follows (in thousands):

Three Months Ended August 29, 2010  
Derivatives in Designated
Cash Flow Hedging
Relationships
  Amount of
Gain/(Loss)
Recognized
in OCI on
Derivatives
(Effective Portion)
  Location of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Amount of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Location of Gain/(Loss)
Recognized in Income on
Derivatives (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
  Amount of Gain/(Loss)
Recognized in Income on
Derivatives (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
 

Diesel fixed price swap contracts

    (7 )

Selling, general and administrative expenses

    33  

Selling, general and administrative expenses

     

Foreign exchange contracts

    141  

Cost of goods sold

    2  

Cost of goods sold

     
                       
 

Total

  $ 134       $ 35       $  
                       

 

Nine Months Ended August 29, 2010  
Derivatives in Designated
Cash Flow Hedging
Relationships
  Amount of
Gain/(Loss)
Recognized
in OCI on
Derivatives
(Effective Portion)
  Location of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Amount of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Location of Gain/(Loss)
Recognized in Income on
Derivatives (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
  Amount of Gain/(Loss)
Recognized in Income on
Derivatives (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
 

Diesel fixed price swap contracts

    (1 )

Selling, general and administrative expenses

    65  

Selling, general and administrative expenses

     

Foreign exchange contracts

    (34 )

Cost of goods sold

    54  

Cost of goods sold

     
                       
 

Total

  $ (35 )     $ 119       $  
                       

 

Three Months Ended August 30, 2009  
Derivatives in Designated Cash
Flow Hedging Relationships
  Amount of
Gain/(Loss)
Recognized
in OCI on
Derivative
(Effective Portion)
  Location of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Amount of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Location of Gain/(Loss)
Recognized in Income on
Derivative (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
  Amount of Gain/(Loss)
Recognized in Income on
Derivative (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
 

Foreign exchange contracts

    70  

Selling, general and administrative expenses

    56  

Selling, general and administrative expenses

     
                       
 

Total

  $ 70       $ 56       $  
                       

 

Nine Months Ended August 30, 2009  
Derivatives in Designated Cash
Flow Hedging Relationships
  Amount of
Gain/(Loss)
Recognized
in OCI on
Derivative
(Effective Portion)
  Location of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
(Effective Portion)
  Amount of Gain/(Loss)
Reclassified from
Accumulated
OCI into Income
  Location of Gain/(Loss)
Recognized in Income on
Derivative (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
  Amount of Gain/(Loss)
Recognized in Income on
Derivative (Ineffective
Portion and Amount
Excluded from
Effectiveness Testing)
 

Interest rate contracts

    (3,864 )

Interest income (expense)

    (5,266 )

Interest income (expense)

     

Interest rate contracts

     

Refinancing expense

     

Refinancing expense

    (15,232 )

Foreign exchange contracts

    259  

Selling, general and administrative expenses

    164  

Selling, general and administrative expenses

     
                       
 

Total

  $ (3,605 )     $ (5,102 )     $ (15,232 )
                       

24



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 10: Derivative Instruments and Hedging Strategies (Continued)

 

Three Months Ended  
 
   
  August 29, 2010   August 30, 2009  
Derivatives Not Designated as
Hedging Instruments
  Location of Gain/(Loss)
Recognized in Income
on Derivatives
  Amount of Gain/(Loss)
Recognized in Income
on Derivatives
  Amount of Gain/(Loss)
Recognized in Income
on Derivatives
 

Interest rate contracts

  Interest income (expense)   $ 36   $ 227  

Rights to purchase convertible notes

  Loss on rights for convertible notes         (1,820 )
               
 

Total

      $ 36   $ (1,593 )
               

 

Nine Months Ended  
 
   
  August 29, 2010   August 30, 2009  
Derivatives Not Designated as
Hedging Instruments
  Location of Gain/(Loss)
Recognized in Income
on Derivatives
  Amount of Gain/(Loss)
Recognized in Income
on Derivatives
  Amount of Gain/(Loss)
Recognized in Income
on Derivatives
 

Interest rate contracts

  Interest income (expense)   $ 57   $ 335  

Rights to purchase convertible notes

  Loss on rights for convertible notes         (4,549 )
               
 

Total

      $ 57   $ (4,214 )
               

Note 11: 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 interest rate swaps, foreign currency derivative contracts and diesel fixed price swap contracts discussed above. See Note 10. 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 and diesel spot and forward rates. We mitigate derivative credit risk by transacting with highly rated counterparties. The fair value of the Company's rights for convertible notes is determined based on the closing price reported on the active market on which the related rights trade. There were no non-financial assets or liabilities requiring initial measurement or subsequent remeasurement during the first nine months of fiscal 2010 or 2009. Further, there were no transfers of assets and liabilities between Level 1 and Level 2 of the fair value measurement hierarchy during the nine months ended August 29, 2010 and August 29, 2009. The following table provides a summary of the fair values of assets and liabilities (in thousands):

 
   
  Fair Value Measurements at August 29, 2010 Using  
 
  August 29, 2010   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant Other
Observable Inputs
(Level 2)
  Significant
Unobservable Inputs
(Level 3)
 

Interest rate, foreign exchange and commodity derivatives

  $ 1,334   $   $ 1,334   $  
                   

25



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 11: Fair Value of Financial Instruments (Continued)

 
   
  Fair Value Measurements at November 29, 2009 Using  
 
  November 29, 2009   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
  Significant Other
Observable Inputs
(Level 2)
  Significant
Unobservable Inputs
(Level 3)
 

Interest rate and foreign exchange derivatives

  $ 1,608   $   $ 1,608   $  
                   

        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 amounts of long term debt, based on quoted market prices, at August 29, 2010 were as follows (in thousands):

Senior Secured Notes

  $ 352,800  

Convertible Notes

    503,318  

Senior Subordinated Notes

    269,617  

Note 12: Impairment of Long-Lived Assets

        The Company reviews property, plant and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by a comparison of the carrying amount of an asset group to future net undiscounted cash flows expected to be generated by the asset group. If such assets are considered to be impaired, the impairment recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

        Based upon an impairment analysis performed in the third quarter of fiscal 2010, the Company determined that the cash flows expected to be generated by the long-lived assets of its Europe segment are less than the carrying amount of these assets. As such, the Company recognized an impairment charge of $23.0 million in the third quarter of fiscal 2010 to reduce the carrying value of these assets to their estimated fair value. The fair value of these assets was estimated based on the expected cash flows to be received from these assets based on current comparable data from market participants (Level 3 inputs).

Note 13: Debt Extinguishment and Refinancing Expense

        Debt extinguishment and refinancing expenses for the nine months ended August 29, 2010 included non-cash charges of $2.7 million related to the write-off of debt issuance costs and original issue discount associated with the $35.0 million of principal amount of the Senior Notes that were repurchased during the nine months ended August 29, 2010. Also included was a cash charge of $1.1 million which represents the premium that was paid to repurchase these notes. See Note 8.

        Debt extinguishment and refinancing expenses for the three and nine months ended August 30, 2009 included non-cash charges of $2.1 million relating to the write-off of debt issuance costs associated with the previously existing senior term loans as well as $15.2 million of cash charges associated with the termination of the interest rate swap agreements that were associated with the old senior credit facility. See Note 9.

26



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 14: Other Income, Net

        Other income, net, included interest income of $0.1 million and $0.2 million for the three and nine months ended August 29, 2010, respectively, and an insignificant amount and $0.1 million for the three and nine months ended August 30, 2009, respectively.

Note 15: Acquisitions and Dispositions

        On December 1, 2008, the Company sold fifty percent of its ownership interest in its 100% owned subsidiary Sealy Korea Company to the Company's Australian licensee, and these operations became part of the group of joint ventures that we participate in with the Australian licensee. In consideration of the sale of the fifty percent interest, the Company received net cash of $1.2 million and recognized a gain on the sale of the subsidiary of $1.3 million which has been recorded as a gain on sale of subsidiary stock in the accompanying Condensed Consolidated Statements of Operations. Upon the close of this transaction, the subsidiary was deconsolidated. The joint venture to which these operations were added is not considered to be a variable interest entity for which the Company is a primary beneficiary and is, therefore, not consolidated for financial statement purposes. The Company accounts for its interest in this joint venture under the equity method.

        On December 4, 2008, the Company and its Australian licensee each acquired a 50% interest in a joint venture that owns the assets of the Company's former New Zealand licensee. The purchase price for the 50% ownership was $1.9 million. Additional contributions of $0.4 million were made by each party to the joint venture to fund the initial working capital of this entity. The New Zealand joint venture is not considered to be a variable interest entity for which the Company is a primary beneficiary and is, therefore, not consolidated for financial statement purposes. The Company accounts for its interest in this joint venture under the equity method.

Note 16: Defined Benefit Pension Expense

        The components of net periodic pension cost recognized for the Company's defined benefit pension plans in the United States, Canada and France for the three and nine months ended August 29, 2010 and August 30, 2009 are as follows (in thousands):

 
  Three Months Ended   Nine Months Ended  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  

Service cost

  $ 244   $ 191   $ 732   $ 574  

Interest cost

    383     359     1,149     1,076  

Expected return on plan assets

    (305 )   (237 )   (916 )   (712 )

Amortization of unrecognized losses

    37     91     111     274  

Amortization of unrecognized prior service cost

    143     64     430     192  
                   

Net periodic pension cost*

  $ 502   $ 468   $ 1,506   $ 1,404  
                   

Cash contributions

  $ 220   $ 285   $ 855   $ 570  
                   

*
Net periodic pension cost recognized for the three and nine months ended August 29, 2010 is based upon preliminary estimates pending the final actuarial determination of such costs for fiscal

27



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 16: Defined Benefit Pension Expense (Continued)

    2010. Similarly, net periodic pension cost for the three and nine months ended August 30, 2009 is based upon preliminary estimates.

        The Company expects to make additional cash contributions to the plans of approximately $0.2 million during the remainder of fiscal 2010.

Note 17: Income Taxes

        The Company's 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. The effective tax rate for the three and nine months ended August 29, 2010 was approximately (62.8)% and 821.9%, respectively, compared to approximately 20.7% and 22.5%, for the three and nine months ended August 30, 2009, respectively. The effective rate for the three and nine months ended August 29, 2010 was higher than the rate for the three and nine months ended August 30, 2009, primarily due to the effect of non-deductible paid in kind interest which resulted from the Refinancing in the second quarter of fiscal 2009 and the impairment of European assets.

        The Condensed Consolidated Balance Sheet as of August 29, 2010 includes accrued interest of $3.9 million and penalties of $2.9 million due to unrecognized tax benefits. As of November 29, 2009, the Company had recorded accrued interest of $3.6 million and penalties of $3.1 million due to unrecognized tax benefits.

        The Company expects the liability for uncertain tax positions to decrease by approximately $1.9 million within the succeeding twelve months due to expiration of income tax statutes of limitations. Federal years open to examination are fiscal year 2006 and forward. State and international jurisdictions remain open to examination for fiscal year 2000 and forward.

        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 29, 2010. The Company also cannot predict when or if any other future tax payments related to these tax positions may occur.

Note 18: Comprehensive Income

        Comprehensive (loss) income for the three and nine months ended August 29, 2010 was $(14.8) million and $(10.9) million, respectively, and $12.2 million and $29.1 million, respectively for the three and nine months ended August 30, 2009. The decrease in comprehensive income for the three months ended August 29, 2010 compared to the three and nine months ended August 30, 2009, was driven primarily by the decrease in net income.

28



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 18: Comprehensive Income (Continued)

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

 
  August 29, 2010   November 29, 2009  

Unrealized gain on cash flow hedges, net of tax

  $ 393   $ 463  

Unrealized actuarial loss and prior service credit for pension liability, net of tax

    (7,474 )   (7,936 )

Accumulated foreign currency translation adjustment

    4,437     6,420  
           

  $ (2,644 ) $ (1,053 )
           

Note 19: Commitments and Contingencies

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 adverse effect on the Company's consolidated financial position, results of operations or cash flows.

        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 has completed essentially all soil remediation with the approval of the New Jersey Department of Environmental Protection and continues to operate a groundwater remediation system 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. 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 29, 2010 for $2.0 million ($2.5 million prior to discounting at 4.75%) associated with this remediation project.

        The Company is also remediating 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 has completed essentially all soil remediation under the remediation plan and is currently monitoring groundwater at the site. The Company identified cadmium in the ground water at the site and removed the contaminated soil and rock from the site during fiscal 2007. The Company has recorded a liability of approximately $0.1 million associated with the additional work and ongoing monitoring. The Company believes the contamination is attributable to the manufacturing operations of previous, unrelated, unaffiliated occupants of the facility.

29



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 19: Commitments and Contingencies (Continued)

        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 adverse effect on the financial position or future operations of the Company. However, in the event of an adverse decision by the agencies involved, or an unfavorable result in the New Jersey natural resources damages matter, these matters could have a material adverse effect.

    Commitments

        The Company has employment agreements with certain of its executive officers and key employees which, among other things, provide severance benefits to those employees. For the three and nine months ended August 29, 2010, severance costs of $0.8 million and $2.2 million, respectively, were recorded as a component of operating income within the accompanying Condensed Consolidated Statements of Operations. For the three and nine months ended August 29, 2009, severance costs of $0.1 million and $1.3 million, respectively, were recorded as a component of operating income within the accompanying Condensed Consolidated Statements of Operations. Severance benefits of $1.0 million and $1.2 million have been accrued as of August 29, 2010 and November 29, 2009, respectively. The entire liability has been recorded as a component of accrued compensation within the accompanying Condensed Consolidated Balance Sheet as of August 29, 2010 and November 29, 2009, respectively.

Note 20: Related Party Transactions

        During the three and nine months ended August 29, 2010, 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 $0.4 million and $1.4 million, respectively. As of August 29, 2010, $0.2 million of this amount was accrued as a component of other accrued liabilities and accounts payable in the accompanying Condensed Consolidated Balance Sheets. We also participate 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. We received lease income on this property of an insignificant amount during the first nine months of fiscal 2010.

        During the three and nine months ended August 30, 2009, 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 $0.7 million and $2.3 million, respectively. The Company was also billed $0.3 million for executive search costs incurred by KKR on the Company's behalf for the three and nine months ended August 30, 2009.

        In connection with the Refinancing (Note 9), the Company entered into an agreement with Sealy Holding, LLC, a company which is owned by KKR, whereby the Purchaser provided $177.1 million in cash to support its obligation to exercise its rights as well as an oversubscription for those rights that are not exercised by other common shareholders. Until the conclusion of the rights offering period, the $177.1 million bore interest at a rate of LIBOR plus 3.0%. At the expiration of the rights offering period, the Company repaid the Purchaser an amount equal to the proceeds obtained from the subscription to the Convertible Notes by other shareholders and Convertible Notes were issued for the remaining amount. For the three and nine months ended August 30, 2009, $0.7 million of interest was

30



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 20: Related Party Transactions (Continued)


recognized on this related party debt. As consideration for the forward purchase, the Company paid the Purchaser $1.0 million which was deferred as debt issuance costs and is being amortized as a component of interest expense.

        Certain funds and accounts managed by KKR Asset Management LLC, an affiliate of KKR, also participated in the Senior Notes that were issued in connection with the Refinancing. At August 29, 2010, KKR Financial LLC held $45.7 million principal amount of the outstanding Senior Notes. Interest expense of $1.2 million and $3.9 million was recorded during the three and nine months ended August 29, 2010, respectively, related to KKR Financial LLC's portion of the outstanding Senior Notes and remains accrued at August 29, 2010.

        During the nine months ended August 29, 2010, the Company's joint ventures declared a distribution of $1.0 million which has been reflected as a reduction of our investment in these joint ventures in the accompanying Condensed Consolidated Balance Sheet as of August 29, 2010.

Note 21: Segment Information

        The Company has determined that it has two reportable segments: the Americas and Europe. These segments have been identified and aggregated based on the Company's organizational structure which is organized around geographic areas.

        Both reportable segments manufacture and market conventional and specialty bedding. The Americas segment's operations are concentrated in the United States, Canada, Mexico, Argentina, Uruguay, Brazil, Puerto Rico and Chile. Europe's operations are concentrated in Western Europe. The accounting policies of the segments are the same as those described in Note 1. The Company evaluates performance based on profit or loss from operations before interest expense, income taxes, depreciation and amortization ("EBITDA"). The Company accounts for inter-segment sales and transfers as if the sales or transfers were to third parties, that is, at current market prices.

        Sales by geographic area are as follows (in thousands):

 
  Three Months Ended   Nine Months Ended  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  

Americas:

                         
 

United States

  $ 251,041   $ 256,755   $ 726,546   $ 713,988  
 

Canada

    49,047     45,201     135,865     108,982  
 

Other International

    21,069     19,763     63,095     58,752  
                   
   

Total Americas

    321,157     321,719     925,506     881,722  

Europe

    25,024     27,854     76,830     76,282  
                   
   

Total

  $ 346,181   $ 349,573   $ 1,002,336   $ 958,004  
                   

Total International

  $ 95,140   $ 92,818   $ 275,790   $ 244,016  

31



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 21: Segment Information (Continued)

        Intersegment sales from the Americas to Europe for the three and nine months ended August 29, 2010 were $0.2 million and $0.6 million, respectively. There were no inter-segment sales for the three and six months ended August 30, 2009. Long lived assets (principally property, plant and equipment) outside the United States were $36.7 million and $60.6 million as of August 29, 2010 and November 29, 2009, respectively.

 
  Three Months Ended   Nine Months Ended  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  
 
  (in thousands)
  (in thousands)
 

Net sales to external customers:

                         
 

Americas

  $ 321,157   $ 321,719   $ 925,506   $ 881,722  
 

Europe

    25,024     27,854     76,830     76,282  
                   

    346,181     349,573     1,002,336     958,004  
                   

Capital expenditures:

                         
 

Americas

    4,586     4,055     10,746     8,392  
 

Europe

    105     87     623     277  
                   

    4,691     4,142     11,369     8,669  
                   

EBITDA:

                         
 

Americas

    42,844     45,210     117,273     99,771  
 

Europe(1)

    (23,427 )   230     (25,211 )   (4,285 )
 

Inter-segment eliminations

                (68 )
                   

    19,417     45,440     92,062     95,418  
                   

Reconciliation of EBITDA to net income:

                         
 

EBITDA from segments(1)

    19,417     45,440     92,062     95,418  
 

Interest

    21,784     22,127     65,890     56,551  
 

Income taxes

    6,379     3,155     13,619     3,201  
 

Depreciation and amortization

    7,077     8,102     21,813     24,655  
                   
   

Net Income

  $ (15,823 ) $ 12,056   $ (9,260 ) $ 11,011  
                   

 

 
  August 29, 2010   November 29, 2009  
 
  (in thousands)
 

Total assets:

             
 

Americas

  $ 935,177   $ 949,051  
 

Europe

    31,259     67,972  
 

Intersegment eliminations

    (1,553 )   (1,553 )
           

  $ 964,883   $ 1,015,470  
           

(1)
Amounts for the three and nine months ended August 29, 2010 include an impairment charge of $23.0 million to adjust the carrying value of the segment's assets to their fair value. (Note 12)

32



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 22: Earnings per Share

        In June 2008, the FASB issued new authoritative guidance that indicates that unvested share-based awards that contain rights to receive non-forfeitable dividends (whether paid or unpaid) are participating securities and should be included in the two-class method of computing earnings per share. As of February 28, 2010, the Company implemented this guidance which requires the unvested shares of its restricted shares outstanding to be treated as participating securities in accordance with the two-class method in the calculation of both basic and diluted earnings per share. Prior period comparative data has been retrospectively restated below, in accordance with the new guidance.

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

 
  Three Months Ended   Nine Months Ended  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  
 
  (in thousands)
  (in thousands)
 

Numerator:

                         

Net income (loss), as reported

  $ (15,823 ) $ 12,056   $ (9,260 ) $ 11,564  

Net income (loss) attributable to participating securities

    34     (38 )   26     (37 )

Interest on convertible notes

        1,820         1,820  
                   

Net income available to common shareholders

  $ (15,789 ) $ 13,838   $ (9,234 ) $ 13,347  
                   

Denominator:

                         

Denominator for basic earnings per share—weighted average shares

    97,043     91,884     95,384     91,836  

Effect of dilutive securities:

                         

Convertible debt

        177,088         60,549  

Stock options

        1,745         1,016  

Restricted share units

        8,172          

Other

        267         201  
                   

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

    97,043     279,156     95,384     153,602  
                   

        Since the Company reported a net loss for the three and nine months ended August 29, 2010, the outstanding options to purchase common stock, restricted shares, share units and Convertible Notes were considered antidilutive and are not included in the computation of diluted earnings per share. For the three and nine month periods, the antidilutive awards were 194,604 and 192,511, respectively (in thousands). Options and share units (in thousands) not included in the computation of diluted earnings per share because their impact is antidilutive for the three and nine months ended August 30, 2009 were 8,617 and 25,188, respectively.

33



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 23: Restructuring Activities

        For the three and nine months ended August 30, 2009, the Company recognized restructuring charges related to initiatives including facility closures and organizational changes. There were no such charges incurred during the three and nine months ended August 29, 2010. The pretax restructuring charges recognized by the Company during the three and nine months ended August 29, 2010 and August 30, 2009 were as follows:

 
  Three Months Ended   Nine Months Ended  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  
 
  (in thousands)
  (in thousands)
 

Americas Segment

  $   $   $   $ 1,448  

Europe Segment

                 
                   

  $   $   $   $ 1,448  
                   

        The following table summarizes the restructuring activity for the nine months ended August 30, 2009 and the related restructuring liabilities balance:

 
  2009 Restructuring Activities  
 
  Liabilities
November 30, 2008
  Charges to
Expense
  Cash
Payments
  Non-cash
Utilized
  Liabilities
August 30, 2009
 
 
  (in thousands)
 

Severance and employee benefits

  $ 393   $ 114   $ (315 ) $   $ 192  

Asset impairment charges

        1,334         (1,334 )    
                       
 

Total

  $ 393   $ 1,448   $ (315 ) $ (1,334 ) $ 192  
                       

        For the nine months ended August 30, 2009, the Company incurred restructuring charges of $0.1 million representing costs incurred to relocate machinery and equipment associated with the closure of its Clarion, Pennsylvania manufacturing facility which occurred in October 2008. Additionally, in the second quarter of fiscal 2009, management made the decision to cease manufacturing of certain foundation components and begin purchasing all of these components from third party suppliers. As a result, the Company incurred certain costs which were insignificant related to one-time terminations of employees. Additionally, the Company recognized an impairment charge of approximately $1.3 million for the related equipment used in this manufacturing process that was not sold. This plan was completed in the second quarter of fiscal 2009 and we do not expect to incur additional costs related to this restructuring activity.

Note 24: 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

34



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)


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 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 29, 2010 and November 29, 2009, Condensed Consolidating Statements of Operations for the three and nine months ended August 29, 2010 and August 30, 2009, and Condensed Consolidating Statements of Cash Flows for the three and nine months ended August 29, 2010 and August 30, 2009.

    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.

        Separate financial statements of each of the Guarantor Subsidiaries are not presented because management believes that these financial statements would not be material to investors.

35



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Balance Sheets

August 29, 2010

(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

  $ 799   $   $ 9,234   $ 35,273   $ 37,204   $   $ 82,510  
   

Accounts receivable, net

            20     109,403     72,335         181,758  
   

Inventories

            1,929     45,936     21,181     (412 )   68,634  
   

Other current assets and deferred income taxes

    391         879     27,922     6,093         35,285  
                               

Total current assets

    1,190         12,062     218,534     136,813     (412 )   368,187  

Property, plant and equipment, at cost

   
   
   
9,423
   
336,551
   
70,380
   
   
416,354
 

Less accumulated depreciation

            (5,189 )   (188,979 )   (52,300 )       (246,468 )
                               

            4,234     147,572     18,080         169,886  

Other assets:

                                           
 

Goodwill

            24,741     301,942     34,195         360,878  
 

Intangible assets, net

                1,449     68         1,517  
 

Net investment in subsidiaries

    (182,002 )   233,964     387,642     180,408     (3 )   (620,009 )    
 

Due from (to) affiliates

    262,844     (415,966 )   534,609     (106,307 )   (98,070 )   (177,110 )    
 

Debt issuance costs, net and other assets

   
   
   
23,477
   
23,170
   
17,768
   
   
64,415
 
                               

    80,842     (182,002 )   970,469     400,662     (46,042 )   (797,119 )   426,810  
                               
 

Total assets

  $ 82,032   $ (182,002 ) $ 986,765   $ 766,768   $ 108,851   $ (797,531 ) $ 964,883  
                               

Liabilities and Stockholders' (Deficit) Equity

                                           

Current liabilities:

                                           
 

Current portion—long-term obligations

  $   $   $   $ 1,750   $ 5,884   $   $ 7,634  
 

Accounts payable

            407     49,030     39,792         89,229  
 

Accrued customer incentives and advertising

                23,535     9,680         33,215  
 

Accrued compensation

            318     18,701     7,447         26,466  
 

Accrued interest

            1,458     15,968     190         17,616  
 

Other accrued liabilities

    (1 )       313     24,895     7,410         32,617  
                               

Total current liabilities

    (1 )       2,496     133,879     70,403         206,777  

Long-term obligations

   
177,320
   
   
750,243
   
38,898
   
5,517
   
(177,320

)
 
794,658
 

Other liabilities

                47,239     10,765         58,004  

Deferred income tax liabilities

    144         62     21     648         875  

Stockholders' equity (deficit)

    (95,431 )   (182,002 )   233,964     546,731     21,518     (620,211 )   (95,431 )
                               
 

Total liabilities and stockholders' equity (deficit)

  $ 82,032   $ (182,002 ) $ 986,765   $ 766,768   $ 108,851   $ (797,531 ) $ 964,883  
                               

36



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Balance Sheets

November 29, 2009

(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

  $ 357   $   $ 29,234   $ 67,950   $ 33,886   $   $ 131,427  
 

Accounts receivable, net

            6     82,339     74,505         156,850  
 

Inventories

            1,663     37,023     18,478     (354 )   56,810  
 

Other current assets and deferred income taxes

    394         1,169     31,405     8,334         41,302  
                               

Total current assets

    751         32,072     218,717     135,203     (354 )   386,389  

Property, plant and equipment, at cost

            9,337     335,302     102,350         446,989  

Less accumulated depreciation

            (4,802 )   (180,116 )   (54,590 )       (239,508 )
                               

            4,535     155,186     47,760         207,481  

Other assets:

                                           
 

Goodwill

            24,741     301,942     33,900         360,583  
 

Intangible assets, net

    271             1,666             1,937  
 

Net investment in subsidiaries

    (170,794 )   245,511     389,844     75,527         (540,088 )    
 

Due from (to) affiliates

    243,154     (416,305 )   553,243     (102,010 )   (98,073 )   (180,009 )    
 

Debt issuance costs, net and other assets

            29,226     17,902     11,952         59,080  
                               

    72,631     (170,794 )   997,054     295,027     (52,221 )   (720,097 )   421,600  
                               
 

Total assets

  $ 73,382   $ (170,794 ) $ 1,033,661   $ 668,930   $ 130,742   $ (720,451 ) $ 1,015,470  
                               

Liabilities and Stockholders' (Deficit) Equity

                                           

Current liabilities:

                                           
 

Current portion—long-term obligations

  $   $   $   $ 2,159   $ 11,534   $   $ 13,693  
 

Accounts payable

            275     45,413     43,283         88,971  
 

Accrued customer incentives and advertising

                24,175     7,629         31,804  
 

Accrued compensation

            391     32,706     10,008         43,105  
 

Accrued interest

    6         1,343     13,658     223         15,230  
 

Other accrued liabilities

    1,116         401     28,046     6,873         36,436  
                               

Total current liabilities

    1,122         2,410     146,157     79,550         229,239  

Long-term obligations

    180,108         785,678     40,220     7,868     (180,108 )   833,766  

Other liabilities

                48,456     11,169         59,625  

Deferred income tax liabilities

    144         62     21     605         832  

Common stock and options subject to redemption

                             

Stockholders' equity (deficit)

    (107,992 )   (170,794 )   245,511     434,076     31,550     (540,343 )   (107,992 )
                               
 

Total liabilities and stockholders' equity (deficit)

  $ 73,382   $ (170,794 ) $ 1,033,661   $ 668,930   $ 130,742   $ (720,451 ) $ 1,015,470  
                               

37



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Three Months Ended August 29, 2010

(in thousands)

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

Net sales

  $   $   $ 20,541   $ 238,680   $ 93,644   $ (6,684 ) $ 346,181  

Cost and expenses:

                                           
 

Cost of goods sold

            12,224     145,109     57,915     (6,632 )   208,616  
 

Selling, general and administrative

    (28 )       1,899     80,139     25,488         107,498  
 

Asset impairment loss

                    22,963         22,963  
 

Amortization expense

                72     (4 )       68  
 

Restructuring expenses and asset impairment

                             
 

Royalty (income) expense, net

                (4,542 )   7         (4,535 )
                               

Income from operations

    28         6,418     17,902     (12,725 )   (52 )   11,571  
 

Interest expense

        80     20,378     557     769         21,784  
 

Loss on rights for convertible notes

                             
 

Gain on sale of subsidiary stock

                             
 

Refinancing and extinguishment of debt and interest rate derivatives

                             
 

Other (income) expense, net

                    (57 )       (57 )
 

Loss (income) from equity investees

    17,648     18,783     (18,796 )           (17,635 )    
 

Loss (income) from non- guarantor equity investees

                16,432         (16,432 )    
 

Capital charge and intercompany interest allocation

            (18,668 )   17,931     737          
                               

Income (loss) before income taxes

    (17,620 )   (18,863 )   23,504     (17,018 )   (14,174 )   34,015     (10,156 )

Income tax provision (benefit)

    (1,797 )   (1,215 )   42,287     (35,724 )   2,970     (142 )   6,379  

Equity in earnings of unconsolidated affiliates

                    712         712  
                               

Net income (loss)

  $ (15,823 ) $ (17,648 ) $ (18,783 ) $ 18,706   $ (16,432 ) $ 34,157   $ (15,823 )
                               

38



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Three Months Ended August 30, 2009

(in thousands)

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

Net sales

  $   $   $ 22,373   $ 242,758   $ 91,307   $ (6,865 ) $ 349,573  

Cost and expenses:

                                           
 

Cost of goods sold

            12,651     139,179     58,561     (6,883 )   203,508  
 

Selling, general and administrative

    (9 )       2,038     86,554     21,673         110,256  
 

Amortization expense

    770             73     (1 )       842  
 

Restructuring expenses and asset impairment

                             
 

Royalty (income) expense, net

    (1,063 )           (4,216 )   1,063         (4,216 )
                               

Income from operations

    302         7,684     21,168     10,011     18     39,183  
 

Interest expense

    19     72     20,300     627     1,109         22,127  
 

Loss on rights for convertible notes

    1,820                         1,820  
 

Gain on sale of subsidiary stock

                             
 

Refinancing and extinguishment of debt and interest rate derivatives

            39                 39  
 

Other (income) expense, net

                    (14 )       (14 )
 

Loss (income) from equity investees

    (5,927 )   (5,544 )   (495 )           11,966      
 

Loss (income) from non- guarantor equity investees

                (5,568 )       5,568      
 

Capital charge and intercompany interest allocation

            (18,508 )   17,858     650          
                               

Income (loss) before income taxes

    4,390     5,472     6,348     8,251     8,266     (17,516 )   15,211  

Income tax provision (benefit)

    (7,666 )   (455 )   804     7,866     2,698     (92 )   3,155  
                               

Net income (loss)

  $ 12,056   $ 5,927   $ 5,544   $ 385   $ 5,568   $ (17,424 ) $ 12,056  
                               

39



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Nine Months Ended August 29, 2010

(in thousands)

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

Net sales

  $   $   $ 60,800   $ 690,959   $ 271,175   $ (20,598 ) $ 1,002,336  

Cost and expenses:

                                           
 

Cost of goods sold

            36,461     412,935     167,557     (20,540 )   596,413  
 

Selling, general and administrative

    351         5,628     241,348     76,309         323,636  
 

Asset impairment loss

                    22,963         22,963  
 

Amortization expense

    266             216     40         522  
 

Restructuring expenses and asset impairment

                             
 

Royalty (income) expense, net

    (368 )           (12,470 )   495         (12,343 )
                               

Income from operations

    (249 )       18,711     48,930     3,811     (58 )   71,145  
 

Interest expense

    1     239     61,426     1,792     2,432         65,890  
 

Refinancing and extinguishment of debt and interest rate derivatives

            3,759                 3,759  
 

Other (income) expense, net

                    (161 )       (161 )
 

Loss (income) from equity investees

    9,500     9,729     454             (19,683 )    
 

Loss (income) from non- guarantor equity investees

                8,130         (8,130 )    
 

Capital charge and intercompany interest allocation

            (56,151 )   52,510     3,641          
                               

Income (loss) before income taxes

    (9,750 )   (9,968 )   9,223     (13,502 )   (2,101 )   27,755     1,657  

Income tax provision (benefit)

    (490 )   (468 )   18,952     (12,992 )   8,731     (114 )   13,619  

Equity in earnings of unconsolidated affiliates

                    2,702         2,702  
                               

Net income (loss)

  $ (9,260 ) $ (9,500 ) $ (9,729 ) $ (510 ) $ (8,130 ) $ 27,869   $ (9,260 )
                               

40



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Operations

Nine Months Ended August 30, 2009

(in thousands)

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

Net sales

  $   $   $ 62,593   $ 676,224   $ 239,641   $ (20,454 ) $ 958,004  

Cost and expenses:

                                           
 

Cost of goods sold

            36,775     396,854     159,185     (20,461 )   572,353  
 

Selling, general and administrative

    (12 )       5,790     233,238     63,517         302,533  
 

Amortization expense

    2,220             217     (2 )       2,435  
 

Restructuring expenses and asset impairment

                1,448             1,448  
 

Royalty (income) expense, net

    (3,066 )           (12,217 )   3,097         (12,186 )
                               

Income from operations

    858         20,028     56,684     13,844     7     91,421  
 

Interest expense

    82     232     52,153     1,869     2,215         56,551  
 

Loss on rights for convertible notes

    4,549                         4,549  
 

Gain on sale of subsidiary stock

                    (1,292 )       (1,292 )
 

Refinancing and extinguishment of debt and interest rate derivatives

            17,461                 17,461  
 

Other (income) expense, net

                    (60 )       (60 )
 

Loss (income) from equity investees

    (6,002 )   (5,660 )   (2,617 )           14,279      
 

Loss (income) from non- guarantor equity investees

                (6,424 )       6,424      
 

Capital charge and intercompany interest allocation

            (47,522 )   45,777     1,745          
                               

Income (loss) before income taxes

    2,229     5,428     553     15,462     11,236     (20,696 )   14,212  

Income tax provision (benefit)

    (9,335 )   (574 )   (5,107 )   12,935     5,433     (151 )   3,201  
                               

Net income (loss)

  $ 11,564   $ 6,002   $ 5,660   $ 2,527   $ 5,803   $ (20,545 ) $ 11,011  
                               

41



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Cash Flows

Nine Months Ended August 29, 2010

(in thousands)

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

Net cash provided by operating activities

  $   $   $ 11,798   $ (18,089 ) $ 12,443   $   $ 6,152  
                               

Investing activities:

                                           
 

Purchase of property, plant and equipment

            (139 )   (9,267 )   (1,963 )       (11,369 )
 

Proceeds from the sale of property, plant, and equipment

            27         40         67  
 

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

    (659 )       4,372     (3,421 )   (292 )        
                               
 

Net cash provided by (used in) investing activities

    (659 )       4,260     (12,688 )   (2,215 )       (11,302 )

Financing activities:

                                           
 

Equity received upon exercise of stock including related excess tax benefits

    1,101                         1,101  
 

Proceeds from issuance of long term obligations

                    2,784         2,784  
 

Repayments of long-term obligations

                (1,900 )   (8,304 )       (10,204 )
 

Repayment of senior secured notes

            (36,050 )               (36,050 )
 

Debt issuance costs

                             
 

Other

            (8 )               (8 )
                               

Net cash used in financing activities

    1,101         (36,058 )   (1,900 )   (5,520 )       (42,377 )
                               

Effect of exchange rate changes on cash

                    (1,390 )       (1,390 )
                               

Change in cash and equivalents

    442         (20,000 )   (32,677 )   3,318         (48,917 )

Cash and equivalents:

                                           
 

Beginning of period

    357         29,234     67,950     33,886         131,427  
                               
 

End of period

  $ 799   $   $ 9,234   $ 35,273   $ 37,204   $   $ 82,510  
                               

42



SEALY CORPORATION

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Note 24: Guarantor/Non-Guarantor Financial Information (Continued)

SEALY CORPORATION

Supplemental Condensed Consolidating Statements of Cash Flows

Nine Months Ended August 30, 2009

(in thousands)

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

Net cash provided by operating activities

  $   $   $ 11,069   $ 28,929   $ 215   $   $ 40,213  
                               

Investing activities:

                                           
 

Purchase of property, plant and equipment

            (57 )   (7,677 )   (935 )       (8,669 )
 

Proceeds from the sale of property, plant, and equipment

            47     10,272     66         10,385  
 

Net proceeds from sale of subsidiary

                    1,237         1,237  
 

Investments in and loans to unconsolidated affiliate

                    (2,322 )       (2,322 )
 

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

    (202 )       (25,985 )   22,349     3,838          
                               
 

Net cash provided by (used in) investing activities

    (202 )       (25,995 )   24,944     1,884         631  

Financing activities:

                                           
 

Equity received upon exercise of stock including related excess tax benefits

    (330 )                       (330 )
 

Proceeds from issuance of long term obligations

                    3,343         3,343  
 

Repayments of long-term obligations

                (4,156 )   (11,512 )       (15,668 )
 

Repayment of old senior term loans

                (377,181 )                     (377,181 )
 

Proceeds from issuance of new senior secured notes

                335,916                       335,916  
 

Proceeds from issuance of related party debt

                177,132                       177,132  
 

Repayment of related party notes

                (83,284 )                     (83,284 )
 

Proceeds from issuance of convertible notes, net

                83,284                       83,284  
 

Borrowings under new asset-based revolver

                                       
 

Borrowings under old revolving credit facilities

            130,300         10,604         140,904  
 

Repayments on old revolving credit facilities

            (194,700 )       (10,604 )       (205,304 )
 

Debt issuance costs

                                         
 

Other

            (27,421 )               (27,421 )
                               

Net cash used in financing activities

    (330 )       44,046     (4,156 )   (8,169 )       31,391  
                               

Effect of exchange rate changes on cash

                    1,009         1,009  
                               

Change in cash and equivalents

    (532 )       29,120     49,717     (5,061 )       73,244  

Cash and equivalents:

                                           
 

Beginning of period

    589         1     2,423     23,583         26,596  
                               
 

End of period

  $ 57   $   $ 29,121   $ 52,140   $ 18,522   $   $ 99,840  
                               

43



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.

BUSINESS OVERVIEW

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

        The current economic and weak retail environments have affected the level of spending by end consumers and have continued to put pressure on U.S. mattress sales, though we have begun to see some stabilization in the retail environment recently. Some of the international markets where we operate are experiencing similar challenges as well. We expect this challenging business environment to potentially continue through 2010. Furthermore, changes in foreign exchange rates contributed favorably to international results but these trends may not continue.

        We have continued our focus on new product development to bring new and innovative products to the market. In February 2010, we introduced Embody by Sealy, a single premium specialty brand that encompasses both memory foam and latex technologies. The Embody line features products at retail price levels ranging from $1,999 to $3,299 per queen set. We also introduced new 60th Anniversary Posturepedic mattresses which feature new innerspring product at retail price points ranging from $750 to $1,000 per queen set. We have recently begun shipping all of these products to retailers.

        Our industry has experienced volatility in the price of petroleum-based and steel products, which affects the cost of our polyurethane foam, polyester, polyethylene foam and steel innerspring component parts. Domestic supplies of these raw materials are limited by supplier consolidation, specific exports of these raw materials outside of the United States and other forces beyond our control. During fiscal 2009, the cost of these components decreased and ultimately became more stable in the latter part of fiscal 2009. While these costs remained relatively stable in the first half of fiscal 2010, the costs have shifted upwards during the latter half of fiscal 2010 as feed stocks adjust to market conditions. The manufacturers of products such as petro-chemicals and wire rod, which are the feed stocks purchased by our suppliers of foam and drawn wire appear to be managing excess capacity an effort to maintain higher prices.

        We have two reportable segments: the Americas and Europe. These segments have been identified and aggregated based on our organizational structure which is organized around geographic areas. Both reportable segments manufacture and market conventional and specialty bedding. The Americas segment's operations take place in the United States, Canada, Mexico, Argentina, Uruguay, Brazil, Puerto Rico and Chile. Europe's operations are concentrated in Western Europe.

RESULTS OF OPERATIONS

        During the year-end financial close process of fiscal 2009, we discovered an error related to the depreciation of the assets acquired through our purchase of certain of our European subsidiaries in fiscal 2001. We also discovered an error related to the deferred income tax liabilities recorded on these assets. The errors, which were immaterial to the prior periods, resulted in an understatement of depreciation expense and an overstatement of the income tax provision in the Consolidated Statement of Operations for prior periods.

44


        As further discussed in Note 3 of our Condensed Consolidated Financial Statements in Item 1 above, we evaluated the effects of these errors in accordance with applicable SEC guidance and concluded that no prior period was materially misstated. Nonetheless, we decided to restate our Consolidated Financial Statements for the nine months ended August 30, 2009, which restated periods are discussed below. Such restatement had no impact on our compliance with the indentures governing our Senior Notes, our 2014 Notes, our Convertible Notes or our ABL Revolver agreement.

    Tabular Information—Current Fiscal Quarter

        The following table sets forth our summarized results of operations for the three months ended August 29, 2010 and August 30, 2009, expressed in thousands of dollars, as well as a percentage of each period's net sales:

 
  For the three months ended:  
 
  August 29, 2010   August 30, 2009  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

Net sales

  $ 346,181     100.0 % $ 349,573     100.0 %

Cost of goods sold

    208,616     60.3     203,508     58.2  
                   
 

Gross profit

    137,565     39.7     146,065     41.8  

Selling, general and administrative expenses

    107,498     31.1     110,256     31.5  

Asset impairment loss

    22,963     6.6          

Amortization expense

    68         842     0.2  

Royalty income, net of royalty expense

    (4,535 )   (1.3 )   (4,216 )   (1.2 )
                   
 

Income from operations

    11,571     3.3     39,183     11.3  

Interest expense

    21,784     6.3     22,127     6.3  

Loss on rights for convertible notes

            1,820     0.5  

Refinancing and extinguishment of debt and interest rate derivatives

            39      

Other income, net

    (57 )       (14 )    
                   
 

(Loss) income before income taxes

    (10,156 )   (3.0 )   15,211     4.5  

Income tax provision

    6,379     1.8     3,155     0.9  

Equity in earnings of unconsolidated affiliates

    712     0.2          
                   
 

Net (loss) income

  $ (15,823 )   (4.6 )% $ 12,056     3.6 %
                   

Effective tax rate

    (62.8 )%         20.7 %      

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

 
  Three Months
Ended:
 
 
  August 29,
2010
  August 30,
2009
 

Americas:

             
 

United States

    72.5 %   73.4 %
 

Canada

    14.2     12.9  
 

Other

    6.1     5.7  
           
   

Total Americas

    92.8     92.0  

Europe

    7.2     8.0  
           
   

Total

    100.0 %   100.0 %
           

45


        The following table shows our net sales and margin profitability for our Americas and Europe segments as well as the major geographic regions within our Americas segment:

 
  For the Three Months Ended  
 
  August 29, 2010   August 30, 2009  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

Total Americas (U.S. Dollars):

                         
 

Net sales

  $ 321,157     100.0 % $ 321,719     100.0 %
 

Cost of goods sold

    188,885     58.8     183,105     56.9  
                   
   

Gross profit

    132,272     41.2     138,614     43.1  

United States (U.S. Dollars):

                         
 

Net sales

    251,041     100.0     256,755     100.0  
 

Cost of goods sold

    149,603     59.6     143,943     56.1  
                   
   

Gross profit

    101,438     40.4     112,812     43.9  

Total International (U.S. Dollars):

                         
 

Net sales

    95,140     100.0     92,818     100.0  
 

Cost of goods sold

    59,013     62.0     59,565     64.2  
                   
   

Gross profit

    36,127     38.0     33,253     35.8  

Canada:

                         
 

US Dollars:

                         
   

Net sales

    49,047     100.0     45,201     100.0  
   

Cost of goods sold

    26,701     54.4     27,263     60.3  
                   
     

Gross profit

    22,346     45.6     17,938     39.7  
 

Canadian Dollars:

                         
   

Net sales

    51,088     100.0     49,996     100.0  
   

Cost of goods sold

    27,812     54.4     30,164     60.3  
                   
     

Gross profit

    23,276     45.6     19,832     39.7  

Other Americas (U.S. Dollars):

                         
 

Net sales

    21,069     100.0     19,763     100.0  
 

Cost of goods sold

    12,581     59.7     11,899     60.2  
                   
   

Gross profit

    8,488     40.3     7,864     39.8  

Europe:

                         
 

US Dollars:

                         
   

Net sales

    25,024     100.0     27,854     100.0  
   

Cost of goods sold

    19,731     78.8     20,403     73.2  
                   
     

Gross profit

    5,293     21.2     7,451     26.8  
 

Euros:

                         
   

Net sales

    19,886     100.0     19,672     100.0  
   

Cost of goods sold

    15,671     78.8     14,405     73.2  
                   
     

Gross profit

    4,215     21.2 %   5,267     26.8 %

46


    Quarter Ended August 29, 2010 compared with Quarter Ended August 30, 2009

        Net Sales.    Our consolidated net sales for the quarter ended August 29, 2010, were $346.2 million, a decrease of $3.4 million, or 1.0%, from the quarter ended August 30, 2009. Total Americas net sales were $321.2 million for the third quarter of fiscal 2010, a decrease of 0.2% from the third quarter of fiscal 2009. This decrease was primarily due to decreases in the U.S. business offset by increases in the Canada and Other Americas businesses. Total U.S. net sales were $251.0 million for the third quarter of fiscal 2010, a decrease of 2.2% from the third quarter of fiscal 2009. The U.S. net sales decrease of $5.7 million was attributable to a 0.3% decrease in wholesale unit volume, which excludes third party sales from our component plants, coupled with a 2.3% decrease in wholesale average unit selling price. The decrease in unit volume was primarily attributable to softness at themed price points in the market. The decrease in wholesale average unit selling price was due to our response to competitive pressures including a growing mix of our promotional priced bedding as we capture more sales with our new Sealy branded products. International net sales increased $2.3 million, or 2.5%, from the third quarter of fiscal 2009 to $95.1 million, primarily driven by unit volume growth in Canada. Excluding the effects of currency fluctuation, international net sales increased 2.6% from the third quarter of fiscal 2009. In Canada, local currency sales increases of 2.2% translated into increases of 8.5% in U.S. dollars due to an increase in the average value of the Canadian dollar versus the U.S. dollar. Local currency sales performance in Canada was driven by a 7.4% increase in unit volume, which was partially offset by a 4.9% decrease in average unit selling price. The increase in unit volume was driven by the strength of our new Stearns & Foster line and the success of our promotional products. The lower average unit selling price was driven primarily by strategic merchandising and promotional activity. In our Europe segment, local currency sales increases of 1.1% translated into decreases of 10.2% in U.S. dollars due to the decrease in the average value of the Euro versus the U.S. dollar. The increase in local currency sales resulted from a 3.4% increase in sales of latex cores. Finished goods sales in local currency decreased 2.0% from the prior year.

        Gross Profit.    Our consolidated gross profit for the quarter ended August 29, 2010 was $137.6 million, a decrease of $8.5 million from the comparable prior year period. As a percentage of net sales, gross profit decreased 2.1 percentage points to 39.7% due to a decrease in gross profit margins in both of our segments. Total Americas gross profit for the quarter ended August 29, 2010 was $132.3 million, a decrease of $6.3 million from the comparable prior year period. As a percentage of net sales, gross profit for the Americas decreased 1.9 percentage points to 41.2%. The decrease in percentage of net sales was primarily driven by decreases in the U.S. business. U.S. gross profit decreased $11.4 million to $101.4 million, which, as a percentage of net sales, represents a decrease of 3.5 percentage points to 40.4% of net sales. The decrease in percentage of net sales was driven primarily by higher discounting on products that are near the end of their life cycle as well as the impact of inflation on material costs. Partially offsetting these decreases were improvements in operations efficiencies and value engineering efforts. The gross profit margin in Canada was 45.6%, which is consistent with historical levels and was achieved through a reduction in material costs per unit, improved operating efficiencies and higher absorption of fixed costs on a 7.4% increase in unit volume. These increases have been partially offset by the lower average unit selling price discussed above. In our Europe segment, the local currency gross profit margin decreased 5.6 percentage points due to material cost increases and providing greater values on Sealy branded product.

47


        Selling, General, Administrative.    Our consolidated selling, general and administrative expense for the quarter ended August 29, 2010 decreased $2.8 million to $107.5 million compared to the same prior year period. As a percentage of net sales, this expense was 31.1% and 31.5% for the quarters ended August 29, 2010 and August 30, 2009, respectively, a decrease of 0.4 percentage points. The decrease as a percentage of net sales was primarily driven by a decrease in compensation costs. The decrease in absolute dollars is primarily due to a decrease in costs related to incentive compensation and expected defined contribution plan payments partially offset by an increase in cooperative advertising and promotional costs and less benefit related to foreign currency translation.

        Asset Impairment Loss.    Based upon an impairment analysis performed in the third quarter of fiscal 2010, we determined that the cash flows expected to be generated by the long-lived assets of our Europe segment are less than the carrying amount of these assets. As such, we recognized an impairment charge of $23.0 million in the third quarter of fiscal 2010 to reduce the carrying value of these assets to their estimated fair value. The fair value of these assets was estimated based on the expected cash flows to be received from these assets based on current comparable data from market participants. No such charges were recognized in the three months ended August 30, 2009.

        Royalty income, net of royalty expense.    Our consolidated royalty income, net of royalty expenses, of $4.5 million for the three months ended August 29, 2010 increased $0.3 million from the prior year period due to royalties earned from international licensees.

        Interest Expense.    Our consolidated interest expense for the third quarter of fiscal 2010 decreased $0.3 million to $21.8 million as compared with the prior year period. This decrease results from a decrease in cash interest expense of approximately $2.0 million due to the repurchase of $35 million of Senior Notes in the second quarter of fiscal 2010, offset by increases in non-cash interest expense as the Convertible Notes were not outstanding for the entire third quarter of fiscal 2009. Non-cash interest for the third quarter of fiscal 2010 was $5.9 million compared with $4.2 million for the third quarter of fiscal 2009. Non cash interest expense on our Convertible Notes was $4.3 million and $2.5 million for the third quarter of fiscal 2010 and 2009, respectively. The remaining portion of non-cash interest relates to the accretion or amortization of original issue discount and deferred debt issuance costs. Our net weighted average borrowing cost was 10.8% and 10.4% for the three months ended August 29, 2010 and August 30, 2009, respectively. Our borrowing cost was unfavorably impacted by the refinancing of our senior secured credit facilities in May 2009 (the "Refinancing") which resulted in increased interest rates and outstanding debt balances.

        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, non-deductible mark to market adjustments for derivatives associated with the Convertible Notes subscription rights, certain foreign tax rate differentials and state and local income taxes. Our effective tax rate for the three months ended August 29, 2010 was (62.8)% compared to 20.7% for the three months ended August 30, 2009. The effective rate for the fiscal 2010 period was lower than the fiscal 2009 period primarily due to the impairment of European assets.

        Equity in Earnings of Unconsolidated Affiliates.    Earnings related to our joint ventures for the third quarter of fiscal 2010 increased from the prior year period due to increased demand seen in the Asian markets.

48


    Tabular Information—Year to Date

        The following table sets forth our summarized results of operations for the nine months ended August 29, 2010 and August 30, 2009, expressed in thousands of dollars, as well as a percentage of each period's net sales:

 
  For the nine months ended:  
 
  August 29, 2010   August 30, 2009  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

Net sales

  $ 1,002,336     100.0 % $ 958,004     100.0 %

Cost of goods sold

    596,413     59.5     572,353     59.7  
                   
 

Gross profit

    405,923     40.5     385,651     40.3  

Selling, general and administrative expenses

    323,636     32.3     302,533     31.6  

Asset impairment loss

    22,963     2.3          

Amortization expense

    522     0.1     2,435     0.3  

Restructuring expenses including related asset impairment

            1,448     0.2  

Royalty income, net of royalty expense

    (12,343 )   (1.2 )   (12,186 )   (1.3 )
                   
 

Income from operations

    71,145     7.0     91,421     9.5  

Interest expense

    65,890     6.6     56,551     5.9  

Loss on rights for convertible notes

            4,549     0.5  

Refinancing and extinguishment of debt and interest rate derivatives

    3,759     0.4     17,461     1.8  

Gain on sale of subsidiary stock

            (1,292 )   (0.1 )

Other income, net

    (161 )       (60 )    
                   
 

Income before income taxes

    1,657     0.0     14,212     1.4  

Income tax provision

    13,619     1.4     3,201     0.3  

Equity in earnings of unconsolidated affiliates

    2,702     0.3          
                   
 

Net (loss) income

  $ (9,260 )   (1.1 )% $ 11,011     1.1 %
                   

Effective tax rate

    821.9 %         22.5 %      

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

 
  Nine Months
Ended:
 
 
  2010   2009  

Americas:

             
 

United States

    72.5 %   74.5 %
 

Canada

    13.6     11.4  
 

Other

    6.2     6.1  
           
   

Total Americas

    92.3     92.0  

Europe

    7.7     8.0  
           
   

Total

    100.0 %   100.0 %
           

49


        The following table shows our net sales and margin profitability for our Americas and Europe segments as well as the major geographic regions within our Americas segment:

 
  For the nine months ended:  
 
  August 29, 2010   August 30, 2009  
 
  (in thousands)   (percentage of
net sales)
  (in thousands)   (percentage of
net sales)
 

Total Americas (U.S. Dollars):

                         
 

Net sales

  $ 925,506     100.0 % $ 881,722     100.0 %
 

Cost of goods sold

    538,134     58.1     514,927     58.4  
                   
   

Gross profit

    387,372     41.9     366,795     41.6  

United States (U.S. Dollars):

                         
 

Net sales

    726,546     100.0     713,988     100.0  
 

Cost of goods sold

    425,706     58.6     410,283     57.5  
                   
   

Gross profit

    300,840     41.4     303,705     42.5  

Total International (U.S. Dollars):

                         
 

Net sales

    275,790     100.0     244,016     100.0  
 

Cost of goods sold

    170,707     61.9     162,070     66.4  
                   
   

Gross profit

    105,083     38.1     81,946     33.6  

Canada:

                         
 

US Dollars:

                         
   

Net sales

    135,865     100.0     108,982     100.0  
   

Cost of goods sold

    75,165     55.3     68,996     63.3  
                   
     

Gross profit

    60,700     44.7     39,986     36.7  
 

Canadian Dollars:

                         
   

Net sales

    141,407     100.0     127,604     100.0  
   

Cost of goods sold

    78,227     55.3     80,959     63.4  
                   
     

Gross profit

    63,180     44.7     46,645     36.6  

Other Americas (U.S. Dollars):

                         
 

Net sales

    63,095     100.0     58,752     100.0  
 

Cost of goods sold

    37,263     59.1     35,648     60.7  
                   
   

Gross profit

    25,832     40.9     23,104     39.3  

Europe:

                         
 

US Dollars:

                         
   

Net sales

    76,830     100.0     76,282     100.0  
   

Cost of goods sold

    58,279     75.9     57,426     75.3  
                   
     

Gross profit

    18,551     24.1     18,856     24.7  
 

Euros:

                         
   

Net sales

    57,532     100.0     56,127     100.0  
   

Cost of goods sold

    43,682     75.9     42,191     75.2  
                   
     

Gross profit

    13,850     24.1 %   13,936     24.8 %

50


        Net Sales.    Our consolidated net sales for the nine months ended August 29, 2010, were $1,002.3 million, an increase of $44.3 million, or 4.6%, from the nine months ended August 30, 2009. Total Americas net sales were $925.5 million for the nine months ended August 29, 2010, an increase of 5.0% from the first nine months of fiscal 2009. This increase was due to increases in the Canada, U.S. and Other Americas businesses. Total U.S. net sales were $726.5 million for the first nine months of fiscal 2010, an increase of 1.8% from the first nine months of fiscal 2009. The U.S. net sales increase of $12.6 million was attributable to a 1.3% increase in wholesale unit volume, which excludes third party sales from our component plants, coupled with a 0.1% increase in wholesale average unit selling price. The increase in unit volume is primarily attributable to the successful launch of our new Stearns & Foster line. The increase in average unit selling price was driven primarily by sales of product priced greater than $1,000, but was offset by increased spending for customer incentive programs. International net sales increased $31.8 million or 13.0%, from the first nine months of fiscal 2009 to $275.8 million. This increase was driven primarily by the favorable changes in foreign currency exchange rates and growth in our Canadian business. Excluding the effects of currency fluctuation, international net sales increased 6.7% from the first nine months of fiscal 2009. In Canada, local currency sales increases of 10.8% translated into increases of 24.7% in U.S. dollars due to an increase in the average value of the Canadian dollar versus the U.S. dollar. Local currency sales performance in Canada was driven by a 17.9% increase in unit volume, which was partially offset by a 6.0% decrease in average unit selling price. The increase in unit volume was driven by strategic promotional activity and the success of our new Stearns & Foster line. The lower average unit selling price was driven primarily by strategic merchandising and promotional activity. Elsewhere in the Americas, we experienced sales increases in our Mexico markets and relatively flat sales in our South American markets. In our Europe segment, local currency sales increases of 2.5% translated into decreases of 0.7% in U.S. dollars due to the increase in the average value of the Euro versus the U.S. dollar. The increase in local currency sales resulted from a 5.8% increase in sales of latex cores. Finished goods sales in local currency remained flat as compared to the prior year.

        Gross Profit.    Our consolidated gross profit for the nine months ended August 29, 2010 was $405.9 million, an increase of $20.3 million from the comparable prior year period. As a percentage of net sales, gross profit increased 0.2 percentage points to 40.5% due to an increase in gross profit margins in the Americas segment. Total Americas gross profit for the nine months ended August 29, 2010 was $387.4 million, an increase of $20.6 million from the comparable prior year period. As a percentage of net sales, gross profit for the Americas increased 0.3 percentage points to 41.9%. The increase in percentage of net sales was primarily due to an increase in gross profit margins in our Canadian operations. U.S. gross profit, as a percentage of net sales, decreased 1.1 percentage points to 41.4% of net sales. The decrease in percentage of net sales was driven primarily by product mix changes and higher discounting on products that are at the end of their life cycle. These decreases were partially offset by slightly lower material costs and improved operational efficiencies. The gross profit margin in Canada was 44.7%. This performance was driven by a reduction in material costs per unit, operational efficiencies and higher absorption of fixed costs on a 17.9% increase in unit volume. These increases were partially offset by the lower average unit selling price discussed above. In our Europe segment, the local currency gross profit margin decreased 0.7 percentage points due to conversion costs reductions.

        Selling, General, Administrative.    Our consolidated selling, general and administrative expense for the nine months ended August 29, 2010 increased $21.1 million to $323.6 million compared to the same prior year period. As a percentage of net sales, this expense was 32.3% and 31.6% for the nine months ended August 29, 2010 and August 30, 2009, respectively, an increase of 0.7 percentage points. The increase as a percentage of net sales was due to volume driven variable expenses and by an increase in non-cash compensation costs. The increase in absolute dollars is primarily due to a $14.4 million

51



increase in volume driven variable expenses including a $17.2 million increase in cooperative advertising and promotional costs, and a $2.4 million increase in delivery costs due primarily to an increase in fuel costs. The increase in these costs was partially offset by a $5.2 million decrease in bad debt expense. Fixed operating costs, exclusive of non-cash compensation expense, decreased $3.3 million from the prior year period primarily due to a $5.3 million decrease in expected defined contribution plan payments and cash incentive-based compensation costs. These decreases were offset by increased product launch and advertising costs of $3.2 million. Non-cash compensation expense increased by $5.4 million compared to the nine months ended August 30, 2009 due primarily to the recognition of expense related to the restricted share unit grants that occurred in the third quarter of fiscal 2009.

        Asset Impairment Loss.    Based upon an impairment analysis performed in the third quarter of fiscal 2010, we determined that the cash flows expected to be generated by the long-lived assets of our Europe segment are less than the carrying amount of these assets. As such, we recognized an impairment charge of $23.0 million in the third quarter of fiscal 2010 to reduce the carrying value of these assets to their estimated fair value. The fair value of these assets was estimated based on the expected cash flows to be received from these assets based on current comparable data from market participants. No such charges were recognized in the nine months ended August 30, 2009 except for those discussed below related to restructuring activities.

        Restructuring expenses including related asset impairment.    We recognized pretax restructuring costs of $1.4 million during the nine months ended August 30, 2009. No such costs were incurred during the nine months ended August 29, 2010.

        In the second quarter of fiscal 2009, management made the decision to cease manufacturing of certain foundation components and to begin purchasing all of these components from third-party suppliers. As a result, we incurred certain insignificant costs related to one-time terminations of employees. Additionally, we recognized an impairment charge of approximately $1.3 million for the related equipment used in this manufacturing process that was not sold. This plan was completed in the second quarter of fiscal 2009, and we do not expect to incur additional costs related to this restructuring activity.

        Royalty income, net of royalty expense.    Our consolidated royalty income, net of royalty expenses, of $12.3 million for the nine months ended August 29, 2010 remained flat compared to the nine months ended August 30, 2009.

        Interest Expense.    Our consolidated interest expense for the first three quarters of fiscal 2010 as compared with the prior year period increased $9.3 million to $65.9 million. Interest expense for the first three quarters of fiscal 2010 included $16.8 million of non-cash interest expense, of which $11.9 million related to non-cash interest on our Convertible Notes and the remainder of which related to the accretion or amortization of original issue discount and deferred debt issuance costs. Our net weighted average borrowing cost was 10.8% and 9.3% for the nine months ended August 29, 2010 and August 30, 2009, respectively. Our borrowing cost was unfavorably impacted by the Refinancing which resulted in increased interest rates and outstanding debt balances.

        Refinancing and extinguishment of debt and interest rate derivatives.    Debt extinguishment and refinancing expenses for the nine months ended August 29, 2010 included non-cash charges of $2.7 million related to the write-off of debt issuance costs and original issue discount associated with the $35.0 million of Senior Notes that were repurchased this period. Also included was a cash charge of $1.1 million which represents the premium that was paid to repurchase these notes.

52


        Debt extinguishment and refinancing expenses for the nine months ended August 30, 2009 included non-cash charges of $2.1 million relating to the write-off of debt issuance costs related to our old senior term loans. Additionally, we incurred $15.2 million of charges associated with termination payments on our interest rate swap agreements that were associated with the old senior credit facility.

        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, non-deductible mark to market adjustments for derivatives associated with the Convertible Notes subscription rights, certain foreign tax rate differentials and state and local income taxes. Our effective tax rate for the nine months ended August 29, 2010 was 821.9% compared to 22.5% for the nine months ended August 30, 2009. The effective rate for the fiscal 2010 period was higher than the fiscal 2009 period primarily due to the effect of non-deductible paid in kind interest which resulted from the Refinancing in the second quarter of fiscal 2009 and the impairment of European assets.

        Equity in Earnings of Unconsolidated Affiliates.    Earnings related to our joint ventures for the first nine months of fiscal 2010 have increased over the prior year period due to increased demand seen in the Asian markets.

LIQUIDITY AND CAPITAL RESOURCES

        Our principal sources of funds are cash flows from operations and borrowings under our asset-based revolving credit facility (the "ABL Revolver"). Our principal use of funds consists of operating expenditures, payments of interest on our senior debt, capital expenditures and interest payments on our outstanding senior subordinated notes. Capital expenditures totaled $11.4 million for the nine months ended August 29, 2010. We expect total 2010 capital expenditures to be approximately $21.0 million. We believe that annual capital expenditure limitations in our current debt agreements will not prevent us from meeting our ongoing capital needs. Our introductions of new products typically require us to make initial cash investments in inventory, promotional supplies and employee training which may not be immediately recovered through new product sales. However, we believe that we have sufficient liquidity to absorb such expenditures related to new products and that these expenses will not have a significant adverse impact on our operating cash flow. At August 29, 2010, the Company had approximately $67.7 million available under the ABL Revolver, which represents the calculated borrowing base reduced by outstanding letters of credit of $16.1 million, and certain reserves related to our outstanding derivative contracts. The calculated borrowing base under the ABL Revolver is determined based on our domestic accounts receivable and inventory balances. Our net weighted average borrowing cost was 10.8% and 9.3% for the nine months ended August 29, 2010 and August 30, 2009, respectively. As of September 21, 2010, we had no borrowings outstanding under the ABL Revolver.

        On May 13, 2009, the Company announced its Refinancing, a comprehensive plan to refinance its existing senior secured credit facilities (the "Old Senior Credit Facility") and replace them with indebtedness that has longer-dated maturities and eliminates quarterly financial ratio based maintenance covenants. The Refinancing converted much of the existing senior debt from debt bearing interest at variable rates to debt bearing interest at fixed rates. Due to increases in the interest rates associated with our senior debt, the amount of debt outstanding and increases in the amortization of debt issuance costs, our interest expense in future periods is expected to increase significantly. However, cash interest payments have not changed significantly due to the payment in kind interest associated with the Convertible Notes (as discussed below).

53


        In connection with the Refinancing, we: 1) entered into a new ABL Revolver which provides commitments of up to $100.0 million maturing in May 2013, and which bears interest at our choice of either a base rate (determined by reference to the higher of several rates as defined by the ABL Revolver agreement) or a LIBOR rate for U.S. dollar deposits plus an applicable margin of 4.00%; 2) issued $350.0 million in aggregate principal amount of senior secured notes due April 2016 (the "Senior Notes"), which bear interest at 10.875% per annum payable semi-annually; and 3) issued $177.1 million in aggregate principal amount of senior secured convertible paid in kind ("PIK") notes due July 2016 which are convertible into shares of the Company's common stock (the "Convertible Notes") and bear interest at 8.00% per annum payable semi-annually in the form of additional Convertible Notes.

        At August 29, 2010, there were no amounts outstanding under the ABL Revolver. The Senior Notes had an outstanding balance of $304.0 million at August 29, 2010 which gave effect to an unamortized original issue discount of $11.0 million. As of August 29, 2010, the Convertible Notes had an outstanding balance of $177.3 million. We also have an outstanding principal balance of $268.9 million at August 29, 2010 on the 8.25% Senior Subordinated Notes due 2014 (the "2014 Notes").

        On March 16, 2010, the Company redeemed 10%, or $35.0 million, 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. In connection with the repurchase, the Company recognized charges of $1.1 million related to the premium paid to repurchase the notes and $2.7 million related to write-off of related debt issuance costs and original issue discount.

        Future interest payments are expected to be paid out of cash flows from operations and borrowings on our ABL Revolver. The ABL Revolver provides for revolving credit financing, subject to borrowing base availability. The borrowing base consists of the following: 1) 85% of the net amount of eligible accounts receivable and 2) the lesser of (a) 85% of the net orderly liquidation value of eligible inventory or (b) 65% of the net amount of eligible inventory. These amounts are reduced by reserves deemed necessary by the lenders. At August 29, 2010, there were no amounts outstanding under the ABL Revolver.

        Prior to the Refinancing, we had three interest rate swap agreements related to term debt under our Old Senior Credit Facility. These interest rate swaps consisted of: 1) an agreement fixing the floating portion of the interest rate at 5.495% on $242 million of the outstanding balance through November 2008, declining to $240 million from December 2008 through November 2009, and further declining to $180 million from December 2009 through November 2010; 2) an agreement fixing the floating portion of the interest rate at 1.952% on $20.0 million of the outstanding balance through November 4, 2009; and 3) an agreement fixing the floating portion of the interest rate at 1.991% on $107.0 million of the outstanding balance through February 4, 2010. In connection with the Refinancing, we paid $15.2 million to terminate these interest rate swap agreements.

        We are also party to three interest rate swaps for 2.3 million Euros, 2.9 million Euros and 3.5 million Euros which fix the floating interest rates on the debt of our Europe segment at 4.92%, 4.85% and 4.50%, respectively. The notional amounts of these contracts amortize over the life of the agreement and the agreements expire in May 2019, January 2013 and October 2013, respectively. We have not formally documented these interest rate swaps as hedges. Therefore, changes in the fair value of these interest rate swaps are recorded as a component of interest expense.

        At August 29, 2010, the Company was in compliance with the covenants contained within its ABL Revolver agreement and the indentures governing the Senior Notes, the Convertible Notes and the 2014 Notes. These agreements also restrict our ability to pay dividends and repurchase common stock.

54


        As part of our ongoing evaluation of our capital structure, we continually assess opportunities to reduce our debt, which opportunities may from time to time include the redemption or repurchase of a portion of our Senior Notes, the 2014 Notes or the Convertible Notes to the extent permitted by our debt covenants. In addition, our Board authorized a common stock repurchase program under which we may repurchase up to $100 million of our common stock. As of August 29, 2010, we have repurchased shares for $16.3 million under this program, none of which was repurchased during fiscal 2010. From August 29, 2010 through September 21, 2010, we did not repurchase any additional shares under this program.

        Our ability to make scheduled payments of principal, or to pay the interest or liquidated damages, if any, on, or to refinance our indebtedness, or to fund planned capital expenditures will depend on our future performance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We will be required to make scheduled principal payments of $7.6 million during the next twelve months, with $1.7 million for our financing obligations and capital leases and the remainder for debt owed by our international subsidiaries. However, as we continually evaluate our ability to make additional prepayments as permitted under our ABL Revolver agreement and the indentures governing the Senior Notes, the Convertible Notes and the 2014 Notes, it is possible that we will redeem or repurchase additional portions of our senior or subordinated debt during that time.

        Our ABL Revolver agreement and the indentures governing the Senior Notes, the 2014 Notes and the Convertible Notes contain restrictions on our ability to pay dividends, including a requirement in the ABL Revolver agreement that we meet a minimum fixed charge coverage ratio and restrictions as to the amount available for payment. Although we met the minimum fixed charge coverage ratio requirement as of August 29, 2010, we do not currently expect a dividend will be declared in the fourth quarter of fiscal 2010.

        The following table summarizes our changes in cash:

 
  Nine Months Ended:  
 
  August 29,
2010
  August 30,
2009
 
 
  (in thousands)
 

Statement of Cash Flow Data:

             
 

Cash flows provided by (used in):

             
     

Operating activities

  $ 10,863   $ 40,213  
     

Investing activities

    (11,302 )   631  
     

Financing activities

    (47,088 )   31,391  
 

Effect of exchange rate changes on cash

    (1,390 )   1,009  
           
 

Change in cash and cash equivalents

    (48,917 )   73,244  
 

Cash and cash equivalents:

             
   

Beginning of period

    131,427     26,596  
           
   

End of period

  $ 82,510   $ 99,840  
           

55


        Cash Flows from Operating Activities.    Our cash flow from operations decreased $29.4 million to a source of cash of $10.9 million for the nine months ended August 29, 2010 from a source of cash of $40.2 million for the nine months ended August 30, 2009. Net income and cash flows from operations for the nine months ended August 30, 2010 compared to the same prior year period reflect a greater use of working capital. The uses include increases in inventories due to the planning for certain promotional events by our customers and the payment of incentive compensation that was accrued at the end of fiscal 2009. Cash flows from operations for the nine months ended August 30, 2009 included a benefit of $8.0 million for the receipt of income tax refunds.

        Cash Flows from Investing Activities.    Our cash flows used in investing activities for the nine months ended August 29, 2010 were $11.3 million as compared to net cash provided by investing activities of $0.6 million for the nine months ended August 30, 2009. This difference of $11.9 million was primarily due to the receipt of $8.4 million of proceeds in the nine months ended August 30, 2009 from the sale-leaseback of the Company's South Gate, California facility as well as higher capital spending in fiscal 2010.

        Cash Flows from Financing Activities.    Our cash flow used in financing activities for the nine months ended August 29, 2010 was $47.1 million compared with cash provided by financing activities of $31.4 million for the nine months ended August 30, 2009. The use of cash during the nine months ended August 29, 2010 was primarily driven by the repayment of $35.0 million of our Senior Notes. Cash provided by financing activities for the nine months ended August 30, 2009 was impacted significantly by the Refinancing which provided $44.0 million of cash after considering the effects of the payments of costs to issue our new debt.

        Significant judgment is required in evaluating our federal, state and foreign tax positions and in the determination of our tax provision. Despite our belief that our 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 matters. We may adjust these liabilities as relevant circumstances evolve, such as guidance from the relevant tax authority, our tax advisors, 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 its corporate income tax returns by tax authorities. Issues related to certain of these reserved positions have been presented to the Company. The Company believes that such audits will not result in a material assessment and payment of taxes related to these positions during the one year period following August 29, 2010. We also cannot predict when or if any other future tax payments related to these tax positions may occur.

        Our long-term obligations contain various financial tests and covenants but do not require that we meet quarterly financial ratio targets in order to maintain compliance with the terms of the obligations unless we are in a minimum availability period under the terms of our ABL Revolver.

        Our ABL Revolver requires us to maintain a minimum fixed charge coverage ratio in excess of 1.1 to 1.0 in periods of minimum availability where the availability for two consecutive calendar days is less than the greater of 1) 15% of the total commitment under the ABL Revolver and 2) $15.0 million. As of August 29, 2010, we were not in a period of minimum availability and did not have any outstanding borrowings under the ABL Revolver. Non-compliance with the minimum fixed charge coverage ratio in a period of minimum availability could result in the requirement to immediately repay all amounts outstanding under the ABL Revolver. The fixed charge coverage ratio is defined by the ABL Revolver agreement as the ratio of Adjusted EBITDA less unfinanced capital expenditures and net cash taxes

56



paid to fixed charges which include cash payments for interest, capital lease obligations, scheduled principal payments on debt and other restricted payments.

        The covenants contained in our senior debt agreements also restrict our ability to enter into certain transactions (the most significant of which are summarized below). Our ABL Revolver requires us to meet a minimum fixed charge coverage ratio of 1.25 to 1.00 in order to make certain restricted payments including dividend distributions to holders of our common stock, dividends or distributions to the parent company (Sealy Corporation), and debt repayments, subject to certain exceptions. The fixed charge coverage ratio is defined by the ABL Revolver agreement as the ratio of Adjusted EBITDA less unfinanced capital expenditures and net cash paid to fixed charges which include cash payments for interest, capital lease obligations, scheduled principal payments on debt and restricted payments. At August 29, 2010, adjustments to Adjusted EBITDA for cash taxes paid and unfinanced capital expenditures were $38.0 million. Fixed charges as calculated under the terms of the ABL Revolver agreement were $72.1 million. This results in a fixed charge coverage ratio of 1.86 to 1.00 at August 29, 2010 under the terms of the ABL Revolver agreement.

        The indentures governing our Senior Notes, Convertible Notes and Senior Subordinated Notes also require us to meet a fixed charge coverage ratio of 2.0 to 1.0 in order to incur additional indebtedness and make certain restricted payments, including dividends or equity distributions, subject to certain exceptions. The fixed charge coverage ratio is defined by the indentures related to these notes as the ratio of Adjusted EBITDA to fixed charges which include interest expense, and cash dividend payments on certain preferred stock. At August 29, 2010, fixed charges as calculated under the terms of the indentures governing our Senior Notes, Convertible Notes and Senior Subordinated Notes were $84.0 million, resulting in a fixed charge coverage ratio of 2.05 to 1.00.

        Non-compliance with the minimum fixed charge ratio contained in the ABL Revolver agreement and the indentures governing the Senior Notes, Convertible Notes and 2014 Notes would prohibit Sealy Mattress Company and its subsidiaries from being able to incur additional indebtedness other than pursuant to specified exceptions.

        The covenants contained within our debt agreements are based on what we refer to herein as "Adjusted EBITDA". In the senior debt agreements, Adjusted EBITDA is defined as net income plus interest, taxes, depreciation and amortization adjusted to exclude unusual items and other adjustments permitted in calculating covenant compliance. Adjusted EBITDA is presented herein as it is a material component of these covenants. Additionally, management uses Adjusted EBITDA to evaluate the Company's operating performance and we believe that this measure provides useful incremental information to investors regarding our operating performance. While the determination of "unusual items" is subject to interpretation and requires judgment, we believe the adjustments listed below are in accordance with the covenants.

        Adjusted EBITDA is not a recognized term under GAAP and does not purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. Additionally, it is not intended to be a measure of free cash flow for management's discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Because not all companies use identical calculations, these presentations may not be comparable to other similarly titled measures of other companies.

57


        The following table sets forth a reconciliation of net income to Adjusted EBITDA for the three and nine months ended August 29, 2010 and August 30, 2009:

 
  Three Months Ended:   Nine Months Ended:  
 
  August 29, 2010   August 30, 2009   August 29, 2010   August 30, 2009  
 
  (in thousands)
  (in thousands)
 

Net loss

  $ (15,823 ) $ 12,056   $ (9,260 ) $ 11,011  
 

Interest expense

    21,784     22,127     65,890     56,551  
 

Income taxes

    6,379     3,155     13,619     3,201  
 

Depreciation and amortization

    7,077     8,102     21,813     24,655  
                   

EBITDA

    19,417     45,440     92,062     95,418  

Adjustments for debt covenants:

                         
 

Refinancing charges

        40     3,759     17,461  
 

Non-cash compensation

    3,545     5,164     12,760     7,387  
 

Impairment charges

    22,963         22,963     0  
 

KKR consulting fees

    405     655     1,425     2,196  
 

Severance charges

    640     229     1,892     2,171  
 

Loss on rights for Convertible Notes

        1,820         4,549  
 

Other (various)(a)

    (91 )   319     163     1,599  
                   

Adjusted EBITDA

  $ 46,879   $ 53,667   $ 135,024   $ 130,781  
                   

(a)
Consists of various immaterial adjustments

        There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", included in our Annual Report on Form 10-K for the fiscal year ended November 29, 2009.

        "Safe Harbor" Statement Under the Private Securities Litigation Reform Act of 1995.    When used in this Quarterly Report on Form 10-Q, the words "believes," "anticipates," "expects," "intends," "projects" and similar expressions are used to identify forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements relate to future financial and operational results. Any forward-looking statements contained in this report represent our management's current expectations, based on present information and current assumptions, and are thus prospective and subject to risks and uncertainties which could cause actual results to differ materially from those expressed in such forward-looking statements. Actual results could differ materially from those anticipated or projected due to a number of factors. These factors include, but are not limited to:

58


        All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this Quarterly Report on Form 10-Q and are expressly qualified in their entirety by the cautionary statements included in this Quarterly Report on Form 10-Q. Except as may be required by law, we undertake no obligation to publicly update or revise forward-looking statements which may be made to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events. For a more detailed discussion of these factors, see the information under the caption "Risk Factors" herein and in the Company's most recent Annual Report on Form 10-K filed with the Securities and Exchange Commission and "Management's Discussion and Analysis of Financial Condition and Results of Operations" herein and in the Company's most recent Annual Report on Form 10-K.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

        The information appearing below relating to our market risk sensitive instruments by major category should be read in conjunction with the related disclosure contained in the management's discussion and analysis section of our Annual Report on Form 10-K (File No. 001-08738).

        Our earnings are affected by fluctuations in the value of our subsidiaries' functional currency as compared to the currencies of our foreign denominated purchases. The result of a uniform 10% change in the value of the U.S. dollar relative to currencies of countries in which we manufacture or sell our products would have an approximate $1.4 million and $0.8 million dollar impact on our financial position for the three and nine months ended August 29, 2010, respectively. This calculation assumes that each exchange rate would change in the same direction relative to the U.S. dollar.

        To protect against the reduction in value of forecasted foreign currency cash flows resulting from purchases in a foreign currency, we have instituted a forecasted cash flow hedging program. We hedge portions of our purchases denominated in foreign currencies and royalty payments to third parties with forward and option contracts. At August 29, 2010, we had outstanding forward and option foreign currency contracts to sell Canadian dollars for a total of 32.9 million U.S. dollars. The expiration dates for the Canadian dollar contracts range from September 15, 2010 to June 15, 2011. At August 29, 2010, the fair value of these contracts was an asset of $0.8 million. The changes in fair value of the foreign currency hedges are included in net income, except for those contracts that have been designated as hedges for accounting purposes. For contracts designated as hedges for accounting purposes, the

59



changes in fair value related to the effective portion of the hedge are recognized as a component of accumulated other comprehensive income.

        At August 29, 2010, the Company has outstanding three interest rate swaps for 2.3 million Euro, 2.9 million Euro and 3.5 million Euro which fix the floating interest rates on the Company's debt of its Europe segment at 4.92%, 4.85% and 4.50%, respectively. The notional amounts of these contracts amortize over the life of the agreement, and the agreements expire in May 2019, January 2013 and October 2013. The fair value of these swaps was an asset totaling $0.5 million as of August 29, 2010 and November 29, 2009, respectively.

        A 10% increase or decrease in market interest rates that affect our interest rate derivative instruments would not have a material impact on our earnings during the next fiscal year. Based on the amount of variable-rate debt outstanding at August 29, 2010, a 12.5 basis point increase or decrease in variable interest rates would have an insignificant dollar impact on our annual interest expense.

        Polyurethane foam, polypropylene, polyethylene foam and High Carbon Steel Wire prices are moving upwards at pace with the market conditions of fiscal 2010. We have entered into commodity-based physical contracts to buy natural gas at agreed-upon fixed prices. These contracts were entered into in the normal course of business. During the first quarter of fiscal 2010, we entered into a program through which we hedge a portion of our expected diesel fuel consumption through the use of fixed price swap contracts. These contracts reduce the Company's exposure to the volatility in diesel fuel prices. At August 29, 2010 we had contracts outstanding for 0.6 million gallons of diesel fuel to be consumed from August 30, 2010 through January 31, 2011. The fair value of these fixed price swap diesel contracts was an asset of an insignificant amount as of August 29, 2010. There were no such contracts outstanding at November 29, 2009.

Item 4.    Controls and Procedures

        Under the supervision and with the participation of our management, including our principal executive officer and principal accounting officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the "Evaluation Date"). Based on this evaluation, our principal executive officer and principal accounting officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the information relating to the Company, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission ("SEC") reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to the Company's management, including our principal executive and principal accounting officers, as appropriate to allow timely decisions regarding required disclosure.

        There were no changes in our internal control over financial reporting identified in connection with the foregoing evaluation that occurred during the third quarter of fiscal 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

60



PART II. OTHER INFORMATION

Item 1.    Legal Proceedings

        See Note 19 to the Condensed Consolidated Financial Statements, Part I, Item 1 included herein.

Item 1A.    Risk Factors.

        In addition to the other information set forth in this report, you should carefully consider the factors discussed below and in Part I, "Item 1A. Risk Factors" in our Annual Report on Form 10-K for the year ended November 29, 2009, which could materially affect our business, financial condition or future results. The risks described herein and in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

The recently enacted legislation on healthcare reform and proposed amendments thereto could impact the healthcare benefits required to be provided by the Company and cause our compensation costs to increase, potentially reducing our net income and adversely affecting our cash flows.

        The recently enacted healthcare legislation and proposed amendments thereto contain provisions which could materially impact the future healthcare costs of the Company. While the legislation's ultimate impact is not yet known, it is possible that these changes could significantly increase our compensation costs which would reduce our net income and adversely affect our cash flows.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

        The table below shows our repurchases of the Company's common stock during the third quarter of fiscal 2010.

Period
  Total number of
shares
purchased(1)
  Average price paid
per share
  Total number of shares
purchased during
quarter as part of
publicly announced
program(2)
  Approximate dollar
value of shares that
may yet be purchased
under program
 

May  31 - June 27, 2010

    2,578,573   $ 3.05       $ 83,746,985  

June 28 - July 25, 2010

    89,372     2.49         83,746,985  

July  26 - August 29, 2010

                83,746,985  
                       
 

Total

    2,667,945                  
                       

(1)
The entire amounts presented above are comprised of common stock surrendered or withheld to cover the minimum tax withholding obligations related to the vesting of restricted shares and restricted stock units as permitted under the 2004 Stock Option Plan.

(2)
Our common stock repurchase program, which authorizes us to repurchase up to $100 million of our Company's common stock, was initially approved by our Board of Directors on February 19, 2007.

        Our ability to pay dividends is restricted by our debt agreements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."

Item 3.    Defaults Upon Senior Securities

        None

61



Item 4.    (Removed and Reserved)

Item 5.    Other Information

        None

Item 6.    Exhibits

  †31.1   Chief Executive Officer Certification of the Quarterly Financial Statements.

 

†31.2

 

Chief Financial Officer Certification of the Quarterly Financial Statements.

 

†32

 

Certification pursuant to 18 U.S.C. Section 1350.

Filed herewith.

62



SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Signature
 
Title

 

 

 
/s/ LAWRENCE J. ROGERS

Lawrence J. Rogers
  President and Chief Executive Officer
(Principal Executive Officer)

/s/ JEFFREY C. ACKERMAN

Jeffrey C. Ackerman

 

Executive Vice President and Chief Financial Officer (Principal Financial Officer)

Date: September 30, 2010

63




QuickLinks

PART I. FINANCIAL INFORMATION
SEALY CORPORATION Condensed Consolidated Statements of Operations (in thousands, except per share data) (unaudited)
SEALY CORPORATION Condensed Consolidated Statements of Operations (in thousands, except per share data) (unaudited)
SEALY CORPORATION Condensed Consolidated Balance Sheets (in thousands, except per share amounts) (unaudited)
SEALY CORPORATION Condensed Consolidated Statement of Stockholders' Deficit (in thousands) (unaudited)
SEALY CORPORATION Condensed Consolidated Statements of Cash Flows (in thousands) (unaudited)
SEALY CORPORATION Notes to Condensed Consolidated Financial Statements (unaudited)
SEALY CORPORATION Supplemental Condensed Consolidating Balance Sheets August 29, 2010 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Balance Sheets November 29, 2009 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Operations Three Months Ended August 29, 2010 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Operations Three Months Ended August 30, 2009 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Operations Nine Months Ended August 29, 2010 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Operations Nine Months Ended August 30, 2009 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Cash Flows Nine Months Ended August 29, 2010 (in thousands)
SEALY CORPORATION Supplemental Condensed Consolidating Statements of Cash Flows Nine Months Ended August 30, 2009 (in thousands)
SEALY CORPORATION
PART II. OTHER INFORMATION
SIGNATURES