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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended July 31, 2012

OR

For the transition period from              to            

Commission file number 001-35354

MATTRESS FIRM HOLDING CORP.

(Exact Name of Registrant as Specified in Its Charter)

5815 Gulf Freeway

Houston, Texas 77023

(Address of Principal Executive Offices) (Zip Code)

(713) 923-1090

(Registrants’ Telephone Number, Including Area Code)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report.)

Indicate by check mark whether the registrant has (1) 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 x  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 x  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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in rule 12b-2 of the Exchange Act)   YES o  NO x

As of September 7, 2012, 33,768,828 shares of common stock, par value $0.01 per share, of the registrant were outstanding.

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of federal securities laws that relate to future events or our future financial performance. In many cases, you can identify forward-looking statements by terminology such as “may,” “would,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other comparable terminology. These forward-looking statements are made based on our management’s expectations and beliefs concerning future events affecting us and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control. These uncertainties and other factors could cause our actual results to differ materially from those matters expressed or implied by these forward-looking statements.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Important factors that may cause actual results to differ materially from the results expressed or implied by these forward-looking statements are set forth under “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2012 filed with the Securities and Exchange Commission (the “SEC”) on April 20, 2012 (as amended on May 30, 2012) (the “Fiscal 2011 Annual Report”) and any additional risk factors identified in our other filings with the SEC. All forward-looking statements in this Quarterly Report on Form 10-Q are based on information available to us on the date of this report. We undertake no obligation to publicly update or revise any of the forward-looking statements, whether as a result of new information, future events or otherwise.

Some of the important factors that could cause our actual results, performance or financial condition to differ materially from expectations are:

·                  downturns in the economy and a reduction in discretionary spending by consumers;

·                  our ability to profitably open and operate new stores;

·                  our intent to aggressively open additional stores in our existing markets;

·                  our relationship with certain mattress manufacturers as our primary suppliers;

·                  our dependence on a few key employees;

·                  the possible impairment of our goodwill or other acquired intangible assets;

·                  the effect of our planned growth and the integration of our acquisitions on our business infrastructure;

·                  the impact of seasonality on our financial results and comparable-store sales;

·                  fluctuations in our comparable-store sales from quarter to quarter;

·                  our ability to raise adequate capital to support our expansion strategy;

·                  our future expansion into new, unfamiliar markets;

·                  our success in pursuing strategic acquisitions;

·                  the effectiveness and efficiency of our advertising expenditures;

·                  our success in keeping warranty claims and comfort exchange return rates within acceptable levels;

·                  our ability to deliver our products in a timely manner;

·                  our status as a holding company with no business operations;

·                  our ability to anticipate consumer trends;

·                  risks related to our controlling stockholder, including the ability of J.W. Childs Associates, L.P. to influence or control all matters affecting us, and the relationships of some of the members of our board of directors with J.W. Childs Associates, L.P.  or its affiliates;

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·                  heightened competition;

·                  changes in applicable regulations;

·                  risks related to our franchises, including our lack of control over their operations, their ability to finance and open new stores and our liabilities if they default on note or lease obligations;

·                  risks related to our stock; and

·                  other factors discussed in “Item 1A. Risk Factors” of Part I of the Fiscal 2011 Annual Report, elsewhere in this report and in our other filings with the SEC.

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MATTRESS FIRM HOLDING CORP.

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PART I
FINANCIAL INFORMATION

Item 1. Financial Statements.

MATTRESS FIRM HOLDING CORP.

Condensed Consolidated Balance Sheets

(Dollars in thousands, except share amounts)

The accompanying Notes to the Unaudited Condensed Consolidated Financial Statements are an integral part of these interim financial statements.

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MATTRESS FIRM HOLDING CORP.

Unaudited Condensed Consolidated Statements of Operations

(Dollars in thousands, except share and per share amounts)

The accompanying Notes to the Unaudited Condensed Consolidated Financial Statements are an integral part of these interim financial statements.

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MATTRESS FIRM HOLDING CORP.

Unaudited Condensed Consolidated Statements of Cash Flows

(Dollars in thousands)

The accompanying Notes to the Unaudited Condensed Consolidated Financial Statements are an integral part of these interim financial statements.

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements

1. Business and Basis of Presentation

Mattress Firm Holding Corp., through its wholly owned subsidiaries, is engaged in the retail sale of mattresses and bedding-related products in various metropolitan markets in the United States through company-operated and franchisee-owned mattress specialty stores that operate primarily under the name Mattress Firm. Mattress Firm Holding Corp. and its wholly owned subsidiaries are referred to collectively as the “Company.”

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) and they reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the Company’s financial position as of January 31, 2012 and July 31, 2012, and the results of operations and cash flows for the periods presented. The Company’s historical and quarterly results of operations may not be indicative of the results that may be achieved for the full year or any future period.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the Company’s most recent audited consolidated financial statements and related notes for the fiscal year ended January 31, 2012, which are included in the Company’s Annual Report on Form 10-K filed with the SEC on April 20, 2012 (as amended on May 30, 2012) (“the Fiscal 2011 Annual Report”).

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Estimates that are more susceptible to change in the near term are the accruals for sales returns and exchanges, product warranty costs, impairment, vendor incentives, self-insured liabilities and store closing costs.

The Company’s fiscal year consists of 52 or 53 weeks ending on the Tuesday closest to January 31. Each of the fiscal years ended January 31, 2012 (“Fiscal 2011”) and ending January 29, 2013 (“Fiscal 2012”) consists of 52 weeks.

2. Business Acquisition

On May 2, 2012, the Company completed the acquisition of all of the equity interests in MGHC Holding Corporation (“Mattress Giant”) for approximately $44 million subject to customary post-closing purchase price adjustments. The closing was funded with existing cash reserves and $10 million of borrowings under the revolving portion of the 2007 Senior Credit Facility (as defined below). The acquisition added 181 mattress specialty retail stores in certain markets in Florida and Texas where the Company currently operates Mattress Firm stores. The process of rebranding the acquired stores as Mattress Firm commenced immediately after the closing of the transaction with the conversion of in-store merchandising and computer systems and the addition of temporary signage.  Permanent rebranding, including renovations and the addition of permanent signage is expected to be complete by the end of fiscal 2012.  The acquisition increased the Company’s store locations and market share in markets in which the Company previously operated, which generally results in greater expense synergies and leverage over market-level costs, such as advertising and warehousing. The acquisition resulted in $43.0 million of goodwill, the majority of which will not be deductible for income tax purposes.

The allocation of the purchase price to the assets and liabilities of the acquisition, based on management’s estimate of their fair values on the acquisition closing date is as follows (amounts in thousands):

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

Goodwill represents the future economic benefits arising from other assets acquired that could not be individually identified and separately recognized. The goodwill arising from the acquisition is primarily due to the factors discussed above.

The net sales included in the Company’s consolidated statement of operations related to the acquisition of Mattress Giant from the acquisition date to July 31, 2012 was $33.2 million.

The following table presents the selected consolidated financial information of the Company on a pro forma basis, assuming that the acquisition of Mattress Giant had occurred as of February 2, 2011.  The historical financial information has been adjusted to give effect to pro forma items that are directly attributable to the acquisition and are expected to have a continuing impact on the consolidated results. These items include adjustments to record incremental depreciation and amortization expense related to the increase in fair value of the acquired assets.

The unaudited financial information set forth below has been compiled from the historical financial statements and other information, but is not necessarily indicative of the results that actually would have been achieved had the transaction occurred on the date indicated or that may be achieved in the future (amounts in thousands except per share amounts):

Acquisition-related costs for U.S. GAAP purposes are costs the acquirer incurs to effect a business combination, including advisory, legal, accounting, valuation, and other professional or consulting fees. The Company incurred a total of $0.6 million and $1.8 million of acquisition-related costs for the thirteen and twenty-six weeks ended July 31, 2012, respectively, related to the Mattress Giant acquisition.

3. Fair Value of Financial Instruments

The amounts reported in the unaudited condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate their respective fair values because of the short-term maturity of these instruments. The table below summarizes the estimated fair values and respective carrying values of the credit agreement, exclusive of the revolver, among Mattress Holding Corp., a subsidiary of Mattress Firm Holding Corp., certain lenders, and UBS Securities LLC, as sole arranger and bookrunner and a lender (the “2007 Senior Credit Facility”) (amounts in millions):

The fair value of the 2007 Senior Credit Facility was estimated based on the ask and bid prices quoted from an external source. The carrying amounts of other debt instruments at fixed rates approximated their respective fair values due to the comparability of interest rates for the same or similar issues that are available.

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

The Financial Accounting Standards Board (“FASB”) has issued guidance on the definition of fair value, the framework for using fair value to measure assets and liabilities, and disclosure about fair value measurements. The guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used to measure fair value. These tiers include:

·                  Level 1:  Defined as observable inputs such as quoted prices in active markets for identical assets or liabilities as of the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis.

·                  Level 2:  Defined as pricing inputs other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable as of the reporting date. Level 2 includes those financial instruments that are valued using models or other valuation methodologies. These models are primarily industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors and current market and contractual prices for the underlying instruments, as well as other relevant economic measures.

·                  Level 3:  Defined as pricing inputs that are unobservable from objective sources. These inputs may be used with internally developed methodologies that result in management’s best estimate of fair value.

The Company measures the fair value of its nonqualified deferred compensation plan on a recurring basis. The plan’s assets are valued based on the marketable securities tied to the plan. Additionally, the Company measures the fair values of goodwill, intangible assets, and property and equipment on a nonrecurring basis if required by impairment tests applicable to these assets. Assets requiring recurring or non-recurring fair value measurements as previously described consisted of the following (amounts in thousands):

4. Goodwill and Intangible Assets

The Company tests goodwill and other indefinite lived intangible assets for impairment annually and when events and circumstances indicate that the carrying value of these assets may exceed their current fair values. The Company assigns the carrying value of goodwill to its “reporting units” and applies the test for goodwill at the reporting unit level. A reporting unit is defined as an operating segment or one level below a segment (a “component”) if the component is a business and discrete information is prepared and reviewed regularly by segment management. Each of the Company’s metropolitan markets is an operating segment. The store unit components that comprise each operating segment are aggregated into a reporting unit on the basis that all stores have similar economic characteristics. All of the Company’s goodwill has been allocated to its metropolitan market reporting units for impairment testing.

The test for goodwill impairment involves a qualitative evaluation as to whether or not it is more likely than not that the fair value of a reporting unit is less than its carrying value using an assessment of relevant events and circumstances. If any reporting unit is concluded to be more likely impaired than not the following steps are performed for such reporting unit: (1) comparing the fair value of a reporting unit with the carrying value of its net assets and (2) if the carrying value exceeds fair value, the fair value of goodwill is compared with the respective carrying value and an impairment loss is recognized in the amount of the excess. An estimated fair value of the enterprise, which is allocated to each reporting unit for goodwill impairment purposes, would be derived by a combination of an income approach and a market approach, which incorporates both management’s views and those of the market. The income approach provides an estimated fair value based on the Company’s anticipated cash flows that are discounted using a weighted average cost of capital rate. The market approach provides an estimated fair value based on multiples of operating results to

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

enterprise value of comparable publicly-traded entities that are applied to the Company’s historical operating results. The estimated fair values computed using the income approach and the market approach are then weighted and combined into a single fair value. The primary assumptions used in the income approach are estimated cash flows and weighted average cost of capital. Estimated cash flows are primarily based on projected revenues, operating costs and capital expenditures and are discounted based on weighted average cost of capital.

The circumstances which impact the valuation of goodwill could also be an indicator of impairment of trade names or trademarks, as could changes in legal circumstances, marketing plans or customer demand. In conjunction with our evaluation of goodwill, the Company also evaluated the carrying value of non-amortizing trade names and trademarks using the relief from royalty method, which values the intangible asset by estimating the savings achieved by ownership as compared to licensing the intangible assets from an independent owner.  The Company did not recognize any impairment losses during the thirteen or twenty-six weeks ended August 2, 2011 or July 31, 2012.

5. Income Taxes

Income tax expense during interim periods is based on the estimated annual effective income tax rate plus any discrete items which are recorded in the period in which they occur. Discrete items include such events as changes in estimates due to the finalization of tax returns, tax audit settlements, tax law changes, and increases or decreases in valuation allowances related to prior year estimates.  The determination of the consolidated provision for income taxes, deferred tax assets and liabilities and related valuation allowance needs require management to make judgments and estimates.  Although management believes that its tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business, as well as the generation of sufficient future taxable income.

The Company recognized $11.5 million of income tax expense for the twenty-six weeks ended July 31, 2012, compared to $0.3 million of income tax expense for the twenty-six weeks ended August 2, 2011. The effective tax rate was 36.7% for the twenty-six weeks ended July 31, 2012, compared to 6.4% for the twenty-six weeks ended August 2, 2011, and differs primarily due to the fact that the Company had a full valuation allowance recorded against its deferred tax assets during the first twenty-six weeks of 2011.  The effective tax rate of 36.7% for the current period differs from the federal statutory rate of 35% primarily due to state income taxes.

The Company files income tax returns in U.S. federal and state jurisdictions. As of July 31, 2012, open tax years in federal and some state jurisdictions date back to October 2002 due to the taxing authorities’ ability to adjust operating loss carryforwards. As of January 31, 2012, the Company had net operating loss carryforwards of $37.2 million expiring in various years through fiscal year 2019.

The Company has established a cumulative liability for unrecognized tax benefits of $0.4 million as of July 31, 2012.  Management does not anticipate there will be a material change in the total amount of unrecognized tax benefits within the next twelve months.  Management had not accrued any interest on these unrecognized tax benefits as of July 31, 2012.

6. Reportable Segments

The Company’s operations consist primarily of the retail sale of mattresses and bedding-related products in various metropolitan areas in the United States through company-operated and franchisee-operated mattress specialty stores that operate under the name Mattress Firm. The Company also generates sales through its website and special events primarily to customers who reside in the metropolitan markets in which company-operated stores are located. The Company’s chief operating decision maker reviews the aggregated results of company-operated stores at the metropolitan market level, including market-level cost data, consisting primarily of advertising, warehousing and overhead expenses that are directly incurred, managed and reported at the market level. Management focuses on improving the profitability at the market level and, therefore, each company-operated metropolitan market is an operating segment. The company-operated market, website and special events business segments are aggregated into a single reportable segment (“retail segment”) as a result of the similar nature of the products sold and other similar economic characteristics that are expected to continue into future periods. Furthermore, the Company generates franchise fees and royalty income from the operation of franchisee-operated Mattress Firm stores in metropolitan markets in which the Company does not operate. Franchise operations are a separate reportable segment, for which the results of operations, as viewed by management, are fully represented by the franchise fees and royalty income reported on the face of the statements of operations because costs associated with the franchise business are not distinguished from other cost data viewed by management. The Company’s assets are used primarily in the operation of its retail segment and the assets directly attributed to the franchise operations are not separately disclosed because they are not material.

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

The Company’s total net sales are generated from the sale of three major categories of products, consisting of (1) conventional mattresses which utilize steel-coil innersprings, (2) specialty mattresses which utilize materials other than steel-coil innersprings and (3) furniture and accessories, which include headboards and footboards, bed frames, mattress pads and pillows, and from delivery service revenues.

The following table represents the components of the Company’s total net sales (amounts in thousands):

Prior-year components of the Company’s total net sales have been reclassified between specialty mattresses and conventional mattresses in a manner consistent with the current-year presentation.

7. Earnings Per Share

The following table presents a reconciliation of the weighted average shares outstanding used in the earnings per common share calculations:

One-half of the stock options granted to the Company’s employees are subject to a five-year time-based vesting schedule, while the remaining one-half of the stock options are subject to a four-year market-based vesting schedule, with such vesting based on specified stock price increase targets, as set forth in the option award agreement evidencing the grant of such stock options. The Company includes market-based stock option awards in the dilutive potential common shares when they become contingently issuable and exclude the awards when they are not contingently issuable. Diluted weighted average shares outstanding for both the thirteen and twenty-six weeks ended July 31, 2012 excludes stock options for the purchase of 458,936 shares of common stock as the applicable vesting criteria were not satisfied as of July 31, 2012.

8. Commitments and Contingencies

The Company conducts the majority of its operations from leased store and warehouse facilities pursuant to non-cancellable operating lease agreements with initial terms ranging from one to 15 years. Certain leases include renewal options generally ranging from one to five years and contain certain rent escalation clauses. Most leases require the Company to pay its proportionate share of the property tax, insurance and maintenance expenses of the property. Certain leases provide for contingent rentals based on sales volumes; however, incremental rent expense resulting from such arrangements was immaterial during all periods presented in the accompanying financial statements.

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

The Company is subject to legal proceedings and claims that arise in the ordinary course of business. Management does not believe that the outcome of any of the currently pending matters will have a material adverse effect on the Company’s financial position, results of operations or cash flows.

9. Related Party Transactions

Management Fees

During the thirteen and twenty-six weeks ended August 2, 2011, the Company incurred management fees and other direct expenses from affiliates of its majority owners. Such fees and expenses were billed by an affiliate of J.W. Childs Associates, L.P. Management fees and other direct expenses included in the results of operations were $0.1 million and $0.2 million for the thirteen and twenty-six weeks ended August 2, 2011, respectively. On November 23, 2011, the management agreement was terminated in connection with the Company’s initial public offering.

2009 Loan Facility, PIK Notes and Convertible Notes

As discussed in Notes 5 and 12 in the Fiscal 2011 Annual Report, prior to the completion of the Company’s initial public offering on November 23, 2011, the Company owed certain indebtness under the 2009 Loan Facility, PIK Notes and convertible notes to parties that owned equity interests in Mattress Holdings, LLC and certain affiliates of those equity investors.  A portion of the balances outstanding under these debt instruments was paid off with proceeds from the Company’s initial public offering, and the remaining portion was converted into shares of the Company’s common stock in connection with the closing of the initial public offering.  The aggregate amount of debt paid and debt converted into equity on November 23, 2011 totaled $188.0 million, including interest accrued thereon.  Under the respective terms of these debt instruments, interest payments on the 2009 Loan Facility, PIK Notes and Convertible Notes were not made in cash, but were instead made by adding the interest to the respective outstanding principal balances.  Interest expense incurred under these debt instruments totaled $6.6 million and $12.9 million for the thirteen and twenty-six weeks ended August 2, 2011, respectively.

10. Recently Issued Accounting Standards

New Accounting Standards Adopted in this Report— In May 2011, the FASB issued new guidance regarding fair value measurements to ensure consistency between U.S. GAAP and International Financial Reporting Standards. The new guidance applies to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s stockholders’ equity in the financial statements. The new guidance applies prospectively effective during periods beginning after December 15, 2011. The Company adopted the provisions of the new guidance effective February 1, 2012 and the adoption of this standard did not have a material impact on the Company’s financial position, results of operations, or cash flows.

In June 2011, the FASB issued new guidance to increase the prominence of other comprehensive income in financial statements. This guidance provides the option to present the components of net income and comprehensive income in either one single statement or in two consecutive statements reporting net income and other comprehensive income. This guidance is effective for fiscal years and interim periods beginning after December 15, 2011. The Company adopted the provisions of the new guidance effective February 1, 2012 and the adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

New Accounting Standards Not Yet Adopted— In December 2011, the FASB issued new guidance which requires disclosures of gross and net information about financial and derivative instruments eligible for offset in the statement of financial position or subject to a master netting agreement. This guidance is effective for the Company in the first fiscal quarter of 2013 and is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In July 2012, the FASB issued new guidance which gives companies the option to perform a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired, and in some cases, bypass the two-

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MATTRESS FIRM HOLDING CORP.

Notes to Unaudited Condensed Consolidated Financial Statements (Continued)

step impairment test. This guidance is effective for annual and interim indefinite-lived intangible asset impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption of the new guidance is permitted. The Company is currently assessing when it will adopt this guidance.

11. Subsequent Events

On August 28, 2012, the Company paid off the outstanding revolver borrowings on the 2007 Senior Credit Facility of $5.0 million. At September 7, 2012, there were standby letters of credit outstanding in the amount of $1.0 million and additional borrowings available of $34.0 million.

On September 4, 2012, the Company entered into an agreement to acquire the leasehold interests, store assets, distribution center assets and related inventories, and assume certain liabilities, of Mattress Xpress, Inc. and Mattress Xpress of Georgia, Inc. (collectively “Mattress Xpress”) relating to the operation of 35 mattress specialty stores located in Florida and Georgia for a total purchase price of approximately $15.8 million, subject to customary adjustments.  Under the terms of the purchase agreement, Mattress Xpress will provide unsecured financing to the Company in the amount of approximately $7.8 million in connection with the purchase, which will be payable over a term of one year in quarterly installments, including interest at 8%.  The closing of the purchase is expected to occur in the third fiscal quarter of 2012 and remains subject to the prior satisfaction of customary closing conditions.  The Company intends to rebrand the stores as Mattress Firm subsequent to the closing of the transaction.

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

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q. The discussion in this section contains forward-looking statements that involve risks and uncertainties. See “Cautionary Note Regarding Forward-Looking Statements” included elsewhere in this report for a discussion of important factors that could cause actual results to differ materially from those described or implied by the forward-looking statements contained herein.

Unless the context otherwise requires, the terms “Mattress Firm,” “our company,” “the Company,” “we,” “us,” “our” and the like refer to Mattress Firm Holding Corp. and its consolidated subsidiaries. Unless otherwise indicated, (i) the term “our stores” refers to our company-operated stores and our franchised stores; and (ii) when used in relation to our company, the terms “market” and “markets” refer to the metropolitan statistical area or an aggregation of the metropolitan statistical areas in which we or our franchisees operate.

In this report, we refer to earnings before interest, taxes, depreciation and amortization and other adjustments (such as goodwill impairment charges, loss on store closings and acquisition expenses), or “Adjusted EBITDA.” Adjusted EBITDA is not a performance measure under accounting principles generally accepted in the United States, or “U.S. GAAP.” See “Adjusted EBITDA to Net Income Reconciliation” below for a definition of Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income.

We report on the basis of a 52- or 53-week fiscal year, which ends on the Tuesday closest to January 31. Each fiscal year is described by the period of the calendar year that comprises the majority of the fiscal year period. For example, the fiscal year ending January 29, 2013 is described as “fiscal 2012.” Fiscal 2012 contains 52 weeks.

Executive Summary

Net sales during the thirteen weeks and twenty-six weeks ended July 31, 2012 improved $82.1 million and $140.0 million, respectively, from the comparable prior year levels as a result of comparable-store sales growth and the addition of new and acquired store units. Net income and other profitability measures improved during both the thirteen and twenty-six weeks ended July 31, 2012. The improvements resulted from the net sales growth and our ability to gain leverage on certain costs through increasing sales per store, which was partially offset by increases in spending in certain expense categories during such periods. Such expenses included advertising and general and administrative expenses. Key results for the thirteen and twenty-six weeks ended July 31, 2012 include:

·                  Net income increased $6.5 million to $10.1 million for the thirteen weeks ended July 31, 2012, compared with net income of $3.6 million for the prior year period. Net income increased $15.1 million to $19.8 million for the twenty-six weeks ended July 31, 2012, compared with $4.7 million for the prior year period.

·                  Net sales increased $82.1 million, or 45.6%, to $262.0 million for the thirteen weeks ended July 31, 2012, compared to $179.9 million for the prior year period. Comparable-store sales increased 5.0% during the thirteen weeks ended July 31, 2012. Net sales increased $140.0 million, or 42.2%, to $471.8 million for the twenty-six weeks ended July 31, 2012 compared to $331.8 million for the prior year period. Comparable-store sales increased 10.1% during the twenty-six weeks ended July 31, 2012.

·                  Income from operations for the thirteen weeks ended July 31, 2012 was $17.6 million. Excluding $5.9 million of acquisition-related costs, adjusted income from operations was $23.5 million, and adjusted operating margin during the thirteen weeks improved from 8.0% in 2011 to 9.0% in 2012. This operating margin growth for the thirteen weeks ended July 31, 2012 on an adjusted basis (excluding acquisition-related costs) was driven primarily by a 125 basis-point improvement in general and administrative expenses. Income from operations for the twenty-six weeks ended July 31, 2012 was $35.6 million. Excluding $7.0 million of acquisition-related costs, adjusted income from operations was $42.6 million, and adjusted operating margin during the twenty-six weeks improved 187 basis points from 7.2% in 2011 to 9.0% in 2012. This operating margin growth for the twenty-six weeks ended July 31, 2012 on an adjusted basis (excluding acquisition-related costs) was driven primarily by a 128 basis-point improvement in gross profit margin and a 87 basis-point improvement in general and administrative expenses. Acquisition-related costs for purposes of management’s discussion and analysis, which are included in the results of operations, consists of the acquisition-related costs as defined under U.S. GAAP, including advisory, legal, accounting, valuation, and other professional or consulting fees and, in addition, costs of integrating store and warehouse operations and corporate functions that are not expected to recur in future periods, related to the Mattress Giant acquisition. See “Reported to Adjusted Statements of Operations Data” below for a reconciliation of net income as reported to adjusted net income.

·                  Adjusted EBITDA increased $9.6 million to $29.6 million for the thirteen weeks ended July 31, 2012, compared with $20.0 million for the prior year period. Adjusted EBITDA as a percentage of sales increased to 11.3% during the thirteen

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weeks ended July 31, 2012, compared with 11.1% for the prior year period. Adjusted EBITDA increased $20.3 million to $55.0 million for the twenty-six weeks ended July 31, 2012 compared with $34.7 million for the prior year period. Adjusted EBITDA as a percentage of sales increased to 11.7% during the twenty-six weeks ended July 31, 2012, compared with 10.5% for the prior year period. See “Adjusted EBITDA to Net Income Reconciliation” below for a definition of Adjusted EBITDA and a reconciliation of Adjusted EBITDA to net income.

·                  The components of the net sales increase were as follows (amounts in millions):

·                  The composition of net sales by major category of product and services were as follows (amounts in millions):

Prior-year components of the  total net sales have been reclassified between specialty mattresses and conventional mattresses in a manner consistent with the current-year presentation.

·                  The activity with respect to the number of company-operated store units was as follows:

·                  Operating cash flows were $11.9 million and $30.1 million during the thirteen weeks and twenty-six weeks ended July 31, 2012, respectively, which were the primary funding source for capital expenditures and debt principal payment requirements.

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·                  On May 2, 2012, we completed the acquisition of the equity interests in MGHC Holding Corporation (“Mattress Giant”) for approximately $44 million subject to customary post-closing purchase price adjustments.  The closing was funded with existing cash reserves and $10 million of temporary borrowings under the revolving portion of the 2007 Senior Credit Facility (as defined below).

The acquisition is expected to advance our market-level profitability model that is centered on the benefits of increasing our “relative market share” in a given market. We believe that the incremental sales and store-level contribution attributable to the acquired stores will support our ability to increase the advertising spend in each of the markets, which is expected to drive sales increases in both the acquired and existing stores.  This strategy is expected to provide sales increases, greater leverage over market-level costs and improved market-level profitability.

·                  We ended the thirteen weeks ended July 31, 2012 with $5.0 million in outstanding borrowings, and total borrowing capacity of $29.0 million, under the revolving credit line portion of the credit agreement among our indirectly owned subsidiary Mattress Holding Corp. (“Mattress Holding”), certain lenders, and UBS Securities LLC, as sole arranger and bookrunner and a lender (the “2007 Senior Credit Facility”). Effective May 22, 2012, we increased our revolver capacity under the 2007 Senior Credit Facility by $10 million to $35 million with no change in interest rate or other terms. On August 28, 2012 we paid off the outstanding revolver borrowings on the 2007 Senior Credit Facility of $5.0 million. At September 7, 2012 there were standby letters of credit outstanding in the amount of $1.0 million and additional borrowings available of $34.0 million.

General Definitions for Operating Results

Net sales includes fees collected for delivery services and is recognized upon delivery and acceptance of mattresses and bedding products by our customers and is recorded net of estimated returns. Customer deposits collected prior to the delivery of merchandise are recorded as a liability. Net sales are recognized net of sales tax collected from customers and remitted to various taxing jurisdictions.

Cost of sales consists of the following:

·                  Costs associated with purchasing and delivering our products to our stores and customers, net of vendor incentives earned on the purchase of products;

·                  Physical inventory losses;

·                  Store and warehouse occupancy and depreciation expense of related facilities and equipment;

·                  Store and warehouse operating costs, including warehouse labor costs and utilities, repairs and maintenance and supplies costs of warehouse and store facilities; and

·                  Estimated costs to provide for customer returns and exchanges and to service customer warranty claims.

Gross profit from retail operations represents net sales minus cost of sales.

Franchise fees and royalty income represents initial franchise fees earned upon the opening of new franchisee stores and ongoing royalties based on a percentage of gross franchisee sales.

Sales and marketing expenses consist of the following:

·                  Advertising and media production;

·                  Payroll and benefits for sales associates; and

·                  Merchant service fees for customer credit and debit card payments, check guarantee fees and promotional financing expense.

General and administrative expenses consist of the following:

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·                  Payroll and benefit costs for corporate office and regional management employees;

·                  Stock-based compensation costs;

·                  Occupancy costs of corporate facility;

·                  Information systems hardware, software and maintenance;

·                  Depreciation related to corporate assets;

·                  Management fees;

·                  Insurance; and

·                  Other overhead costs.

Loss (gain) on store closings and impairment of store assets consists of the following:

·                  Estimated future costs to close locations at the time of closing including, as applicable, the difference between future lease obligations and anticipated sublease rentals;

·                  The write off of unamortized fixed assets related to store leasehold costs on closed stores; and

·                  Non-cash charges recognized for long-lived assets, consistently primarily of store leasehold costs and related equipment, to reduce the carrying value to estimated fair value, based on our periodic assessment of whether projected future cash flows of individual stores are sufficient to recover the carrying value of the related assets.

Income (loss) from operations consists of gross profit from retail operations plus franchise fees and royalty income, minus the sum of sales and market expenses, general and administrative expenses, goodwill and intangible asset impairment charges, and loss (gain) on store closings and impairment of store assets.

Total other expense includes interest income, interest expense and gain (loss) on early debt extinguishments. Interest expense includes interest on outstanding debt, amortization of debt discounts and amortization of financing costs.

Results of Operations

The following table presents the consolidated historical financial operating data for our business expressed as a percentage of net revenues for each period indicated. Certain percentages presented are calculated using actual results prior to rounding. The historical results are not necessarily indicative of results to be expected for any future period.

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Thirteen Weeks Ended July 31, 2012 Compared to Thirteen Weeks Ended August 2, 2011

Net sales. Net sales increased $82.1 million, or 45.6%, to $262.0 million for the thirteen weeks ended July 31, 2012, compared to $179.9 million for the thirteen weeks ended August 2, 2011. The components of the net sales increase were as follows (amounts in millions):

The increase in comparable-store net sales represents a 5.0% comparable-store sales increase, which was primarily the result of an increase in the number of customer transactions. The increase in our net sales from new stores was the result of 123 new stores opened at various times during the twelve fiscal periods ended July 31, 2012, including 27 stores opened during the thirteen-week period ended July 31, 2012, prior to their inclusion in the comparable-store sales calculation beginning with the thirteenth full fiscal period of operations. The increase in net sales for acquired stores was the result of the acquisition of 55 stores in November 2011 and 181 stores in May 2012. We closed 22 stores during the twelve fiscal periods ended July 31, 2012, including six stores during the thirteen-week period ended July 31, 2012, and the reduction in sales during the thirteen-week period ended July 31, 2012 from these closings totaled $2.0 million. We operated 957 stores at July 31, 2012, compared with 620 stores at August 2, 2011.

Cost of sales.  Cost of sales increased $50.6 million, or 46.3%, to $159.9 million during the thirteen weeks ended July 31, 2012, compared to $109.3 million for the thirteen weeks ended August 2, 2011. The major components of the increase in cost of sales are discussed below. Cost of sales as a percentage of net sales increased to 61.0% for the thirteen weeks ended July 31, 2012, as compared to 60.7% for the thirteen weeks ended August 2, 2011.

Product costs increased by $27.8 million, or 39.0%, to $99.1 million for the thirteen weeks ended July 31, 2012, compared with $71.3 million for the thirteen weeks ended August 2, 2011. Product costs as a percentage of sales decreased to 37.8% for the thirteen weeks ended July 31, 2012 from 39.6% for the thirteen weeks ended August 2, 2011. The increase in the amount of product costs is the result of the corresponding increase in net sales. The decrease of this expense as a percentage of net sales for the thirteen weeks ended July 31, 2012 is primarily the result of an increase in the mix of products with lower product costs and improvement in vendor incentive terms with certain vendors.

Store and warehouse occupancy costs, consisting primarily of lease-related costs of rented facilities, increased $12.8 million, or 57.2%, to $35.1 million during the thirteen weeks ended July 31, 2012, compared to $22.3 million for the thirteen weeks ended August 2, 2011. Store and warehouse occupancy costs as a percentage of net sales increased to 13.4% during the thirteen weeks ended July 31, 2012, compared to 12.4% in the thirteen weeks ended August 2, 2011. The increase in the amount of expense during the thirteen weeks ended July 31, 2012 was mainly attributable to the increase in the number of stores we operated and the commencement of warehouse operations in a number of new markets. The increase of expense as a percentage of net sales during the thirteen weeks ended July 31, 2012 was primarily attributable to the acquisition of Mattress Giant stores in November 2011 and May 2012 with lower store occupancy expense leverage as a result of average sales per store that were lower than the Company average.

Depreciation expense of leasehold improvement and other fixed assets used in stores and warehouse operations increased $1.2 million, or 29.9%, to $5.1 million, for the thirteen weeks ended July 31, 2012, compared to $3.9 million for the thirteen weeks ended August 2, 2011. The increase in expense was primarily attributable to the increase in the number of stores we operated during the thirteen weeks ended July 31, 2012, as compared with the prior year period.

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Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $8.8 million, or 74.7%, to $20.6 million, for the thirteen weeks ended July 31, 2012, compared to $11.8 million for the thirteen weeks ended August 2, 2011, primarily as a result of the increase in net sales and in the number of stores we operated during the thirteen weeks ended July 31, 2012, as compared with the prior year period. Other cost of sales includes $1.3 million of acquisition-related costs related to the Mattress Giant acquisition.

Gross profit from retail operations.  As a result of the foregoing, gross profit from retail operations increased $31.5 million, or 44.6%, to $102.2 million, during the thirteen weeks ended July 31, 2012, compared with $70.6 million during the thirteen weeks ended August 2, 2011. Gross profit from retail operations as a percentage of net sales, decreased to 39.0% for the thirteen weeks ended July 31, 2012, compared to 39.3% for the thirteen weeks ended August 2, 2011.

Franchise fees and royalty income.  Franchise fees and royalty income increased $0.2 million, or 22.3%, to $1.3 million for the thirteen weeks ended July 31, 2012, compared to $1.1 million during the thirteen weeks ended August 2, 2011. The increase in income was attributable to an increase in royalty income, which was mainly due to increases in sales for franchise stores as compared with the prior year period mainly due to new stores and comparable-store sales increases. Our franchisees operated 141 stores at July 31, 2012.

Sales and marketing expenses.  Sales and marketing expenses increased $21.5 million, or 47.7%, to $66.6 million for the thirteen weeks ended July 31, 2012, compared to $45.1 million for the thirteen weeks ended August 2, 2011. Sales and marketing expense as a percentage of net sales increased to 25.4% for the thirteen weeks ended July 31, 2012, compared to 25.1% for the thirteen weeks ended August 2, 2011. The components of sales and marketing expenses are explained below.

Advertising expense increased $7.5 million, or 41.9%, to $25.4 million for the thirteen weeks ended July 31, 2012, from $17.9 million for the thirteen weeks ended August 2, 2011. Advertising expense as a percentage of net sales decreased to 9.7% for the thirteen weeks ended July 31, 2012, compared to 10.0% for the thirteen weeks ended August 2, 2011. The increase in the amount of advertising spending was mainly attributable to our efforts to increase the number of customers shopping in our stores and, to a lesser extent, to the increase in the number of markets in which we operate as a result of new store growth and acquisitions. We expect to maintain or increase advertising expense as a percentage of sales if we continue to experience sales per store and comparable-store sales growth and gain expense leverage in other operating expense areas. We receive funds from time to time from certain vendors to advertise their products that are recognized as a direct reduction of advertising expense. The amount of vendor advertising funds that were recognized as a reduction of advertising expense totaled $1.8 million for the thirteen weeks ended July 31, 2012, compared with $1.2 million for the thirteen weeks ended August 2, 2011.

Other sales and marketing expenses, consisting mainly of salesman compensation costs and, to a lesser extent, costs incurred to accept payments from our customers, including credit card and third party finance fees, increased $13.9 million, or 51.1%, to $41.1 million for the thirteen weeks ended July 31, 2012, compared to $27.2 million for the thirteen weeks ended August 2, 2011, primarily as a result of the increase in net sales during the period. Other sales and marketing expenses as a percentage of net sales increased to 15.7% for the thirteen weeks ended July 31, 2012, compared to 15.1% for the thirteen weeks ended August 2, 2011. The increase reflects higher staffing levels in stores over the summer selling period and modifications to the compensation system.

General and administrative expenses.  General and administrative expenses increased $6.9 million, or 55.8%, to $19.2 million for the thirteen weeks ended July 31, 2012, compared to $12.4 million for the thirteen weeks ended August 2, 2011. General and administrative expenses as a percentage of net sales, increased to 7.4% for the thirteen weeks ended July 31, 2012, compared to 6.9% for the thirteen weeks ended August 2, 2011. General and administrative expenses increased primarily as a result of our growth, including a $2.6 million increase in wages and benefits resulting from employee additions to our corporate office and $4.6 million of acquisition-related costs related to the Mattress Giant acquisition. We expect to continue making investments in our corporate infrastructure commensurate with our growth strategy.

Other expense, net.  Other expense, net, for both periods consists primarily of interest expense. Interest expense decreased $6.5 million, or 74.5%, to $2.2 million for the thirteen weeks ended July 31, 2012, compared to $8.7 million during the thirteen weeks ended August 2, 2011, primarily as a result of the repayment of related-party debt in conjunction with the initial public offering in

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November 2011. The thirteen weeks ended August 2, 2011 also includes a $1.9 million loss from debt extinguishment related to the repayment of related-party debt.

Income tax (benefit) expense.  We recognized $5.3 million of income tax expense for the thirteen weeks ended July 31, 2012, compared to $0.2 million of income tax expense for the thirteen weeks ended August 2, 2011. The effective tax rate was 34.6% for the thirteen weeks ended July 31, 2012, compared to 6.2% for the thirteen weeks ended August 2, 2011, and differs primarily due to the fact that we had a full valuation allowance recorded against our deferred tax assets during the thirteen weeks ended August 2, 2012.

Net income (loss).  As a result of the foregoing, our net income was $10.1 million for the thirteen weeks ended July 31, 2012 compared to $3.6 million for the thirteen weeks ended August 2, 2011.

Twenty-Six Weeks Ended July 31, 2012 Compared to Twenty-Six Weeks Ended August 2, 2011

Net sales. Net sales increased $140.0 million, or 42.2%, to $471.8 million for the twenty-six weeks ended July 31, 2012, compared to $331.8 million for the twenty-six weeks ended August 2, 2011. The components of the net sales increase were as follows (amounts in millions):

The increase in comparable-store net sales represents a 10.1% comparable-store sales increase, which was primarily the result of an increase in the number of customer transactions and in the average net sales per transaction. The increase in our net sales from new stores was the result of 123 new stores opened at various times during the twelve fiscal periods ended July 31, 2012, including 57 stores opened during the twenty-six-week period ended July 31, 2012, prior to their inclusion in the comparable-store sales calculation beginning with the thirteenth full fiscal period of operations. The expected increase in net sales for acquired stores was the result of the acquisition of 55 stores in November 2011 and 181 stores in May 2012. We closed 22 stores during the twelve fiscal periods ended July 31, 2012, including ten stores during the twenty-six-week period ended July 31, 2012, and the reduction in sales during the twenty-six-week period ended July 31, 2012 from these closings totaled $4.1 million. We operated 957 stores at July 31, 2012, compared with 620 stores at August 2, 2011.

Cost of sales.  Cost of sales increased $81.9 million, or 39.9%, to $287.1 million during the twenty-six weeks ended July 31, 2012, compared to $205.2 million for the twenty-six weeks ended August 2, 2011. The major components of the increase in cost of sales are discussed below. Cost of sales as a percentage of net sales decreased to 60.9% for the twenty-six weeks ended July 31, 2012, as compared to 61.9% for the twenty-six weeks ended August 2, 2011.

Product costs increased by $49.6 million, or 38.2%, to $179.4 million for the twenty-six weeks ended July 31, 2012, compared with $129.8 million for the twenty-six weeks ended August 2, 2011. Product costs as a percentage of sales decreased to 38.0% for the twenty-six weeks ended July 31, 2012 from 39.1% for the twenty-six weeks ended August 2, 2011. The increase in the amount of product costs is the result of the corresponding increase in net sales. The decrease of this expense as a percentage of net sales for the twenty-six weeks ended July 31, 2012 is primarily the result of an increase in the mix of products with lower product costs and improvement in vendor incentive terms with certain vendors.

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Store and warehouse occupancy costs, consisting primarily of lease-related costs of rented facilities, increased $17.6 million, or 39.3%, to $62.4 million during the twenty-six weeks ended July 31, 2012, compared to $44.8 million for the twenty-six weeks ended August 2, 2011. Store and warehouse occupancy costs as a percentage of net sales decreased to 13.2% during the twenty-six weeks ended July 31, 2012, compared to 13.5% in the twenty-six weeks ended August 2, 2011. The increase in the amount of expense during the twenty-six weeks ended July 31, 2012 was mainly attributable to the increase in the number of stores we operated and the commencement of warehouse operations in a number of new markets.

Depreciation expense of leasehold improvement and other fixed assets used in stores and warehouse operations increased $1.4 million, or 18.2%, to $9.3 million, for the twenty-six weeks ended July 31, 2012, compared to $7.9 million for the twenty-six weeks ended August 2, 2011. The increase in expense was primarily attributable to the increase in the number of stores we operated during the twenty-six weeks ended July 31, 2012, as compared with the prior year period.

Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $13.2 million, or 58.2%, to $36.0 million, for the twenty-six weeks ended July 31, 2012, compared to $22.8 million for the twenty-six weeks ended August 2, 2011, primarily as a result of the increase in net sales and in the number of stores we operated during the twenty-six weeks ended July 31, 2012, as compared with the prior year period. Other cost of sales includes $1.3 million of acquisition-related costs related to the Mattress Giant acquisition.

Gross profit from retail operations.  As a result of the foregoing, gross profit from retail operations increased $58.1, million or 45.9%, to $184.7 million, during the twenty-six weeks ended July 31, 2012, compared with $126.6 million during the twenty-six weeks ended August 2, 2011. Gross profit from retail operations as a percentage of net sales, increased to 39.2% for the twenty-six weeks ended July 31, 2012, compared to 38.2% for the twenty-six weeks ended August 2, 2011.

Franchise fees and royalty income.  Franchise fees and royalty income increased $0.4 million, or 22.2%, to $2.5 million for the twenty-six weeks ended July 31, 2012, compared to $2.1 million during the twenty-six weeks ended August 2, 2011. The increase in income was attributable to a $0.5 million increase in royalty income, which was mainly due to increases in sales for franchise stores as compared with the prior year period mainly due to new stores and comparable-store sales increases, which was offset by a $0.1 million decrease in initial fees, resulting from a decrease in the number of new franchisee stores opened during the twenty-six weeks ended July 31, 2012 as compared with the prior year period.  Our franchisees operated 141 stores at July 31, 2012.

Sales and marketing expenses.  Sales and marketing expenses increased $35.0 million, or 43.3%, to $115.7 million for the twenty-six weeks ended July 31, 2012, compared to $80.7 million for the twenty-six weeks ended August 2, 2011. Sales and marketing expense as a percentage of net sales increased to 24.5% for the twenty-six weeks ended July 31, 2012, compared to 24.3% for the twenty-six weeks ended August 2, 2011. The components of sales and marketing expenses are explained below.

Advertising expense increased $12.3 million, or 40.0%, to $43.0 million for the twenty-six weeks ended July 31, 2012, from $30.7 million for the twenty-six weeks ended August 2, 2011. Advertising expense as a percentage of net sales decreased to 9.1% for the twenty-six weeks ended July 31, 2012, compared to 9.3% for the twenty-six weeks ended August 2, 2011. The increase in the amount of advertising spending was mainly attributable to our efforts to increase the number of customers shopping in our stores and, to a lesser extent, to the increase in the number of markets in which we operate as a result of new store growth and acquisitions. We expect to maintain or increase advertising expense as a percentage of sales if we continue to experience sales per store and comparable-store sales growth and gain expense leverage in other operating expense areas. We receive funds from time to time from certain vendors to advertise their products that are recognized as a direct reduction of advertising expense. The amount of vendor advertising funds that were recognized as a reduction of advertising expense totaled $2.4 million for the twenty-six weeks ended July 31, 2012, compared with $1.5 million for the twenty-six weeks ended August 2, 2011.

Other sales and marketing expenses, consisting mainly of salesman compensation costs and, to a lesser extent, costs incurred to accept payments from our customers, including credit card and third party finance fees, increased $22.7 million, or 45.4%, to $72.7 million for the twenty-six weeks ended July 31, 2012, compared to $50.0 million for the twenty-six weeks ended August 2, 2011, primarily as a result of the increase in net sales during the period due to an increase in the number of operating stores. Other sales and marketing expenses as a percentage of net sales increased to 15.4% for the twenty-six weeks ended July 31, 2012, compared to 15.1% for the twenty-six weeks ended August 2, 2011. The increase reflects higher staffing levels in stores over the summer selling period and modifications to the compensation system.

General and administrative expenses.  General and administrative expenses increased $11.7 million, or 48.7%, to $35.9 million for the twenty-six weeks ended July 31, 2012, compared to $24.1 million for the twenty-six weeks ended August 2, 2011.

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General and administrative expenses as a percentage of net sales, increased to 7.6% for the twenty-six weeks ended July 31, 2012, compared to 7.3% for the twenty-six weeks ended August 2, 2011. General and administrative expenses increased primarily as a result of our growth, including a $4.7 million increase in wages and benefits resulting from employee additions to our corporate office, $5.7 million of acquisition-related costs related to the Mattress Giant acquisition and an aggregate increase of $1.3 million in various other general and administrative expense categories. We expect to continue making investments in our corporate infrastructure commensurate with our growth strategy.

Other expense, net.  Other expense, net, for both periods consists primarily of interest expense. Interest expense decreased $12.7 million, or 74.7%, to $4.3 million for the twenty-six weeks ended July 31, 2012, compared to $17.0 million during the twenty-six weeks ended August 2, 2011, primarily as a result of the repayment of related-party debt in conjunction with the initial public offering in November 2011. The twenty-six weeks ended August 2, 2011 also includes a $1.9 million loss from debt extinguishment related to the repayment of related-party debt.

Income tax (benefit) expense.  We recognized $11.5 million of income tax expense for the twenty-six weeks ended July 31, 2012, compared to $0.3 million of income tax expense for the twenty-six weeks ended August 2, 2011. The effective tax rate was 36.7% for the twenty-six weeks ended July 31, 2012, compared to 6.4% for the twenty-six weeks ended August 2, 2011, and differs primarily due to the fact that we had a full valuation allowance recorded against our deferred tax assets during the twenty-six weeks ended August 2, 2011.

Our estimated full year effective tax rate for Fiscal 2012, before discrete period adjustments, is approximately 38.5%, which is above the federal statutory rate of 35.0% primarily due to state income taxes.

Net income (loss).  As a result of the foregoing, our net income was $19.8 million for the twenty-six weeks ended July 31, 2012 compared to $4.7 million for the twenty-six weeks ended August 2, 2011.

Off-Balance Sheet Arrangements

Except for a guarantee of approximately $1.1 million that we have provided with respect to one real estate lease of a franchisee, we do not have any “off-balance sheet arrangements” (as such term is defined in Item 303 of Regulation S-K) that are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

Liquidity and Capital Resources

As of July 31, 2012, we had cash and cash equivalents of $6.2 million compared with $29.7 million as of August 2, 2011. The following table summarizes our cash flows (amounts in thousands):

Net cash provided by operating activities was $30.1 million for the twenty-six weeks ended July 31, 2012, compared to cash provided of $48.8 million for the twenty-six weeks ended August 2, 2011. The $18.7 million decrease in cash flows from operating activities was primarily due to the following differences as compared to the prior year :

·                  $15.2 million improvement in our net income for the twenty-six weeks ended July 31, 2012, offset by elements of the increase that are related to non-cash expense included in net income of the prior year, including:

·                  $12.5 million of non-cash paid-in-kind interest related to debt repaid and debt converted into shares of our common stock in connection with the initial public offering in November 2011, and

·                  $1.9 million of non-cash loss from debt extinguishment;

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·                  Decrease to fund $9.8 million increase in inventory related to new and acquired stores and warehouses in new markets;

·                  Decrease of $11.3 million related to the timing of cash requirements for accounts payable payments in the prior year;

·                  Increase of $4.3 million in non-cash deferred tax expense; and

·                  Decrease of $2.7 million due to other changes in operating assets and liabilities.

Net cash used in investing activities was $75.7 million for the twenty-six weeks ended July 31, 2012, compared to net cash used of $11.8 million for the twenty-six weeks ended August 2, 2011. The $63.9 million increase in cash flows from investing activities was primarily due to the May 2012 Mattress Giant acquisition for approximately $44.0 million. Capital expenditures increased $19.9 million.  The increase in capital expenditures reflected new store openings, renovations of the stores acquired in November 2011 and May 2012 from Mattress Giant, and the ongoing design and implementation of our new enterprise resource planning system.  The renovations of Mattress Giant stores acquired in November 2011 were substantially completed during the twenty-six weeks ended July 31, 2012 and resulted in $3.1 million in capital expenditures.  The renovations of Mattress Giant stores acquired in May 2012, expected to be substantially complete by the end of Fiscal 2012, resulted in $4.7 million in capital expenditures in the thirteen weeks ended July 31, 2012. We expect to incur additional capital expenditures of approximately $10.1 million in completing the renovation of the acquired Mattress Giant stores.

Our financing cash flows consist of proceeds from the issuance of debt, borrowings, and repayments for scheduled debt service payments, and prepayments of other debt. Net cash provided by financing activities was $3.8 million for the twenty-six weeks ended July 31, 2012, compared to cash used of $11.8 million for the twenty-six weeks ended August 2, 2011. The $15.6 million decrease was the result of a reduction in debt repayments primarily as a result of the repayment of related-party debt in conjunction with the initial public offering in November 2011.

Covenant Compliance

The 2007 Senior Credit Facility requires us to comply on a quarterly basis with financial covenants, including a maximum total leverage ratio and a minimum interest coverage ratio.  These financial covenants are measured using, among other things, Adjusted EBITDA of Mattress Holding and its subsidiaries, as adjusted to include pro forma results of acquisitions.  The 2007 Senior Credit Facility limits the permitted capital expenditures of Mattress Holding and its subsidiaries to $40 million for fiscal 2012.  The interest rate for borrowings under the 2007 Senior Credit Facility is a LIBOR-based rate with a margin spread of 225 to 275 basis points depending upon the maintenance of certain ratios. At July 31, 2012, the interest rate was 2.72%.  At July 31, 2012, there were outstanding revolver borrowings under the 2007 Senior Credit Facility of $5.0 million. There were standby letters of credit outstanding in the amount of $1.0 million and additional borrowings available of $29.0 million. On August 28, 2012, we paid off the outstanding revolver borrowings on the 2007 Senior Credit Facility.  At September 7, 2012, there were standby letters of credit outstanding in the amount of $1.0 million and additional borrowings available of $34.0 million.

For more information about the restrictive covenants imposed on us by the 2007 Senior Credit Facility, please see “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended January 31, 2012 filed with the SEC on April 20, 2012 (as amended on May 30, 2012) (referred to herein as the “Fiscal 2011 Annual Report”). The debt instruments governing the indebtedness under the 2009 Loan Facility, PIK Notes and Convertible Notes did not contain any financial covenants.  Such debt instruments were terminated following repayment in full or conversion into our common stock of all indebtedness outstanding thereunder in connection with our initial public offering.

We were in compliance with all of the covenants required under the 2007 Senior Credit Facility and our other indebtedness as of July 31, 2012. We believe that we will be able to maintain compliance with the various covenants required under our debt facilities for the next twelve months without amending any of the credit facilities or requesting waivers from the lenders that are party to the agreements.

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Seasonality

Our business is subject to seasonal fluctuations.  We generally have experienced more sales and a greater portion of income during the second and third quarters of our fiscal year due to a concentration of summer season holidays, including Memorial Day, the Fourth of July and Labor Day, and other seasonal factors. While we expect this trend to continue for the foreseeable future, we also expect that the acquisitions we make and the timing of those acquisitions may have some effect on the impact of these seasonal fluctuations.

Recent Accounting Pronouncements

In May 2011, the FASB issued new guidance regarding fair value measurements to ensure consistency between U.S. GAAP and International Financial Reporting Standards. The new guidance applies to all reporting entities that are required or permitted to measure or disclose the fair value of an asset, a liability, or an instrument classified in a reporting entity’s stockholders’ equity in the financial statements. The new guidance applies prospectively to periods beginning after December 15, 2011. The Company adopted the provisions of the new guidance effective February 1, 2012 and the adoption of this standard did not have a material impact on the Company’s financial position, results of operation, or cash flows.

In June 2011, the FASB issued new guidance to increase the prominence of other comprehensive income in financial statements. This guidance provides the option to present the components of net income and comprehensive income in either one single statement or in two consecutive statements reporting net income and other comprehensive income. This guidance is effective for fiscal years and interim periods beginning after December 15, 2011. The Company adopted the provisions of the new guidance effective February 1, 2012 and the adoption of this standard did not have a material impact on the Company’s consolidated financial statements.

In December 2011, the FASB issued Accounting Standards Update No. 2011-11 “Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities” (“ASU 2011-11”), which requires disclosures of gross and net information about financial and derivative instruments eligible for offset in the statement of financial position or subject to a master netting agreement. ASU 2011-11 will be effective for the Company in the first fiscal quarter of 2013 and is not expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In July 2012, the FASB issued new guidance which gives companies the option to perform a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired, and in some cases, bypass the two-step impairment test. This guidance is effective for annual and interim indefinite-lived intangible asset impairment tests performed for fiscal years beginning after September 15, 2012. Early adoption of the new guidance is permitted. The Company is currently assessing when it will adopt this guidance.

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Adjusted EBITDA to Net Income Reconciliation

Adjusted EBITDA is defined as net income before income tax expense, interest income, interest expense, depreciation and amortization (“EBITDA”), without giving effect to non-cash goodwill and intangible asset impairment charges, gains or losses on store closings and impairment of store assets, gains or losses related to the early extinguishment of debt, financial sponsor fees and expenses, non-cash charges related to stock-based awards and other items that are excluded by management in reviewing the results of operations. We have presented Adjusted EBITDA because we believe that the exclusion of these items is appropriate to provide additional information to investors about our ongoing operating performance excluding certain non-cash and other items and to provide additional information with respect to our ability to comply with various covenants in documents governing our indebtedness and as a means to evaluate our period-to-period results. In evaluating Adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments in this presentation. Our presentation of Adjusted EBITDA should not be construed to imply that our future results will be unaffected by any such adjustments. We have provided this information to analysts, investors and other third parties to enable them to perform more meaningful comparisons of past, present and future operating results and as a means to evaluate the results of our ongoing operations. Management also uses Adjusted EBITDA to determine executive incentive compensation payment levels. In addition, our compliance with certain covenants under our 2007 Senior Credit Facility are calculated based on similar measures, which differ from Adjusted EBITDA primarily by the inclusion of pro forma results for acquired businesses in those similar measures. Other companies in our industry may calculate Adjusted EBITDA differently than we do. Adjusted EBITDA is not a measure of performance under U.S. GAAP and should not be considered as a substitute for net income prepared in accordance with U.S. GAAP. Adjusted EBITDA has significant limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under U.S. GAAP. Some of the limitations to the use of Adjusted EBITDA are:

·                  Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual commitments;

·                  Adjusted EBITDA does not reflect interest expense or the cash requirements necessary to service interest or principal payments on our debt;

·                  Adjusted EBITDA does not reflect tax expense or the cash requirements necessary to pay for tax obligations;

·                  Although depreciation and amortization are non-cash charges, the asset being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;

·                  Adjusted EBITDA does not reflect the cash requirements of closing underperforming stores;

·                  Adjusted EBITDA does not reflect costs related to management services that were historically provided by J.W. Childs Associates, L.P.; and

·                  Adjusted EBITDA does not reflect certain other costs that may recur in future periods.

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We compensate for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only as a supplemental measure. The following table contains a reconciliation of our net income determined in accordance with U.S. GAAP to EBITDA and Adjusted EBITDA for the periods indicated (amounts in thousands):