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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended October 30, 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 December 6, 2012, 33,768,771 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;

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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 October 30, 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, impairments, 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 Acquisitions

On May 2, 2012, the Company completed the acquisition of all of the equity interests in MGHC Holding Corporation (“Mattress Giant”) for approximately $43.9 million. 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 operated Mattress Firm stores at the time of the acquisition. 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.

On September 25, 2012, the Company acquired the leasehold interests, store assets, distribution center assets and related inventories, and assumed certain liabilities, of Mattress XPress, Inc. and Mattress XPress of Georgia, Inc. (collectively, “Mattress X-Press”) relating to the operation of 34 mattress specialty stores located in Florida and Georgia for a total purchase price of approximately $13.2 million, subject to customary post-closing purchase price adjustments. Mattress Xpress provided unsecured financing to the Company in the amount of approximately $7.8 million in connection with the purchase, which is payable over a term of one year in quarterly installments, including interest at 8%. Permanent rebranding, including renovations and the addition of permanent signage is expected to be complete by the end of Fiscal 2012.

The acquisitions increased the Company’s store locations and market share in markets in which the Company previously operated, which generally is expected to result in greater expense synergies and leverage over market-level costs, such as advertising and warehousing. The acquisitions resulted in $58.1 million of goodwill, of which $38.4 million will not be deductible for income tax purposes.

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

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 derived from the Mattress Giant and Mattress X-Press acquisitions from the respective acquisition dates to October 30, 2012 was $71.5 million and $1.6 million, respectively.

The following table presents the selected consolidated financial information of the Company on a pro forma basis, assuming that the Mattress Giant acquisition 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 $2.4 million of acquisition-related costs for the thirteen and thirty-nine weeks ended October 30, 2012, respectively, related to the acquisitions discussed above.

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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.

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

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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 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 using a 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 thirty-nine weeks ended November 1, 2011 or October 30, 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 $20.0 million of income tax expense for the thirty-nine weeks ended October 30, 2012, compared to $0.9 million of income tax expense for the thirty-nine weeks ended November 1, 2011. The effective tax rate was 38.2% for the thirty-nine weeks ended October 30, 2012, compared to 4.9% for the thirty-nine weeks ended November 1, 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 thirty-nine weeks of 2011. The effective tax rate of 38.2% for the current period differs from the federal statutory rate of 35.0% primarily due to state income taxes.

The Company files income tax returns in U.S. federal and state jurisdictions. As of October 30, 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 October 30, 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 October 30, 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 directed primarily at customers who reside in the metropolitan markets in which company-operated stores are located. The Company’s chief operating decision maker

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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.

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 thirty-nine weeks ended October 30, 2012 excludes stock options for the purchase of 303,008 shares of common stock as the applicable vesting criteria were not satisfied as of October 30, 2012. Diluted net income per common share for both the thirteen and

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thirty-nine weeks ended October 30, 2012 excludes stock options for the purchase of 105,148 shares of common stock as their inclusion would be anti-dilutive.

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.

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 thirty-nine weeks ended November 1, 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 $0.3 million for the thirteen and thirty-nine weeks ended November 1, 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 indebtedness under the loan facility between Mattress Intermediate Holdings, Inc., the Company’s direct subsidiary, and a group of lenders maturing in January 2015 (the “2009 Loan Facility”), 12% payment-in-kind investor notes maturing at various times from October 24, 2012 through March 15, 2015 (“PIK Notes”) and 12% convertible notes due July 18, 2016 (“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 $6.5 million and $19.4 million for the thirteen and thirty-nine weeks ended November 1, 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.

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

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fiscal years beginning after September 15, 2012; however, early adoption of the new guidance is permitted. The Company adopted this guidance effective August 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.

11. Subsequent Events

Effective November 5, 2012, Mattress Holding Corp., an indirect subsidiary of the Company, entered into an amendment and restatement of the 2007 Senior Credit Facility. The amendment, among other things, (a) increased the revolving loan commitment from $35 million to $100 million, (b) extended the maturity date of the revolving loan by two years to January 2015, (c) extended the maturity date of outstanding term loans having an aggregate principal amount of $200 million by two years to January 2016, (d) increased the interest rate applicable to amounts outstanding under the extended term loans and revolving loans by 1.25%, (e) increased the amount of permitted capital expenditures to $80 million on an annual basis, beginning with capital expenditures incurred during Fiscal 2012, and (f) increased the maximum cumulative amount that Mattress Holding Corp. and its subsidiary guarantors may spend through the extended maturity date.  The Company incurred fees in connection with the restatement and amendment of approximately $1.5 million.

On November 9, 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 Factory Mattress & Water Bed Outlet of Charlotte, Inc. (“Mattress Source”) relating to the operation of 28 mattress specialty stores located in North Carolina and South Carolina for a total purchase price of approximately $11.2 million, subject to customary adjustments. The closing of the purchase is expected to occur in the fourth 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 thirty-nine weeks ended October 30, 2012 improved $93.8 million and $233.7 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 thirty-nine weeks ended October 30, 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 thirty-nine weeks ended October 30, 2012 include:

·                  Net income increased $0.2 million to $12.5 million for the thirteen weeks ended October 30, 2012, compared with net income of $12.3 million for the prior year period. Net income increased $15.3 million to $32.3 million for the thirty-nine weeks ended October 30, 2012, compared with $17.0 million for the prior year period.

·                  Net sales increased $93.8 million, or 51.1%, to $277.3 million for the thirteen weeks ended October 30, 2012, compared to $183.5 million for the prior year period. Comparable-store sales increased 6.6% during the thirteen weeks ended October 30, 2012. Net sales increased $233.7 million, or 45.4%, to $749.1 million for the thirty-nine weeks ended October 30, 2012 compared to $515.4 million for the prior year period. Comparable-store sales increased 8.8% during the thirty-nine weeks ended October 30, 2012.

·                  Income from operations for the thirteen weeks ended October 30, 2012 was $23.0 million. Excluding $5.0 million of acquisition-related and secondary offering costs, adjusted income from operations was $28.0 million, and adjusted operating margin during the thirteen weeks decreased 160 basis points from 11.7% in 2011 to 10.1% in 2012. This operating margin decrease for the thirteen weeks ended October 30, 2012 on an adjusted basis (excluding acquisition-related and secondary offering costs) is comprised of a 10 basis-point decline in gross profit margin and a 40 basis-point improvement in general and administrative expense leverage, offset by a 180 basis-point decrease in sales and marketing expense leverage and 10 basis-points of operating margin deleveraging in other categories. Income from operations for the thirty-nine weeks ended October 30, 2012 was $58.6 million. Excluding $12.0 million of acquisition-related and secondary offering costs, adjusted income from operations was $70.6 million, and adjusted operating margin during the thirty-nine weeks improved 60 basis points from 8.8% in 2011 to 9.4% in 2012. This operating margin growth for the thirty-nine weeks ended October 30, 2012 on an adjusted basis (excluding acquisition-related and secondary offering costs) is comprised of a 80 basis-point improvement in gross profit margin and a 70 basis-point improvement in general and administrative expense leverage, offset by a 80 basis-point decrease in sales and marketing expense and 10 basis-points of operating margin deleveraging in other categories. 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 and Mattress Xpress acquisitions. See “Reported to Adjusted Statements of Operations Data” below for a reconciliation of net income as reported to adjusted net income.

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·                  Adjusted EBITDA increased $7.8 million to $35.1 million for the thirteen weeks ended October 30, 2012, compared with $27.3 million for the prior year period. Adjusted EBITDA as a percentage of sales decreased to 12.6% during the thirteen weeks ended October 30, 2012, compared with 14.9% for the prior year period. Adjusted EBITDA increased $28.1 million to $90.1 million for the thirty-nine weeks ended October 30, 2012 compared with $61.9 million for the prior year period. Adjusted EBITDA as a percentage of sales decreased remained flat at 12.0% during the thirty-nine weeks ended October 30, 2012, compared with 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 $36.4 million and $66.5 million during the thirteen weeks and thirty-nine weeks ended October 30, 2012, respectively, which, in addition to existing cash reserves, 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 $43.9 million. 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).

On September 25, 2012, we acquired the leasehold interests, store assets, distribution center assets and related inventories, and assumed certain liabilities, of Mattress XPress, Inc. and Mattress XPress of Georgia, Inc. (collectively, “Mattress X-Press”) for approximately $13.2 million, subject to customary post-closing purchase price adjustments. Mattress X-Press provided unsecured financing to the Company in the amount of approximately $7.8 million in connection with the purchase, which is payable over a term of one year in quarterly installments, including interest at 8%.

The acquisitions are 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 intend to rebrand approximately 20 additional stores to Mattress Firm during the first quarter of fiscal 2013 that were acquired in December 2010 and are currently operated under the name Mattress Discounters. A noncash impairment charge will be recorded in the fiscal fourth quarter of $2.1 million, before income tax benefit, related to the Mattress Discounters intangible trade name asset.

·                  We ended the thirty-nine weeks ended October 30, 2012 with no outstanding borrowings, and total borrowing capacity of $34.0 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. Effective November 5, 2012, we increased our revolver capacity under the 2007 Senior Credit Facility by $65 million to $100 million and extended the maturity date of the revolver by two years to January 2015.

·                  Effective November 5, 2012, we entered into an amendment and restatement of the 2007 Senior Credit Facility. The amendment, among other things, (a) increased the revolving loan commitment from $35 million to $100 million, (b) extended the maturity date of the revolving loan by two years to January 2015, (c) extended the maturity date of outstanding term loans having an aggregate principal amount of $200 million by two years to January 2016, (d) increased the interest rate applicable to amounts outstanding under the extended term loans and revolving loans by 1.25%, (e) increased the amount of permitted capital expenditures to $80 million on an annual basis, beginning with capital expenditures incurred during Fiscal 2012, and (f) increased the maximum cumulative amount that Mattress Holding Corp. and its subsidiary guarantors may spend through the extended maturity date.  The Company incurred fees in connection with the restatement and amendment of approximately $1.5 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.

Comparable-store sales includes new stores beginning in the thirteenth full month of operation. Acquired stores are included in the comparable-store sales calculation beginning in the first month following the one-year anniversary date of the acquisition. The comparable-store sales calculation includes sales related to our e-commerce and other comparable sales channels. New stores that are relocated within a two mile radius of a closed store are included in the comparable-store sales calculation beginning with the first full month of operations by measuring the growth in revenue against the prior year sales of the closed store. Stores that are closed, other than relocated stores, are removed from the comparable-store sales calculation in the month of closing. Comparable-store sales during fiscal years that are comprised of 53 weeks exclude sales for the fifty-third week of the year.

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.

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Sales and marketing expenses consist of the following:

·                  Advertising and media production;

·                  Payroll and benefits for sales associates; and

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

General and administrative expenses consist of the following:

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

·                  Stock-based compensation costs;

·                  Occupancy costs of corporate facility;

·                  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.

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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.

Due to rounding totals may not equal the sum of the line items in the table above.

Thirteen Weeks Ended October 30, 2012 Compared to Thirteen Weeks Ended November 1, 2011

Net sales. Net sales increased $93.8 million, or 51.1%, to $277.3 million for the thirteen weeks ended October 30, 2012, compared to $183.5 million for the thirteen weeks ended November 1, 2011. The components of the net sales increase were as follows (amounts in millions):

The increase in comparable-store net sales represents a 6.6% 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 129 new stores opened at various times during the twelve fiscal periods ended October 30, 2012, including 31 stores opened during the thirteen-week period ended October 30, 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, 181 stores in May 2012 and 34 stores in September 2012. We closed 28 stores during the twelve fiscal periods ended October 30, 2012, including 11 stores during the thirteen-week period ended October 30, 2012, and the reduction in sales during the thirteen-week period ended October 30, 2012 from these closings totaled $2.0 million. We operated 1,011 stores at October 30, 2012, compared with 640 stores at November 1, 2011.

Cost of sales. Cost of sales increased $57.1 million, or 51.8%, to $167.2 million during the thirteen weeks ended October 30, 2012, compared to $110.1 million for the thirteen weeks ended November 1, 2011. The major components of the increase in cost of

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sales are discussed below. Cost of sales as a percentage of net sales increased to 60.3% for the thirteen weeks ended October 30, 2012, as compared to 60.0% for the thirteen weeks ended November 1, 2011.

Product costs increased by $33.2 million, or 46.9%, to $104.0 million for the thirteen weeks ended October 30, 2012, compared with $70.8 million for the thirteen weeks ended November 1, 2011. Product costs as a percentage of sales decreased to 37.5% for the thirteen weeks ended October 30, 2012 from 38.6% for the thirteen weeks ended November 1, 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 October 30, 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 $13.6 million, or 59.8%, to $36.2 million during the thirteen weeks ended October 30, 2012, compared to $22.6 million for the thirteen weeks ended November 1, 2011. Store and warehouse occupancy costs as a percentage of net sales increased to 13.1% during the thirteen weeks ended October 30, 2012, compared to 12.3% in the thirteen weeks ended November 1, 2011. The increase in the amount of expense during the thirteen weeks ended October 30, 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 October 30, 2012 was primarily attributable to the acquisition of Mattress Giant stores in November 2011 and May 2012 and Mattress X-Press stores in September 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 $1.9 million, or 51.1%, to $5.7 million, for the thirteen weeks ended October 30, 2012, compared to $3.8 million for the thirteen weeks ended November 1, 2011. The increase in expense was primarily attributable to the increase in the number of stores we operated during the thirteen weeks ended October 30, 2012, as compared with the prior year period.

Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $8.4 million, or 65.4%, to $21.3 million, for the thirteen weeks ended October 30, 2012, compared to $12.9 million for the thirteen weeks ended November 1, 2011, primarily as a result of the increase in net sales and in the number of stores we operated during the thirteen weeks ended October 30, 2012, as compared with the prior year period. Other cost of sales includes $0.5 million of acquisition-related costs related to Mattress Giant and Mattress X-Press.

Gross profit from retail operations. As a result of the foregoing, gross profit from retail operations increased $36.7 million, or 50.0%, to $110.1 million, during the thirteen weeks ended October 30, 2012, compared with $73.4 million during the thirteen weeks ended November 1, 2011. Gross profit from retail operations as a percentage of net sales decreased to 39.7% for the thirteen weeks ended October 30, 2012, compared to 40.0% for the thirteen weeks ended November 1, 2011.

Franchise fees and royalty income. Franchise fees and royalty income increased $0.2 million, or 12.7%, to $1.5 million for the thirteen weeks ended October 30, 2012, compared to $1.3 million during the thirteen weeks ended November 1, 2011. The increase in income was attributable to a $0.3 million increase in royalty income, which was mainly due to increases in sales for franchise stores as compared with the prior year period due to new stores and comparable-store sales increases, which was partially offset by a $0.1 million decrease in initial fees. Our franchisees operated 160 stores at October 30, 2012.

Sales and marketing expenses. Sales and marketing expenses increased $26.1 million, or 62.9%, to $67.5 million for the thirteen weeks ended October 30, 2012, compared to $41.4 million for the thirteen weeks ended November 1, 2011. Sales and marketing expense as a percentage of net sales increased to 24.3% for the thirteen weeks ended October 30, 2012, compared to 22.6% for the thirteen weeks ended November 1, 2011. The components of sales and marketing expenses are explained below.

Advertising expense increased $9.3 million, or 67.0%, to $23.0 million for the thirteen weeks ended October 30, 2012, from $13.7 million for the thirteen weeks ended November 1, 2011. Advertising expense as a percentage of net sales increased to 8.3% for the thirteen weeks ended October 30, 2012, compared to 7.5% for the thirteen weeks ended November 1, 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 $2.1 million for the thirteen weeks ended October 30, 2012, compared with $1.4 million for the thirteen weeks ended November 1, 2011.

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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 $16.8 million, or 60.8%, to $44.5 million for the thirteen weeks ended October 30, 2012, compared to $27.7 million for the thirteen weeks ended November 1, 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 16.1% for the thirteen weeks ended October 30, 2012, compared to 15.1% for the thirteen weeks ended November 1, 2011. The increase reflects higher staffing levels that have occurred in connection with the recent acquisitions and lower productivity of the recent large number of new sales associates.

General and administrative expenses. General and administrative expenses increased $9.2 million, or 79.4%, to $20.9 million for the thirteen weeks ended October 30, 2012, compared to $11.7 million for the thirteen weeks ended November 1, 2011. General and administrative expenses as a percentage of net sales, increased to 7.5% for the thirteen weeks ended October 30, 2012, compared to 6.3% for the thirteen weeks ended November 1, 2011. General and administrative expenses increased primarily as a result of our growth, including a $4.8 million increase in wages and benefits resulting from employee additions to our corporate office, $2.5 million of acquisition-related costs related to the Mattress Giant and Mattress X-Press acquisitions and $1.9 million of costs borne by the Company in connection with a secondary offering of shares of common stock by certain of the Company’s stockholders, which was completed in October 2012. 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 $6.4 million, or 75.4%, to $2.1 million for the thirteen weeks ended October 30, 2012, compared to $8.5 million during the thirteen weeks ended November 1, 2011, primarily as a result of the repayment of related-party debt in conjunction with the initial public offering in November 2011.

Income tax (benefit) expense. We recognized $8.5 million of income tax expense for the thirteen weeks ended October 30, 2012, compared to $0.6 million of income tax expense for the thirteen weeks ended November 1, 2011. The effective tax rate was 40.5% for the thirteen weeks ended October 30, 2012, compared to 4.3% for the thirteen weeks ended November 1, 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 November 1, 2011.

Net income (loss). As a result of the foregoing, our net income was $12.5 million for the thirteen weeks ended October 30, 2012 compared to $12.3 million for the thirteen weeks ended November 1, 2011.

Thirty-Nine Weeks Ended October 30, 2012 Compared to Thirty-Nine Weeks Ended November 1, 2011

Net sales. Net sales increased $233.7 million, or 45.4%, to $749.1 million for the thirty-nine weeks ended October 30, 2012, compared to $515.4 million for the thirty-nine weeks ended November 1, 2011. The components of the net sales increase were as follows (amounts in millions):

The increase in comparable-store net sales represents a 8.8% 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 129 new stores opened at various times during the twelve fiscal periods ended October 30, 2012, including 88 stores opened during the thirty-nine-week period ended October 30, 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, 181 stores in May 2012 and 34 stores in September 2012. We closed

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28 stores during the twelve fiscal periods ended October 30, 2012, including 21 stores during the thirty-nine-week period ended October 30, 2012, and the reduction in sales during the thirty-nine-week period ended October 30, 2012 from these closings totaled $6.2 million. We operated 1,011 stores at October 30, 2012, compared with 640 stores at November 1, 2011.

Cost of sales. Cost of sales increased $139.0 million, or 44.1%, to $454.3 million during the thirty-nine weeks ended October 30, 2012, compared to $315.3 million for the thirty-nine weeks ended November 1, 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 60.7% for the thirty-nine weeks ended October 30, 2012, as compared to 61.2% for the thirty-nine weeks ended November 1, 2011.

Product costs increased by $82.8 million, or 41.3%, to $283.5 million for the thirty-nine weeks ended October 30, 2012, compared with $200.7 million for the thirty-nine weeks ended November 1, 2011. Product costs as a percentage of sales decreased to 37.8% for the thirty-nine weeks ended October 30, 2012 from 38.9% for the thirty-nine weeks ended November 1, 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 thirty-nine weeks ended October 30, 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 $31.2 million, or 46.2%, to $98.6 million during the thirty-nine weeks ended October 30, 2012, compared to $67.4 million for the thirty-nine weeks ended November 1, 2011. Store and warehouse occupancy costs as a percentage of net sales increased to 13.2% during the thirty-nine weeks ended October 30, 2012, compared to 13.1% in the thirty-nine weeks ended November 1, 2011. The increase in the amount of expense during the thirty-nine weeks ended October 30, 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 thirty-nine weeks ended October 30, 2012 was primarily attributable to the acquisition of Mattress Giant stores in November 2011 and May 2012 and Mattress X-Press stores in September 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 $3.4 million, or 28.9%, to $15.0 million, for the thirty-nine weeks ended October 30, 2012, compared to $11.6 million for the thirty-nine weeks ended November 1, 2011. The increase in expense was primarily attributable to the increase in the number of stores we operated during the thirty-nine weeks ended October 30, 2012, as compared with the prior year period.

Other cost of sales, consisting of store and warehouse operating and delivery costs, increased $21.6 million, or 60.8%, to $57.2 million, for the thirty-nine weeks ended October 30, 2012, compared to $35.6 million for the thirty-nine weeks ended November 1, 2011, primarily as a result of the increase in net sales and in the number of stores we operated during the thirty-nine weeks ended October 30, 2012, as compared with the prior year period. Other cost of sales includes $1.9 million of acquisition-related costs related to Mattress Giant and Mattress X-Press.

Gross profit from retail operations. As a result of the foregoing, gross profit from retail operations increased $94.8 million, or 47.4%, to $294.8 million, during the thirty-nine weeks ended October 30, 2012, compared with $200.0 million during the thirty-nine weeks ended November 1, 2011. Gross profit from retail operations as a percentage of net sales, increased to 39.4% for the thirty-nine weeks ended October 30, 2012, compared to 38.8% for the thirty-nine weeks ended November 1, 2011.

Franchise fees and royalty income. Franchise fees and royalty income increased $0.6 million, or 18.5%, to $4.0 million for the thirty-nine weeks ended October 30, 2012, compared to $3.4 million during the thirty-nine weeks ended November 1, 2011. The increase in income was attributable to a $0.9 million increase in royalty income, which was mainly due to increases in sales for franchise stores as compared with the prior year period due to new stores and comparable-store sales increases, which was partially offset by a $0.3 million decrease in initial fees, resulting from a decrease in the number of new franchisee stores opened during the thirty-nine weeks ended October 30, 2012 as compared with the prior year period. Our franchisees operated 160 stores at October 30, 2012.

Sales and marketing expenses. Sales and marketing expenses increased $61.0 million, or 50.0%, to $183.1 million for the thirty-nine weeks ended October 30, 2012, compared to $122.1 million for the thirty-nine weeks ended November 1, 2011. Sales and marketing expense as a percentage of net sales increased to 24.5% for the thirty-nine weeks ended October 30, 2012, compared to 23.7% for the thirty-nine weeks ended November 1, 2011. The components of sales and marketing expenses are explained below.

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Advertising expense increased $21.5 million, or 48.3%, to $65.9 million for the thirty-nine weeks ended October 30, 2012, from $44.4 million for the thirty-nine weeks ended November 1, 2011. Advertising expense as a percentage of net sales increased to 8.8% for the thirty-nine weeks ended October 30, 2012, compared to 8.6% for the thirty-nine weeks ended November 1, 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 $4.5 million for the thirty-nine weeks ended October 30, 2012, compared with $2.9 million for the thirty-nine weeks ended November 1, 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 $39.5 million, or 50.9%, to $117.2 million for the thirty-nine weeks ended October 30, 2012, compared to $77.7 million for the thirty-nine weeks ended November 1, 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 15.7% for the thirty-nine weeks ended October 30, 2012, compared to 15.1% for the thirty-nine weeks ended November 1, 2011. The increase reflects higher staffing levels that have occurred in connection with the recent acquisitions and lower productivity of the recent large number of new sales associates.

General and administrative expenses. General and administrative expenses increased $21.0 million, or 58.7%, to $56.7 million for the thirty-nine weeks ended October 30, 2012, compared to $35.7 million for the thirty-nine weeks ended November 1, 2011. General and administrative expenses as a percentage of net sales, increased to 7.6% for the thirty-nine weeks ended October 30, 2012, compared to 6.9% for the thirty-nine weeks ended November 1, 2011. General and administrative expenses increased primarily as a result of our growth, including a $9.5 million increase in wages and benefits resulting from employee additions to our corporate office, $8.2 million of acquisition-related costs related to the Mattress Giant and Mattress X-Press acquisitions, $1.9 million of costs borne by the Company in connection with a secondary offering of shares of common stock by certain of the Company’s stockholders, which was completed in October 2012, and an aggregate increase of $1.4 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 $20.9 million, or 76.7%, to $6.4 million for the thirty-nine weeks ended October 30, 2012, compared to $27.3 million during the thirty-nine weeks ended November 1, 2011, primarily as a result of the repayment of related-party debt in conjunction with the initial public offering in November 2011. The thirty-nine weeks ended November 1, 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 $20.0 million of income tax expense for the thirty-nine weeks ended October 30, 2012, compared to $0.9 million of income tax expense for the thirty-nine weeks ended November 1, 2011. The effective tax rate was 38.2% for the thirty-nine weeks ended October 30, 2012, compared to 4.9% for the thirty-nine weeks ended November 1, 2011, and differs primarily due to the fact that we had a full valuation allowance recorded against our deferred tax assets during the thirty-nine weeks ended November 1, 2011.

Our estimated full year effective tax rate for fiscal 2012, before discrete period adjustments, is approximately 38.9%, 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 $32.3 million for the thirty-nine weeks ended October 30, 2012 compared to $17.0 million for the thirty-nine weeks ended November 1, 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.

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Liquidity and Capital Resources

As of October 30, 2012, we had cash and cash equivalents of $10.9 million compared with $27.5 million as of November 1, 2011. The following table summarizes our cash flows (amounts in thousands):