UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

Commission file number 333-117081-27

 

 

SEALY MATTRESS CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware		20-1178482
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
Sealy Drive One Office Parkway Trinity, North Carolina		27370
(Address of principal executive offices)*		(Zip Code)
(336) 861-3500
Registrant’s telephone number, including area code

 

 

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

 

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

 

The number of shares of the registrant’s common stock outstanding as of September 30, 2004 was 1,000.

 

 

PART I.   FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

SEALY MATTRESS CORPORATION

 

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)

 

		Quarter Ended August 29, 2004			Quarter Ended August 31, 2003
Net sales—Non-affiliates		$	357,263		$	318,326
Net sales—Affiliates (Note 15)		—			6,615
Total net sales		357,263			324,941
Costs and expenses:
Cost of goods sold—Non-affiliates		193,945			185,170
Cost of goods sold—Affiliates (Note 15)		—			3,797
Total cost of goods sold		193,945			188,967
Gross profit		163,318			135,974
Selling, general and administrative		119,885			105,617
Recapitalization expense (Notes 1, 2, 13)		394			—
Stock based compensation (Note 3)		—			492
Amortization of intangibles		297			287
Royalty income, net		(3,875		)	(3,064		)
Income from operations		46,617			32,642
Interest expense (Notes 2, 9)		17,324			17,662
Other (income) expense, net (Note 8)		(102		)	(246		)
Income before income tax expense		29,395			15,226
Income tax expense (Note 2)		9,003			6,529
Net income		$	20,392		$	8,697

 

See accompanying notes to condensed consolidated financial statements.

 

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SEALY MATTRESS CORPORATION

 

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)

 

		Nine Months Ended August 29, 2004			Nine Months Ended August 31, 2003
Net sales—Non-affiliates		$	984,985		$	857,348
Net sales—Affiliates (Note 15)		7,030			25,680
Total net sales		992,015			883,028
Costs and expenses:
Cost of goods sold—Non-affiliates		553,448			501,191
Cost of goods sold—Affiliates (Note 15)		4,035			15,081
Total cost of goods sold		557,483			516,272
Gross profit		434,532			366,756
Selling, general and administrative		327,258			290,990
Recapitalization expense (Notes 1, 2, 13)		133,134			—
Stock based compensation (Note 3)		—			1,482
Amortization of intangibles		887			820
Royalty income, net		(10,578		)	(8,625		)
(Loss) income from operations		(16,169		)	82,089
Interest expense (Notes 2, 9)		51,182			51,614
Other (income) expense, net (Note 8)		(844		)	1,255
(Loss) income before income tax expense		(66,507		)	29,220
Income tax expense (benefit) (Note 2)		(16,002		)	12,448
Net (loss) income		$	(50,505	)	$	16,772

 

See accompanying notes to condensed consolidated financial statements.

 

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SEALY MATTRESS CORPORATION

 

Condensed Consolidated Balance Sheets

(In thousands)

(Unaudited)

 

		August 29, 2004			November 30, 2003*
ASSETS
Current assets:
Cash and cash equivalents		$	18,662		$	101,100
Accounts receivable—Non-affiliates, net		196,728			160,984
Accounts receivable—Affiliates, net (Note 15)		—			1,758
Inventories (Note 4)		50,227			49,413
Prepaid expenses, deferred taxes and other current assets (Notes 2, 11)		59,160			43,404
		324,777			356,659
Property, plant and equipment, at cost		309,919			299,718
Less: accumulated depreciation		141,313			128,893
		168,606			170,825
Other assets:
Goodwill (Note 7)		381,713			381,891
Other intangibles, net (Note 7)		4,602			5,364
Long-term notes receivable (Note 15)		—			13,323
Debt issuance costs, net, and other assets (Notes 2, 11)		46,667			31,004
		432,982			431,582
		$	926,365		$	959,066
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Current portion of long-term obligations (Note 9)		$	8,203		$	47,623
Accounts payable		95,384			85,478
Accrued interest (Note 11)		17,145			23,565
Accrued incentives and advertising		41,744			35,546
Accrued compensation		32,330			27,583
Other accrued expenses (Notes 5, 6, 11)		53,439			44,839
		248,245			264,634
Due to Parent Company (Note 17)		3,475			—
Long-term obligations, net		1,025,786			699,630
Other noncurrent liabilities (Note 11)		37,610			48,851
Deferred income taxes		16,851			22,113
Stockholders’ equity (deficit) (Note 13):
Common stock		—			324
Additional paid-in capital		454,421			146,240
Accumulated deficit		(853,681		)	(201,497		)
Accumulated other comprehensive loss		(6,342		)	(8,165		)
Common stock held in treasury, at cost		—			(13,064		)
		(405,602		)	(76,162		)
		$	926,365		$	959,066

 

*                      Condensed from audited financial statements.

 

See accompanying notes to condensed consolidated financial statements.

 

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SEALY MATTRESS CORPORATION

 

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

		Nine Months Ended August 29, 2004			Nine Months Ended August 31, 2003
Net cash provided by (used in) operating activities		$	(19,425	)	$	29,314
Cash flows from investing activities:
Purchase of property, plant and equipment, net		(18,706		)	(9,337		)
Cash received from affiliate note and investment		13,573			13,611
Proceeds from the sale of property, plant and equipment		1,499			—
Net cash provided by (used in) investing activities		(3,634		)	4,274
Cash flows from financing activities:
Cash flows associated with financing of the recapitalization (Note 2):
Proceeds from issuance of common stock		436,050			—
Treasury stock repurchase		(748,141		)	—
Proceeds from the issuance of new long-term debt		1,050,000			—
Repayment of existing long-term debt		(737,128		)	—
Debt issuance costs		(36,403		)	—
Proceeds from the issuance of notes to refinance Tranche debt		—			51,500
Prepayment of refinanced Tranche debt		—			(49,000		)
Debt issuance costs or other deferred finance charges		(500		)	(3,860		)
Borrowings (repayments) of other long-term obligations, net		(23,320		)	(14,756		)
Equity contributions from exercise of stock options		63			88
Net cash used in financing activities		(59,379		)	(16,028		)
Change in cash and cash equivalents		(82,438		)	17,560
Cash and cash equivalents:
Beginning of period		101,100			27,443
End of period		$	18,662		$	45,003
Supplemental disclosures:
Selected non-cash items:
Depreciation and amortization		$	18,309		$	16,718
Non-cash compensation		—			1,482
Write-off of deferred debt costs and dedesignated cash flow hedge associated with the early extinguishment of debt		—			2,531
Non-cash expense associated with the recapitalization (Note 2)		41,342			—
Cash used for recapitalization expenses included in cash flows from operating activities		(90,664		)	—
Non-cash interest expense associated with:
Junior Subordinated Notes		—			4,196
Debt issuance costs		4,216			4,275
Discount (premium) on Senior Subordinated Notes, net		(227		)	188
Net interest (income) expense associated with interest rate swap and cap agreements		(432		)	(549		)

 

See accompanying notes to condensed consolidated financial statements

 

5

 

SEALY MATTRESS CORPORATION

Notes to Condensed Consolidated Financial Statements

 

Note 1:   Basis of Presentation

 

The condensed consolidated financial statements are unaudited, and certain information and footnote disclosures related thereto normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with Rule 10-01 of Regulation S-X.  In the opinion of management, the accompanying unaudited consolidated financial statements were prepared following the same policies and procedures used in the preparation of the audited financial statements and reflect all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position of Sealy Mattress Corporation and its subsidiaries (“the Company”).  The results of operations for the interim periods are not necessarily indicative of the results for the entire fiscal year.  These condensed consolidated financial statements should be read in conjunction with the Annual Report of Sealy Corporation on Form 10-K for the year ended November 30, 2003.

 

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

 

On April 6, 2004, Sealy Corporation, owner of 100% of the Company’s common stock, completed a merger with affiliates of Kohlberg Kravis Roberts & Co. L.P. (“KKR”) whereby KKR acquired 92% of Sealy Corporation’s capital stock.  Certain of Sealy Corporation’s previous stockholders, including affiliates of Bain Capital, LLC and others, retained an 8% interest in Sealy Corporation’s stock.  The merger was accounted for as a recapitalization.  See Note 2 for further details on the recapitalization.  Subsequent to the recapitalization, the Company received as contributed capital all of Sealy Corporation’s 100% interest in Sealy Mattress Company.  The Company also replaced Sealy Corporation as the parent-guarantor of the 8.25% Senior Subordinated Notes due 2014 issued by Sealy Mattress Company.  Accordingly, the Company is now the reporting guarantor-parent company and as a result of being an entity under common control has reflected the operation of Sealy Corporation prior to April 6, 2004 in a manner similar to a pooling-of-interests.  Additionally, all assets, liabilities, and stockholders’ deficit of Sealy Corporation existing upon the completion of the recapitalization as of April 6, 2004 has been pushed down to and included with those of the Company as of August 29, 2004.  Therefore, all reported amounts as of and for the three and nine months ended August 29, 2004 are comparable in all material respects to those for the prior periods presented herein except as to common stock and additional paid-in capital, which reflect the respective outstanding shares of the Company and Sealy Corporation.  Subsequent to the recapitalization, none of the activity of Sealy Corporation will be included in the consolidated financial statements of the Company and its subsidiaries (see Note 17).

 

Note 2:   Merger and Recapitalization

 

On April 6, 2004, Sealy Corporation completed a merger with affiliates of KKR whereby KKR acquired approximately 92% of Sealy Corporation’s capital stock.  Certain of Sealy Corporation’s current stockholders, including affiliates of Bain Capital, LLC and others (the “Rollover Stockholders”), retained approximately an 8% interest in Sealy Corporation’s stock.  In connection with the merger, Sealy Corporation recapitalized substantially all of its outstanding debt.  The following table summarizes the estimated sources and uses of cash in connection with the recapitalization as if all amounts were funded as of the date of the recapitalization:

 

 

Sources:					Uses:
		(in millions)					(in millions)
Available cash		$	128.8		Purchase outstanding equity		$	740.5
Settlement of MFI Note		13.6			Repayment of existing debt and accrued interest		751.1
Senior secured term loan facility		560.0			Redemption of existing stock options		21.0
Senior unsecured term loan		100.0			Fees, expenses and other transaction costs		115.9
Senior subordinated notes		390.0
Equity contribution		436.1
Total sources		$	1,628.5		Total uses		$	1,628.5

 

Sealy Corporation’s capital stock outstanding immediately prior to the merger, except with respect to those shares to be retained by the Rollover Stockholders, was cancelled and exchanged for aggregate cash consideration of approximately $740.5 million.  Sealy

 

6

 

Corporation issued new Class A Common Stock to KKR and the Rollover Stockholders retained their Class A Common Stock in proportion to their respective ownership interests.  All outstanding amounts under the existing Senior Credit Agreement were repaid.  On April 6, 2004, the Company closed tender offers with respect to the outstanding $300 million aggregate principal amount of the 9.875% Senior Subordinated Notes and the outstanding $128 million aggregate principal amount of 10.875% Senior Subordinated Discount Notes for cash in amounts equal to 103.542% and 103.875% of the principal amounts, respectively.  Approximately 91% and 99% of the 9.875% Senior Subordinated Notes and 10.875% Senior Subordinated Discount Notes were tendered, respectively, and the remaining amount was called and paid by the Company on May 6, 2004 for approximately $31.2 million including approximately $1.1 million of accrued interest and prepayment premiums of approximately $1.0 million. The Company also repaid the $50 million outstanding balance of its existing 10% Junior Subordinated Notes.

 

The Company entered into new senior credit facilities consisting of a $125 million senior secured revolving credit facility with a six-year maturity and a $560 million senior secured term loan facility with an eight-year maturity.  Annual maturities will be 1% of the original principal amount for the first seven years, with the balance of the facility to be repaid at final maturity.  Subsequent to the Recapitalization, the Company has prepaid all annual maturities due prior to the final maturity. The Company will also be required to prepay the term loans to the extent of 50% of excess cash flow (as defined in the credit agreement).  The senior credit facilities bear interest at a floating rate. The Company also borrowed $100 million under a senior unsecured term loan.  This loan will be due in nine years and bears interest at a floating rate.  There are required prepayment provisions in the event of a change in control or to the extent of certain excess proceeds from any asset sales.  The Company also issued $390 million aggregate principal amount of new Senior Subordinated Notes due 2014.  The notes bear interest at 8.25% payable semi-annually on June 15 and December 15.  The Company incurred approximately $36.4 million of costs associated with establishing the new senior credit facilities and the senior unsecured term loan and the issuance of the new Senior Subordinated Notes.  Such costs are included in the above total amount for estimated fees, expenses and other costs and will be amortized as interest expense over the term of the respective debt.

 

All stock options to purchase the Sealy Corporation’s common stock outstanding immediately prior to the merger, whether or not vested, other than certain options held by members of management that those members elected to rollover (the “Rollover Options”) were cancelled and converted into a right to receive cash consideration upon the completion of the merger.  Accordingly, the Company paid approximately $21.0 million to settle the options which were not rolled over, resulting in a charge to expense during the quarter ended May 30, 2004.  The Rollover Options, which had intrinsic value of approximately $24.6 million upon the completion of the merger, now have an expiration date which was extended beyond that of the previously existing options, resulting in a new measurement date. Consequently, a non-cash charge to expense of $24.6 million was recorded during the quarter ended May 30, 2004.

 

The Company incurred approximately $78.2 million of other cash costs primarily associated with debt breakage costs, merger advisory fees, management retention bonuses and other costs, of which $70.6 million was charged to expense, with the remaining $7.6 million of direct costs related to the repurchase of shares charged against paid-in capital.  The Company also incurred non-cash charges of approximately $11.8 million primarily related to the write-off of previous debt issuance costs, and various other non-cash charges of approximately $5.1 million related to the recapitalization.  Included in the amounts disclosed above are losses associated with the extinguishment of the previously-existing debt totalling $32.2 million.

 

Certain of the charges included in recapitalization expense are not deductible for Federal income tax purposes, resulting in an adverse impact on the Company’s effective tax rate for the three and nine months ended August 29, 2004.  Included in prepaid expenses, deferred taxes and other current assets is approximately $16 million of recoverable income taxes primarily as a result of the recapitalization.

 

Note 3:   Stock Option and Restricted Stock Plans

 

Certain employees of the Company have been granted options to purchase the common stock of the Company’s 100% owner, Sealy Corporation.  Such options are accounted for by the Company and reported herein as if granted by the Company.  As permitted by FAS 123, “Accounting for Stock-Based Compensation”, the Company continues to account for its stock option and stock incentive plans in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and makes no charges (except to the extent required by APB Opinion No. 25) against earnings with respect to options granted. FAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure an Amendment of FASB Statement No. 123” does however require interim disclosure of pro forma information regarding net income and earnings per share determined as if the Company had accounted for its stock options under the fair value method.

 

For purposes of this pro forma disclosure, the estimated fair value of the options is amortized as an expense over the options’ vesting period.  The Company recognized compensation expense under APB Opinion No. 25 totaling $45.6 million for the nine months ended August 29, 2004 in connection with the recapitalization, such expense being included with recapitalization expense in the accompanying condensed consolidated statements of operations (see Note 2). The Company recognized no compensation expense

 

7

 

associated with stock options for the three and nine months ended August 31, 2003 as all options were granted at or above the fair market value of the stock at the date of grant.

 

		Three months ended							Nine months ended
		August 29, 2004			August 31, 2003				August 29, 2004			August 31, 2003
		(In thousands)
Net income (loss), as reported		$	20,392		$	8,697			$	(50,505	)	$	16,772
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax		395			112				(854		)	402
Pro forma net income (loss)		$	19,997		$		8,585		$	(49,651	)	$	16,370

 

For the three and nine months ended August 31, 2003 the Company recognized stock-based compensation expense of $0.5 million and $1.5 million, respectively, to revalue an obligation to repurchase common stock from a former officer of the Company.  This obligation was retired in connection with the recapitalization.

 

Note 4:   Inventories

 

The major components of inventories were as follows:

 

 

Note 5:   Warranty Costs

 

The Company’s warranty policy provides a 10-year non-prorated warranty service period on all currently manufactured Sealy Posturepedic, Stearns & Foster and Bassett bedding products and some other Sealy-branded products. The Company’s policy is to accrue the estimated cost of warranty coverage at the time the sale is recorded. The change in the company’s accrued warranty obligations from November 30, 2003 to August 29, 2004 was as follows:

 

 

Note 6:   Plant Closure

 

On May 1, 2004, the Company closed its manufacturing facility at Randolph, Massachusetts.  Accordingly, the Company incurred restructuring charges of approximately $0.6 million included in selling, general and administrative expenses during the nine months ended August 29, 2004, primarily associated with severance and retention costs. The Company also incurred additional period costs during the year as the business was primarily shifted to the new Albany facility.

 

8

 

Note 7:   Goodwill and Other Intangible Assets

 

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

 

The changes in the carrying amount of goodwill for the nine months ended August 29, 2004 are as follows (in thousands):

 

 

Total other intangibles of $4.6 million (net of accumulated amortization of $15.1 million) as of August 29, 2004 primarily consist of acquired licenses, which are amortized on the straight-line method over periods ranging from 5 to 15 years.

 

Note 8:   Other (Income) Expense, Net

 

Other (income) expense, net includes interest income of $0.1 million and $0.8 million for the three and nine months ended August 29, 2004 and $0.2 million and $1.3 million for the three and nine months ended August 31, 2003, respectively.

 

Other (income) expense, net in the three and nine months ended August 31, 2003 also includes a $2.0 million write-off of previously deferred derivative losses recorded in accumulated other comprehensive loss and $0.5 million of deferred debt costs associated with the early extinguishment of debt in May 2003.

 

Note 9:   Long-Term Obligations

 

Long-term debt as of August 29, 2004 and November 30, 2003 consisted of the following:

 

 

Subsequent to the quarter ended August 29, 2004, the Company made additional prepayments of $20 million and $25 million on September 8, 2004 and October 7, 2004, respectively, partially funded by net borrowings of approximately $10.5 million under the revolving credit facility.

 

 

See Note 2 for additional information regarding new debt issued in association with the recapitalization.

 

Note 10:    Recently Issued Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46-R”, as revised December 2003 with respect to effective dates).  The primary objectives of FIN 46-R are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (“variable interest entities” or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE (the “primary beneficiary”). This new model for consolidation applies to an entity which either (1) the equity investors (if any) do not have

 

9

 

a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46-R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46-R is effective for the Company’s second quarter of 2004 with transitional disclosure required with these financial statements. The Company adopted these provisions in its second quarter, however the Company does not believe it is a primary beneficiary of a VIE or holds any significant interests or involvement in a VIE, therefore adoption of FIN 46-R did not have an impact on the Company’s consolidated financial statements.

 

In December 2003, The FASB issued FAS 132 (Revised), “Employers’ Disclosure about Pensions and Other Postretirement Benefits.” A revision of the pronouncement originally issued in 1998, FAS 132R expands employers’ disclosure requirements for pension and postretirement benefits to enhance information about plan assets, obligations, benefit payments, contributions, and net benefit cost. FAS 132R does not change the accounting requirements for pensions and other postretirement benefits. This statement is effective for fiscal years ending after December 15, 2003, with interim-period disclosure requirements effective for interim periods beginning after December 15, 2003. Accordingly, the Company has implemented FAS 132R beginning with its second fiscal quarter of 2004. The adoption of this statement did not have an impact on the Company’s financial position or results of operations.

 

Note 11:   Hedging Strategies

 

In 2000, the Company entered into an interest rate swap agreement that effectively converted $236 million of its floating-rate debt to a fixed-rate basis through December 2006, thereby hedging against the impact of interest rate changes on future interest expense (forecasted cash flows). Use of hedging contracts allows the Company to reduce its overall exposure to interest rate changes, since gains and losses on these contracts will offset losses and gains on the transactions being hedged. The Company formally documents all hedged transactions and hedging instruments, and assesses, both at inception of the contract and on an ongoing basis, whether the hedging instruments are effective in offsetting changes in cash flows of the hedged transaction. The fair values of the interest rate agreements are estimated by obtaining quotes from brokers and are the estimated amounts that the Company would receive or pay to terminate the agreements at the reporting date, taking into consideration current interest rates and the current creditworthiness of the counterparties. Effective June 3, 2002, the Company dedesignated the interest rate swap agreement for hedge accounting. As a result of the dedesignation, $12.9 million previously recorded in accumulated other comprehensive loss as of the date of dedesignation was being amortized into interest expense. During the quarter ended May 30, 2004, the remaining $4.7 million previously recorded in accumulated other comprehensive loss was charged to recapitalization expense (see Note 2). Prior to the recapitalization, $0.9 million was amortized into interest expense. For the three and nine months ended August 31, 2003, $0.6 million and $2.7 million, was amortized into interest expense, respectively. Prior to June 3, 2002, the changes in the fair market value of the interest rate swap were recorded in accumulated other comprehensive income (loss). Subsequent to June 3, 2002, changes in the fair market value of the interest rate swap are recorded in interest expense. For the three and nine months ended August 29, 2004, $1.0 million and $1.4 million, and for the three and nine months ended August 31, 2003, $(3.0) million and $4.5 million, respectively, was recorded as net interest expense as a result of the cash requirements of the swap net of the non-cash interest associated with the change in its fair market value.  At August 29, 2004 and November 30, 2003, the fair value carrying amount of this instrument was $(8.8) million and $(14.9) million, respectively, which is recorded as follows:

 

 

During the second quarter of 2002, the Company entered into another interest rate swap agreement that has the effect of reestablishing as floating rate debt the $236 million of debt previously converted to fixed rate debt through December 2006. This interest rate swap agreement has not been designated for hedge accounting and, accordingly, any changes in the fair value are recorded in interest expense. For the three and nine months ended August 29, 2004, $0.9 million and $1.3 million, and for the three and nine months ended August 31, 2003, $(2.9) million and $4.3 million, respectively, was recorded as a reduction of net interest expense as a result of the cash interest received on the swap net of the non-cash interest associated with the change in its fair market value. At August 29, 2004 and November 30, 2003, the fair value carrying amount of this instrument was $3.7 million and $6.8 million, respectively, with $3.5 million and $5.1 million recorded in prepaid expenses and other current assets, and $0.2 million and $1.7 million recorded in noncurrent assets.

 

10

 

The Company also entered into an interest rate cap agreement during the second quarter of 2002 with a notional amount of $175.0 million that capped the LIBOR rate on which certain of its previous floating-rate debt was based at 8% through June 2005. This agreement has not been designated for hedge accounting and, accordingly, any changes in the fair value are recorded in interest expense. The fair value of this instrument is not material.

 

In June 2004, the Company entered into an additional swap agreement that has the effect of converting $200 million of the floating-rate debt under the Company’s new senior credit facilities to a fixed-rate basis, declining to $150 million through November 2007.  The Company has formally designated this swap agreement as a cash flow hedge and expects the hedge to be highly effective in offsetting fluctuations in the designated interest payments resulting from changes in the benchmark interest rate.  Accordingly, the effective portion of changes in the market value of the swap will be recorded in other comprehensive income (loss). As of August 29, 2004, $0.7 million was recorded in interest expense.  At August 29, 2004, the fair value carrying amount of the instrument was $3.5 million which is recorded as follows:

 

 

At August 29, 2004 and November 30, 2003, accumulated other comprehensive income (loss) associated with the interest rate swaps was ($1.7) million and $(5.6) million, respectively.

 

To protect against the reduction in value of forecasted foreign currency cash flows resulting from purchases in a foreign currency, the Company has instituted a forecasted cash flow hedging program. The Company hedges portions of its purchases denominated in foreign currencies with forward and option contracts. At August 29, 2004, the Company had forward contracts to sell a total of 6.0 million Mexican pesos with expiration dates ranging from September 24, 2004 through November 24, 2004, and forward contracts to sell a total of 39.5 million Canadian dollars with expiration dates ranging from September 7, 2004 through November 15, 2005.  At August 29, 2004, the fair value of the Company’s net obligation under the forward contracts was $0.3 million.

 

In the accompanying statements of cash flows, the cash flows from hedging activities are included in the same categories as the hedged items.  Cash flows from operating activities include increases in cash balances due to foreign exchange rate fluctuations.  The effect of such foreign exchange rate fluctuations for the nine months ended August 29, 2004 was not material. For the nine months ended August 31, 2003 the effect of such foreign exchange rate fluctuations was $0.2 million.

 

Note 12:   Defined Benefit Pension Expense

 

The components of net periodic pension cost recognized for the Company’s defined benefit pension plan for the three and nine months ended August 29, 2004 and August 31, 2003 are as follows (in thousands):

 

		Three months ended						Nine months ended
		August 29, 2004			August 31, 2003			August 29, 2004			August 31, 2003
Service cost		$	118		$	19		$	355		$	102
Interest cost		179			28			538			148
Expected return on plan assets		(136		)	(21		)	(408		)	(108		)
Amortization of unrecognized losses		56			11			294			55
Amortization of unrecognized transition asset		(22		)	(4		)	(66		)	(21		)
Amortization of unrecognized prior service cost		40			6			121			31
Net periodic pension cost*		$	235		$	39		$	834		$	207
Cash contributions		$	1,381		$	128		$	1,845		$	257

 

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* Net periodic pension costs recognized for the three and nine months ending August 29, 2004 are based upon preliminary estimates pending the final actuarial determination of such costs for fiscal 2004.  Similarly, net periodic pension costs for the three and nine months ended August 31, 2003 were based upon preliminary estimates.

 

The Company expects to make additional cash contributions to the plan of approximately $0.3 million during the remainder of 2004 and $1.0 million in fiscal 2005.

 

Note 13:   Stockholders’ Deficit

 

Total comprehensive income (loss) for the three and nine months ended August 29, 2004 was $19.8 million and $(48.7) million and for the three and nine months ended August 31, 2003 was $4.9 million and $30.4 million, respectively.

 

Activity in Stockholders’ equity (deficit) is as follows (dollar amounts in thousands):

 

		Comprehensive Income			Common Stock			Additional Paid-in Capital			Accumulated Deficit			Treasury Stock			Accumulated Other Comprehensive Loss			Total
Balance at November 30, 2003					$	324		$	146,240		$	(201,497	)	$	(13,064	)	$	(8,165	)	$	(76,162	)
Net loss for the nine months ended August 29, 2004		$	(50,505	)	—			—			(50,505		)	—			—			(50,505		)
Exercise of stock options		—			2			570			—			—			—			572
Purchase of treasury stock		—			—			—			—			(508		)	—			(508		)
Change in fair value of cash flow hedge		(1,691		)	—			—			—			—			(1,691		)	(1,691		)
Amortization of dedesignated cash flow hedge, net of tax		595			—			—			—			—			595			595
Foreign currency translation adjustment		176			—			—			—			—			176			176
Effects of recapitalization:
Stock compensation related to rollover of options		—			—			24,570			—			—			—			24,570
Treasury stock repurchase, including direct costs		—			(302		)	(153,033		)	(608,378		)	13,572			—			(748,141		)
Issuance of common stock		—			250			435,800									—			436,050
Write-off of dedesignated cash flow hedge, net of tax		2,743			—			—			—			—			2,743			2,743
Change in aggregate par value of common stock due to change in reporting entity (Note 1)		—			(274		)	274			—			—			—			—
Cancellation of former officer’s equity put option		—			—			—			6,699			—			—			6,699
Balance at August 29, 2004		$	(48,682	)	$	—		$	454,421		$	(853,681	)	$	—		$	(6,342	)	$	(405,602	)

 

Sealy Mattress Corporation common stock consists of 1,000 shares $0.01 par value stock, all of which is owned by Sealy Corporation.

 

Note 14:   Contingencies

 

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

 

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The Company is currently conducting an environmental cleanup at a formerly owned facility in South Brunswick, New Jersey pursuant to the New Jersey Industrial Site Recovery Act. The Company and one of its subsidiaries are parties to an Administrative Consent Order issued by the New Jersey Department of Environmental Protection. Pursuant to that order, the Company and its subsidiary agreed to conduct soil and groundwater remediation at the property. The Company does not believe that its manufacturing processes were the source of contamination. The Company sold the property in 1997. The Company and its subsidiary retained primary responsibility for the required remediation. The Company has completed essentially all soil remediation with the New Jersey Department of Environmental Protection approval, and has concluded a pilot test of the groundwater remediation system. The Company has received approval from the New Jersey Department of Environmental Protection to implement a remediation plan for the sediment in Oakeys Brook adjoining the site.  The Company expects to begin that remediation effort shortly.

 

The Company is also remediating soil and groundwater contamination at an inactive facility located in Oakville, Connecticut. Although the Company is conducting the remediation voluntarily, it obtained Connecticut Department of Environmental Protection approval of the remediation plan. The Company has completed essentially all soil remediation under the remediation plan and is currently monitoring groundwater at the site. The Company believes the contamination is attributable to the manufacturing operations of previous unaffiliated occupants of the facility.

 

The Company removed three underground storage tanks previously used for diesel, gasoline, and waste oil from its South Gate, California facility in March 1994 and remediated the soil in the area. Since August 1998, the Company has been working with the California Regional Water Quality Control Board, Los Angeles Region to monitor ground water at the site.

 

While the Company cannot predict the ultimate timing or costs of the South Brunswick, Oakville, and South Gate environmental matters, based on facts currently known, the Company believes that the accruals recorded are adequate and does not believe the resolution of these matters will have a material adverse effect on the financial position or future operations of the Company; however, in the event of an adverse decision, these matters could have a material adverse effect. The state of California adopted new flame retardant regulations related to manufactured mattresses and box springs which will be effective January 1, 2005. The Company expects to be in full compliance with those regulations by the effective date. The Company does not expect the impact of those regulations to be significant to the Company’s results of operations or financial position.

 

In 2000, Montgomery Ward, a customer of Sealy, declared bankruptcy and filed for protection under Chapter 7 of the U.S. Bankruptcy Code. In 2003, the bankruptcy trustee filed a claim of $3.7 million associated with certain alleged preferential payments by Montgomery Ward to Sealy. Currently, the case is in the discovery phase and the Company believes it has significant defenses against such claims. While the Company cannot predict the ultimate outcome, the Company believes it has adequate accruals recorded with respect to this claim and does not believe the resolution of these matters will have a material adverse effect on the financial position or future operations of the Company.

 

Note 15:   Related Party Transactions

 

The Company previously contributed cash and other assets to Mattress Holdings International LLC (“MHI”), a company which was controlled by the Company’s previous largest stockholder, Bain Capital, LLC (“Bain”), in exchange for a non-voting interest. MHI was formed to invest in domestic and international loans, advances and investments in joint ventures, licensees and retailers. The equity ownership of MHI was transferred from Bain to the Company in November 2002. In 1999, MHI indirectly through a Bain controlled holding company acquired a minority interest in Mattress Holdings Corporation (“MHC”). MHC owns an interest in Mattress Discounters Corporation (“Mattress Discounters”), a domestic mattress retailer. In addition, MHC sold all of its equity interest in an international retailer on April 15, 2003. This international retailer had been an affiliate of the Company since MHC’s acquisition in 2000.

 

In October 2002, Mattress Discounters filed a voluntary joint petition with the U.S. Bankruptcy Court for the District of Maryland for reorganization under Chapter 11 of the U.S. Bankruptcy Code and was operating as a debtor in possession under the Bankruptcy Code. Effective March 14, 2003, Mattress Discounters emerged from bankruptcy. At the time Mattress Discounters filed for bankruptcy protection, the Company had recorded in its financial statements a $12.5 million participation in Mattress Discounters’ banking facility and $16.0 million in trade receivables. The Company had fully-reserved the trade receivables. As part of the approved bankruptcy settlement, the Company received a non-controlling minority interest in Mattress Discounters and a $12.9 million secured note, guaranteed by MHC. Other entities affiliated with Bain also received a minority interest in Mattress Discounters. Since emerging from bankruptcy, Mattress Discounters has generally been paying within stated terms. Concurrent with the previously mentioned sale of the international bedding retailer by MHC, Sealy consummated the sale to MHC of the $12.9 million note and the equity interest that the Company received in the Mattress Discounters bankruptcy, as well as MHI’s equity interest in MHC for $13.6 million. As a result of these transactions, the Company no longer has any direct interest in Mattress Discounters other than trade receivables in the

 

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normal course of business.   In addition, as a result of the recapitalization discussed in Note 2, after April 6, 2004 Mattress Discounters has ceased to be considered an affiliate of the Company.

 

As previously mentioned, MHC sold its interest in an international bedding retailer on April 15, 2003. Consequently, this retailer is no longer an affiliate of Sealy and sales to this retailer after this date have been included in sales to non-affiliates in the statement of operations.

 

The following table provides affiliate sales for the three and nine months ended August 29, 2004 and August 31, 2003:

 

 

(1) Through April 6, 2004

 

The Company believes that the terms on which mattresses were supplied to these affiliates were not materially more or less favorable than those that might reasonably be obtained in a comparable transaction on an arm’s length basis from a person that is not an affiliate or related party.

 

Included in fees, expenses and other transaction costs as shown in Note 2 are approximately $31.8 million of merger and acquisition advisory fees paid to KKR and Bain Capital, LLC.  During the three months ended August 29, 2004, the Company paid management fees of $0.2 million to KKR.  Also during the quarter ended August 29, 2004, the Company incurred $1.1 million for consulting services provided by Capstone Consulting LLC, the chief executive officer of which is on the Company’s board of directors.  During the nine months ended August 31, 2003, the Company paid $1.5 million to Bain Capital, LLC for management fees.

 

Note 16:   Segment Information

 

The Company operates predominately in one industry segment, that being the manufacture and marketing of conventional bedding.

 

Note 17:   Parent Company Financing

 

On July 16, 2004, Sealy Corporation, the 100% owner of the Company, issued $75.0 million aggregate principal amount of senior subordinated pay-in-kind (PIK) notes (the “PIK Notes”) and $37.5 million of Sealy Corporation common stock to certain institutional investors in transactions exempt from registration under the Securities Act of 1933.  This transaction was executed and recorded by Sealy Corporation and, accordingly, is not reflected in the financial statements of the Company.

 

The PIK Notes accrue interest in-kind at 10% per year, compounded semi-annually. Sealy Corporation is not required to pay accrued interest on the PIK Notes in cash until maturity. The PIK Notes mature on July 15, 2015, following the maturities of substantially all other existing indebtedness of the Company and its wholly owned subsidiaries, including its $535 million outstanding senior secured term loan, $125 million senior secured revolving credit facility, $100 million senior unsecured term loan and $390 million senior subordinated notes. At maturity, the outstanding principal amount of the PIK Notes, along with any accrued and unpaid interest, will be paid in cash by Sealy Corporation.

 

Sealy Corporation may redeem the PIK Notes at its option at any time, in whole or in part, at an initial price of 105% of the principal amount thereof plus all accrued interest not previously paid in cash, which price declines to 102.5% after the first anniversary of issue, 101% after the second anniversary of issue and 100% after the third anniversary of issue. At any time prior to the third anniversary of issue, Sealy Corporation may also use the proceeds of an equity offering to redeem any or all of the PIK Notes at its option at a price of 101% of the principal amount thereof plus all accrued interest not previously paid in cash. In addition, upon a change of control Sealy Corporation and the repayment of the Company’s senior secured credit facility, holders of the PIK Notes will be able to require Sealy Corporation to repurchase the PIK Notes at a price of 101% of the principal amount thereof plus all accrued

 

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interest not previously paid in cash. The terms of the PIK Notes include covenants and events of default similar to those contained in the outstanding notes and exchange notes.

 

The $112.5 million in gross proceeds from the transactions was returned to existing investors in Sealy Corporation by a combination of cash distributions to shareholders and option holders as well as share repurchases of Sealy Corporation common stock.  In connection with the distribution to option holders, the Company recorded an expense of approximately $4.0 million in the fiscal third quarter of 2004 since the holders of the Sealy Corporation options are employees of the Company.  This charge, net of approximately $0.5 million of deferred financing costs related to the issuance of the PIK Notes which were paid on behalf of Sealy Corporation by a subsidiary of Sealy Mattress Corporation, has resulted in an approximately $3.5 million liability owed by the Company to Sealy Corporation at August 29, 2004.  This obligation does not bear interest and has no scheduled repayment terms.  Management anticipates that the balance will be gradually reduced over time as the Company pays for various expenses of Sealy Corporation in the ordinary course of business.

 

Note 18:   Guarantor/Non-Guarantor Financial Information

 

The Parent (as defined below) and each of the subsidiaries of Sealy Mattress Company (the “Issuer”) that guarantee the Notes (as defined below) (the “Guarantor Subsidiaries”) has fully and unconditionally guaranteed, on a joint and several basis, the obligation to pay principal and interest with respect to the 8.25% Senior Subordinated Notes due 2014 (the “Notes”) of the Issuer. Substantially all of the Issuer’s operating income and cash flow is generated by its subsidiaries. As a result, funds necessary to meet the Issuer’s debt service obligations are provided in part by distributions or advances from its subsidiaries. Under certain circumstances, contractual and legal restrictions, as well as the financial condition and operating requirements of the Issuer’s subsidiaries, could limit the Issuer’s ability to obtain cash from its subsidiaries for the purpose of meeting its debt service obligations, including the payment of principal and interest on the Notes. Although holders of the Notes will be direct creditors of the Issuer’s principal direct subsidiaries by virtue of the guarantees, the Issuer has subsidiaries (“Non-Guarantor Subsidiaries”) that are not included among the Guarantor Subsidiaries, and such subsidiaries will not be obligated with respect to the Notes. As a result, the claims of creditors of the Non-Guarantor Subsidiaries will effectively have priority with respect to the assets and earnings of such companies over the claims of creditors of the Issuer, including the holders of the Notes.

 

The following supplemental consolidating condensed financial statements present:

 

1.                    Consolidating condensed balance sheets as of August 29, 2004 and November 30, 2003 and consolidating condensed statements of operations for the three and nine months ended August 29, 2004 and August 31, 2003 and the consolidating condensed statements of operations and cash flows for the nine months ended August 29, 2004 and August 31, 2003.

 

2                       Sealy Corporation, for periods prior to April 6, 2004, and Sealy Mattress Corporation, as Successor to Sealy Corporation from April 6, 2004 (see Note 1) (each, for the respective period, the “Parent” and a “guarantor”), Sealy Mattress Company (the “Issuer”), combined Guarantor Subsidiaries and combined Non-Guarantor Subsidiaries with their investments in subsidiaries accounted for using the equity method (see Note 1).

 

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

 

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

 

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SEALY MATTRESS CORPORATION

 

Supplemental Consolidating Condensed Balance Sheet

August 29, 2004

(in thousands)

 

		Sealy Mattress Corporation			Sealy Mattress Company			Combined Guarantor Subsidiaries			Combined Non-Guarantor Subsidiaries			Eliminations			Consolidated
ASSETS
Current assets:
Cash and cash equivalents		$	—		$	2		$	7,553		$	11,107		$	—		$	18,662
Accounts receivable—Non-affiliates, net		—			68			134,387			62,273			—			196,728
Inventories		—			1,119			33,298			15,810			—			50,227
Prepaid expenses, deferred taxes and other current assets		—			4,925			49,318			4,917			—			59,160
		—			6,114			224,556			94,107			—			324,777
Property, plant and equipment, at cost		—			6,668			240,067			63,184			—			309,919
Less: accumulated depreciation		—			3,526			121,337			16,450			—			141,313
		—			3,142			118,730			46,734			—			168,606
Other assets:
Goodwill		—			24,741			304,773			52,199			—			381,713
Other intangibles, net		—			—			4,198			404			—			4,602
Net investment in and advances to (from) subsidiaries and affiliates		(401,666		)	902,258			(279,882		)	(73,013		)	(147,697		)	—
Debt issuance costs, net and other assets		—			34,892			9,306			2,469			—			46,667
		(401,666		)	961,891			38,395			(17,941		)	(147,697		)	432,982
Total assets		$	(401,666	)	$	971,147		$	381,681		$	122,900		$	(147,697	)	$	926,365
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Current portion of long-term obligations		$	—		$	—		$	—		$	8,203		$	—		$	8,203
Accounts payable		—			195			58,752			36,437			—			95,384
Accrued interest		—			784			16,326			35			—			17,145
Accrued incentives and advertising		—			1,450			35,554			4,740			—			41,744
Accrued compensation		—			125			26,199			6,006			—			32,330
Other accrued expenses		24			8,384			38,988			6,043			—			53,439
		24			10,938			175,819			61,464			—			248,245
Due to Parent Company		3,975			(500		)	—			—			—			3,475
Long-term obligations, net		—			1,025,000			44			742			—			1,025,786
Other noncurrent liabilities		—			2,949			28,177			6,484			—			37,610
Deferred income taxes		(63		)	(2,329		)	14,984			4,259			—			16,851
Stockholders’ equity (deficit)		(405,602		)	(64,911		)	162,657			49,951			(147,697		)	(405,602		)
Total liabilities and stockholders’ equity (deficit)		$	(401,666	)	$	971,147		$	381,681		$	122,900		$	(147,697	)	$	926,365

 

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