Somnigroup International Inc. Q3 FY2020 Earnings Call

Good day ladies and gentlemen and thank you for standing by. Welcome to the Tempur Sealy Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the opening remarks, there will be a question-and-answer session. At this time I would like to turn the conference over to Ms. Aubrey Moore, thank you. Ma'am please begin.

Thank you, operator. Good morning, everyone and thank you for participating in today's call. Joining me in our Lexington headquarters are Scott Thompson, Chairman, President and CEO; and Bhaskar Rao, Executive Vice President and Chief Financial Officer. After prepared remarks, we will open the call for Q&A. Forward-looking statements that we make during this call are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that these forward-looking statements, including the company's expectations regarding sales, earnings, net income and adjusted EBITDA and anticipated performance of 2020 and subsequent periods involve uncertainties. Actual results may differ due to a variety of factors that could adversely affect the company's business. The factors that could cause actual results to differ materially from those identified include economic, regulatory, competitive, operating and other factors discussed in the press release issued today. These factors are also discussed in the company's SEC filings, including, but not limited to, annual reports on Form 10-K and the company's quarterly reports on Form 10-Q under the heading Special Notes Regarding the Forward-Looking Statements and/or Risk Factors. Any forward-looking statement speaks only as on the day on which it was made. The company undertakes no obligation to update any forward-looking statements. This morning's commentary will include non-GAAP financial information. The press release contains reconciliations of this non-GAAP financial information to the most directly comparable GAAP information except as otherwise discussed in the press release as well as information regarding the methodology used in our constant currency presentations. We have posted the press release on the company's investor website at investor.tempursealy.com and have also filed it with the SEC. Our comments will supplement the detailed information provided in the press release. And now with that introduction, it is my pleasure to turn the call over to Scott.

Thank you, Aubrey. Good morning and thank you for joining us on our 2020 third quarter earnings call. Our thoughts continue to be with those around the world whose lives have been impacted by the global health crisis. I'm proud of the team's success in providing employees and customers a safe environment while dealing with and mitigating an array of complex issues caused by the global health crisis. I'll begin the call with an overview of the quarter with some highlights. Then Bhaskar will review our record quarterly financial performance in more detail. Finally, I'll conclude with our thoughts on long-term capital allocation. The quarter was very strong. In the third quarter global net sales grew a record 38% year-over-year despite the material impact of supply chain constraints on our operations. Our results reflect a continuation of solid broad-based industry trends and our worldwide leadership position. The third quarter sales growth of 38% exceeded our internal target primarily driven by an overperformance of Tempur-Pedic in the U.S. and a quicker than anticipated recovery in our international operations. Sales would have been higher in the quarter if not for the continued supply chain constraints impacting Sealy and Sherwood in North America. Today the industry and specifically Tempur Sealy are squarely in the middle of people rethinking their priorities in life. One impact of COVID-19 has been people's increased focus on their health and wellness and simultaneously spending a great amount of time at home. We believe this focus on health, wellness and quality of life is going to remain a priority for consumers in the future and that our products will continue to resonate for those seeking quality sleep as part of their overall wellness plan. COVID-19 has caused so many disruptions and noise in our day-to-day lives, but at times it's hard to see some shifts in the market. Let me take a step back. The domestic bedding industry is in the healthiest position I've seen. It is now structured for sustained profitable growth. The days of uneconomical retail store expansion are behind us. The number of retail doors has been rationalized, improving average sales and profit per store. The days of significant unfair dumping of overseas product into the market are also behind us. We expect new anti-dumping actions to reduce the number of imports coming in from overseas and benefit domestic manufacturers. The days of new startups focused on uneconomical web-only strategies have been mitigated and their strategies have moved toward profitability. At the same time legacy retailers and manufacturers have become skilled in producing profitable internet sales. These dynamics, in addition to worldwide consumers focused on the category, provide an attractive backdrop for our business. It's important to remember that we entered the year in the strongest competitive position in our history, having made significant investments in our brands, products, people and manufacturing operations. As a result we reported record sales and earnings in the fourth quarter of 2019 and the first quarter of 2020, the two quarters prior to the pandemic. Although we're benefiting from the current market trends, the lion's share of our performance is from our market position, investments and our long-term strategies. As we all know, consumers' buying habits and expectations are evolving. For a brand to be relevant today, consumers expect that the brand will have an integrated omnichannel presence. One of our long-term initiatives is to optimize our powerful omni distribution platform and give consumers whatever channel they want to shop. Our execution on this initiative has positioned us well to meet their expectations. We believe our dedicated network of third-party retailers is key to our distribution footprint and will continue to be an area of growth going forward. At the same time we've been focused on building our own direct-to-consumer channel. Tempur-Pedic was the original direct-to-consumer bedding company and today we continue to experience success both online and with high-end brick-and-mortar retail stores. The trend toward online purchase has accelerated during the pandemic and we believe that consumers will continue to live in and shop through digital channels. Our direct channel web sales grew over 100% in the quarter while driving higher EBITDA margin in an already very profitable distribution channel. Our robust sales trends include over 200% growth on our compressed bedding offering, which compares favorably with others in the industry. We've also built out and elevated our brand throughout the entire market. We've opened six new stores in the third quarter and expect to have over 75 stores by the end of 2020. Our most recent opening was our Manhattan flagship, our 71st location which is located in the Bloomberg building. Turning to the third quarter profitability. Adjusted EBITDA was a record $279 million, almost double that of the prior year, making this quarter the most profitable quarter in the company's history. We realized outstanding free cash flow generation resulting in a record low leverage ratio of 1.9 times adjusted EBITDA. The company has grown trailing 12-month adjusted EBITDA for seven quarters in a row and achieved trailing 12-month adjusted EBITDA of $694 million this quarter, a 47% increase over the prior year. This performance triggered our long-term aspirational incentive compensation plan, which applies to approximately 150 of the company’s leaders. The aspirational plan was put in place five years ago to motivate the company's leaders to drive the business toward meaningful growth during a challenging period in the industry. With that I'll turn over to Bhaskar to walk you through the financial results in more detail.

Thank you, Scott. Before going into the detail, I would like to highlight a few items as compared to the prior year. Adjusted gross margin improved 300 basis points to 46.9%. Adjusted operating margin improved 540 basis points to 20.1%. Adjusted EBITDA increased 86% to $279 million which is a record high for any one quarter in the company's history and adjusted earnings per share more than doubled to $2.94. The increase in adjusted EBITDA was primarily due to higher sales volume and fixed cost leverage. These benefits were somewhat offset by plant inefficiencies due to the supply chain issues previously mentioned and various virus-related items. As a reminder, our business is flexible and our cost structure is highly variable as evidenced by our ability to quickly reduce cost in order to maintain profitability in the second quarter when we were uncertain of the outlook. Our confidence sequentially improved and in the third quarter we brought back virtually all of our expenses that we had previously cut. Those costs we're incurring now reflect forward-looking confidence we have about the business as we make the investments necessary to grow over the long-term. Commodities were slightly higher than expected for the third quarter as prices had increased off their record lows over the past year. We now expect to experience headwinds going forward. To offset these commodity headwinds, we recently announced a price increase across all of our U.S. brands including Sealy, Stearns & Foster and Tempur-Pedic. We expect this price increase to fully offset the commodity cost inflation we're now anticipating in 2021. Turning to North America. Net sales increased 43% in the third quarter. On a reported basis the wholesale channel increased 44% driven by broad-based demand across existing and new distribution. The direct channel increased 35% driven by strong web sales partially offset by muted performance at our company-owned stores, some of which were closed for time during the third quarter. In addition virtually all of our stores operated below capacity due to reduced hours to comply with local government directives and landlord requirements. The 43% growth in North America is exceptional given that Sealy and Sherwood supplier issues restrained sales growth. The primary driver of the supply chain bottleneck is a spring shortage, primarily an encased inner-spring component. We expect the supply constraints on these products to continue for the next few quarters. This quarter we estimate that there were over $100 million in customer orders that were either cancelled or reduced due to allocation. Our orders received outpaced our component supply which resulted in our U.S. order bank at the end of the third quarter being significantly higher than the end of the second quarter. In fact, we entered the fourth quarter with our largest order bank in the company's history. North American adjusted gross profit margin improved 290 basis points to 45% as compared to the prior year. The improvement was principally driven by fixed cost leverage and productivity on higher unit volumes, brand mix and commodities. North American adjusted operating margin was 23.9%, an improvement of 630 basis points as compared to the prior year. This improvement was primarily driven by operating expense leverage and improvement in gross margin. Turning to international. Net sales increased 12% on a reported basis and on a constant currency basis international net sales increased 10%. We were very pleased with our international performance during the third quarter as it ended the period above our expectations. We remain mindful that certain international markets are now experiencing new restrictions related to COVID that are expected to cause some headwinds in the fourth quarter. As compared to the prior year, our international gross margin improved 570 basis points to 58.8%. The improvement was primarily driven due to favorable mix, fixed cost leverage and productivity on higher unit volumes and lower commodity cost. International adjusted operating margin was 29%, an improvement of 940 basis points as compared to the prior year. This improvement was primarily driven by improved gross margin and operating expense leverage. This includes the cost actions we took last quarter. We have one international transaction to report this quarter and although relatively small, it is very important to our long-term plans for Sealy internationally. We acquired Sealy distribution rights and assets to manufacture, market and distribute Sealy and Stearns & Foster branded products in the United Kingdom. We entered into a 50:50 joint venture with the objective of developing, repositioning and significantly expanding the sale of Sealy products in one of the largest bedding markets in Europe. We expect that joint venture will report a small operating loss for a year or two, but I expect we will look back a year from now and be thrilled with the results. Now moving onto the balance sheet and cash flow items. We generated a record third quarter operating cash flow of $328 million. To put that into context, our operating cash flow for this quarter was greater than any cash flow in any previous full year. With strong cash flow from operations and liquidity above our target as part of our capital structure and liquidity management process, we decided to redeem $200 million of the $450 million 2023 senior notes. The transaction is expected to be complete in the fourth quarter and will result in annual interest savings of approximately $5 million. We continue to monitor the overall bond market and its understanding of our improved financial strength as we consider future refinancing activities. At the end of the third quarter consolidated debt less cash was $1.3 billion. As Scott pointed out our leverage ratio under our large credit facility is 1.9 times, down significantly from 3.2 times at the end of the third quarter of 2019 and slightly below our target range of 2 to 3 times. We're not issuing official guidance today, but I would like to offer some thoughts on our near-term expectation excluding any material and unforeseen changes in the operating environment. As a reminder, we were shipping large amounts of floor models and back-stock inventory in the fourth quarter of 2019 as we expanded into new distribution which represent a headwind to our fourth quarter compare. Our internal target for the fourth quarter 2020 includes net sales growth in the low double-digits with adjusted EBITDA growing high teens as compared to the prior year. Turning to the aspirational plan. We exceeded the trailing four quarters adjusted EBITDA threshold of $650 million by delivering adjusted EBITDA of $694 million, a growth rate of 47% compared to the same period last year. Since the high end of the plan was triggered approximately 825,000 restricted stock units were included in the third quarter share count resulting in a dilution of about 1.5% of shares outstanding. This will also result in a non-cash amortization charge of $50 million of which $45 million was incurred in the third quarter. This does not impact EBITDA. Based on our fourth quarter expectations, our performance will also trigger the maximum payout of our annual variable compensation and stock-based compensation programs. We expect to record additional expense related to these compensation plans in the fourth quarter. Our financial results this quarter, including amortization, reflect a true-up of these items in-line with our improved outlook. We would expect 2021 compensation expense to decline as targets adjust and the aspirational plan expires. Lastly, I would like to flag a few items for modeling purposes. For the full year of 2020, we currently expect D&A to be about $155 million which excludes $50 million of amortization related to the aspirational plan. We expect total CapEx to be between $110 million to $115 million which includes maintenance CapEx of about $70 million. Interest expense of $75 million to $80 million and the tax rate between 25% and 26%. And finally, a diluted share count of 54 million shares or approximately 216 million shares adjusted for the impact of the four-for-one stock split that we announced this morning. This is before any potential repurchase activity. With that I'll turn the call back over to Scott.

Thank you Bhaskar, great job. I'd like to take a moment on behalf of the Board of Directors and the leadership team to thank all of our outstanding employees, third-party retailers, suppliers, licensees and joint venture partners for their contributions this quarter. The results reported are due to the hard work and dedication of the entire Tempur Sealy team and our strategic partners all over the world. I'm especially proud of our dedicated global workforce who continue to deliver exceptional results each day in spite of supply disruptions, the pandemic and the general health uncertainty in their lives. Together we've weathered everything thrown our way by remaining focused on our four key long-term corporate initiatives. As a reminder our four initiatives are as follows: first, develop the highest quality bedding products in all of the markets we serve; second, promote worldwide brands with compelling marketing; third, optimize our powerful omnichannel distribution platform; and fourth, drive increased EBITDA. These long-term initiatives are focused on serving all bedding consumers in the marketplace with the highest quality products and services. In further pursuit of our first and fourth objectives, about 12 months ago we began applying our skill set to the bedding OEM market in the United States. This diversification will drive incremental sales and allow us to capture manufacturing profits from bedding brands beyond our own. Think of this as a mining-miners kind of strategy. Besides its profitability on a standalone basis, it makes our whole business stronger as we create additional synergies and level the workload in our plants. This strategy is consistent with our willingness to invest in new streams of business over the last few years such as our expansion of our company-owned stores with Tempur-Pedic and Sleep Outfitters, our highly successful own web channel and alternate retail partnerships, and our expanded private label opportunities via the recent Sherwood acquisition. We're looking forward to sharing more details about the team's expected growth in this category of the bedding market in early 2021. Turning to long-term capital allocation. The Board of Directors and the executive management team have been working on optimizing our long-term capital allocation plan for years. Our strategy to this point has been focused on four areas: investing in operations, repurchasing shares, repaying debt taken on in the Sealy acquisition and making small tuck-in acquisitions. Over the last five years we've allocated approximately $1.5 billion of capital pursuant to our strategy including about $400 million on capital projects including expanding manufacturing and standing up DTC retail stores; $75 million on strategic tuck-in acquisitions; $860 million in the repurchase of 13.2 million shares of common stock at an average price of $65 a share or about 20% of the company; and $100 million reduction in net debt, which combined with our robust adjusted EBITDA growth, resulted in the leverage ratio reaching a record low. We've consulted with financial institutions, studied valuation data, stress tested our cash flows under different market conditions and carefully considered alternatives to develop our new capital allocation plan. I'm pleased to share the following details of our go-forward plan which we feel is balanced and will over time drive further shareholder value. First, we'll continue to spend approximately $70 million annually on maintenance CapEx and we'll consider additional capital projects based on expected returns. Investing in people, product and processes will always be our number one priority. Second, we plan to initiate a quarterly cash dividend beginning in early 2021 as we believe it's appropriate to return a portion of our cash flow to shareholders in the form of a reliable dividend. We're currently targeting a payout equal to approximately 15% of net income and we expect to provide additional details on the dividend amount and exact timing in early 2021. Third, we'll resume our share repurchase program targeting annual repurchases of at least 3% of shares outstanding. The Board has authorized an increase of about $170 million to our share repurchase program bringing the total share repurchase authorization to $300 million. Finally, we'll evaluate acquisition opportunities with a focus on strategic tuck-in acquisition similar to those we've completed the last few years. In addition to our new capital allocation program, we also are announcing a four-for-one stock split, which will be effective as of November 24, 2020 as we adjust the price of the stock to increase the diversity of our shareholder base. Turning to ESG. It is our belief that as a good corporate citizen we must serve all of our stakeholders including our people, our community and our environment and we are proud of our initiatives to-date and we plan to continue focusing on this area. Beginning this year we will source 100% renewable energy for our U.S. and European manufacturing operations. We will now utilize energy sources from wind farms across the U.S. to power our domestic facilities. Additionally, we have committed to achieve zero landfill waste for our U.S. and European manufacturing operations by the end of 2022. We also expect the installation of solar panel technology at our largest manufacturing facility in Albuquerque, New Mexico to be completed in the first half of 2021. The solar panels will generate an incredible amount of clean energy. In fact, the amount of solar energy they're capable of producing is sufficient to power all of the plant's assembly lines. Turning to our social initiatives. Our operating performance has allowed us to increase our workforce by about 20% or approximately 1,500 employees since this time last year and the increase of our stock price has benefited our Tempur Sealy Foundation by driving its assets up to over $4 million. As a reminder, the Tempur Sealy Foundation supports charities assisting children in their development. The foundation also benefited this quarter from over $500,000 in cash contributions from employees and the company's payments funded by our directors' waiver of their board fees. Our progress on sustainability initiatives, job creation, community service and maximizing shareholder returns is our game plan going forward. The combination of strong operations, a healthy tailwind of consumers eager to spend on their homes and a balanced and disciplined capital allocation strategy has positioned Tempur Sealy to meet the objectives of our stakeholders for years to come. I said this five years ago and I believe it more today: execution is where most value creation takes place. Lastly a comment or two about 2021. Clearly 2020 is going to go down as one of the strangest years in most of our lives. Until we get this COVID-19 issue behind us it is difficult to give guidance. However, we are committed to providing you with timely updates and additional comments on the general trajectory of the business as they become available. Robust sales trends that we've experienced recently have exceeded our expectations which has resulted in significant earnings, but we believe that the earnings potential was at the same time muted by operational inefficiencies from COVID-19 related measures and supply constraints. When I look at the totality of the picture in 2020 my belief and that of the executive team is that while 2020 is going to be a record year in sales and adjusted EBITDA, 2021 will be another solid growth year for Tempur Sealy. With that operator please open the call up for questions.

Our first question or comment comes from the line of Peter Keith from Piper Sandler. Your line is open.

Morning everyone, great results and nice execution. Maybe I'll just ask a question around the price increases that you highlighted. There has been some chatter in the industry that the price increases by you and even others are a bit bigger than normal. I was wondering if you could comment on that and is there potential that some of the increase is exceeding that of the commodity cost inflation?

Well thank you for the kind words. When you look at the price increase obviously most of it is commodity-based, but I'm sure if we benchmarked it against other Sealy and probably Tempur Sealy price increases it's probably the largest price increase in the company's history in total. Whether or not it more than covers commodities is hard to tell because obviously commodities is an estimate. I think what I'd call out is one, it demonstrates that the industry manufacturing still has pricing power and the business model is to pass on commodity increases. The other thing I might call out that might be a little bit different is this price increase timing. Normally we incur the commodity expense and have a negative impact on our operations for a quarter or two before it gets passed on to the customer at retail. This particular situation is the price increase is coming in with what Bhaskar and I think is one quarter lag, so it's considerably faster into the marketplace than previous price increases. And I guess the other thing I point out is it's heavily loaded towards entry-level pricing which will, as you probably know, the lower-value bedding has lower margins and so it should be healthier for the entire industry.

Thank you. Our next question or comment comes from the line of Keith Hughes from Truist Securities. Your line is open.

My congratulations as well, outstanding numbers. On the fourth quarter there's clearly going to be a gap here between the price increase and the raw material inflation. Can you give us any sort of feel for how much that's going to impact the EBITDA in the fourth quarter?

Sure. Great question. If you think about it on a year-over-year basis we do expect some headwinds from commodities. A way to think about it would be in the order of around $5 million on a year-over-year basis, perhaps slightly ahead of that.

Thank you. Our next question or comment comes from the line of Curtis Nagle from Bank of America. Your line is open. Mr. Nagle you may need to unmute your phone.

Guys good morning. How are you doing?

Good morning.

So just a quick one on I guess it's not official guidance but the comment for high teens EBITDA growth, growth relative to low double-digits sales growth, it just looks a little light. I'm assuming it's pretty conservative just considering the terrific results you guys are putting up, the leverage, the product mix, all that sort of stuff. So maybe you can contextualize that a little bit?

Well, let me talk about it in general and then I'll let Bhaskar really answer your question as I dodge it. When we look around the world, Asia is doing very well. The Asian market has dealt with the health crisis very well. Business feels normal, growing double digits, very impressive operations from an Asian perspective. If you go over into Europe, Northern Europe orders look good and then Southern Europe has been a little choppy and they've recently got some closures. So we've baked all of that into our targets. North America has been certainly solid. I think the reason we call them targets is with the virus around you're just not sure what's going to hit you next, but in general we feel very good about the fourth quarter and the trends going into the fourth quarter and as I think someone called out earlier, we went into the quarter with the largest backlog in the company's history. So we go into the fourth quarter very strong. On the other side, a tougher compare because we were loading in new distribution last year, so we've got a slightly tougher compare. Bhaskar, did I miss anything?

Not much to say incremental to that. The only thing I would call out is we do remain capacity constrained from a springs perspective and we have that contemplated in how we're thinking about the fourth quarter.

Yes and that's something we're not in control of which always makes it difficult to do a forecast.

Thank you. Our next question or comment comes from the line of Bobby Griffin from Raymond James. Your line is open.

Thanks for taking my questions and congrats on another good quarter.

Thank you.

Quickly I just want to see Scott I understand you don't want to give detail by account but can you help us maybe put in context of 43% North America growth on an organic basis and then including your new distribution wins to maybe help separate that out where we can get a good feel of maybe what the industry was doing in the third quarter?

I can work around that a little bit. Obviously, we're benefiting from some large distribution gains from last year but I got to tell you we have strong growth online which we called out specifically with our compressed bedding growing over 200% and our online business over 100%, and a little bit of headwind from our stores because we were very conservative on the reopening of the stores. Certainly the industry grew. Excluding distribution gains we saw good growth in the non-new distribution channels. I don't know that we have a precise number, but I'd say industry up roughly 10% to 12%, maybe something in that area. That's an imprecise guess and we need some more public companies to report and a little more information on imports which I expect will start coming down very rapidly, but in the third quarter there were a lot of imports that were pushed ahead in front of the tariffs.

Yes. That's helpful. And then you would think you outperformed that 10 to 12 percent guess without the new distribution?

I think if you look at the whole industry it depends on how you cut the industry. Clearly the online segment grew probably faster than brick-and-mortar and we have more business in brick-and-mortar than online. So depending how you cut the industry yes we grew faster. That's why we put out that 200% number from a compressed bedding perspective because I think that market grew very rapidly. So I'm expecting people who have concentrations in that smaller segment might have higher growth rates. But when you look at total I don't think there's any question that we outgrew the industry in total.

Okay. Thank you Scott. Thank you Bhaskar.

Thank you. Our next question or comment comes from the line of Atul Maheswari from UBS. Your line is open.

How confident are you that sales growth will be solid as you lap these big numbers especially in the back half of next year? If I ask this question another way, do you think the current strength is pulling forward demand from future periods which will simply make it harder for you to grow sales meaningfully as you lap these numbers? Thank you.

Okay. Great question. When we say solid it means we have a high degree of confidence generally. The caveats I would put around that are we're assuming there's not a global recession and we're assuming a positive trend in the health crisis. If you take those two off the table, I would tell you that we feel very confident that we'll be able to comp the current performance. It doesn't feel to us that we're pulling forward demand and the best market I can point to is the China market. When markets reopen it doesn't feel like we pulled forward demand—demand clicks and comes on. It may be housing formations. It may be a permanent or semi-permanent change in disposable income and the share of the wallet that we're going to get. In a prior life I was in the car business where we did pull forward demand occasionally because of high incentives from the manufacturer and you get a spike then it comes off—that is not what we're seeing in any of the markets around the world.

Hey man, I'm on the call.

You may want to mute your phone, others on the call. They want to mute your call. I'm not sure who's on the phone but we might learn something we're not supposed to so. Hello? Okay. Anyway that's the answer to that question. Operator are we still on?

Yes sir. Next question or comment comes from the line of Brad Thomas from KeyBanc.

Hi, thanks for taking the question. Congrats on the great execution momentum here. I just want to follow up on that question about thinking about 2021, obviously there's easy comparisons in some quarters from a sales perspective and tougher in other quarters. Could you step back and give your thoughts on elements of difficulty in comparisons and puts and takes as we fine-tune our models for 2021? Thanks.

Look, let's talk a little about growth vectors. Clearly we expect online in total next year to grow; we're seeing lots of success in our compressed product. Store openings are going to continue and they're going to be additive. We called out an OEM initiative that is new and that's a new opportunity that I expect we'll talk about more in the first quarter, but it's clearly incremental. Our stepping into the private label business through Sherwood we're expecting to see strong growth in the Sherwood area. If you go quarter by quarter, the first quarter was slightly impacted by the virus. The second quarter is going to be an easy compare because that was a weak quarter everywhere. The third quarter was a hard compare but I think we can probably comp it. When we look at it in total that's why I called it out that in our view it looks pretty good. The other thing I mentioned in the prepared remarks that you can't really see but hopefully this will help you think about how our business went this year: we closed factories, furloughed people, brought them back; it was inconsistent and at times sloppy. Then we had excess demand which created an enormous amount of overtime—which is very expensive for us—that we normally don't run at that level. Then we had component issues where we hired up people to build more beds expecting we were going to get components; after we hired them we didn't get the components. So our labor factor in the third quarter was relatively sloppy. When you put all that together there might be a little bit of extra sales in the third quarter but there are a lot of COVID-related costs and component disruption costs underneath, so we didn't get the leverage and the full profitability that we would normally get. So when I put it all together, barring a recession or an unusually difficult health crisis, we expect to get a little bit better and it shouldn't be a problem to grow sales and EBITDA next year.

Thank you. Our next question or comment comes from the line of Laura Champine from Loop Capital. Your line is open.

Springs. Firstly what's the why behind that component shortage? Is it impacting your competitors as much as it's impacting Tempur Sealy? And then in the not too distant past Tempur Sealy made its own springs—is that something that you might need to look at again just given the issues that you are clearly having with the supplier?

Laura it's good talking to you. As it relates to the challenges that we have on springs, number one is yes that is an industry-wide issue and the primary driver of that is there is material that encases a coil called an encased coil and that input material is being diverted to pull together PPE. Therefore, there is a shortage of that item, which is putting constraints on not only us but across the industry. As we specifically called out, we expect an impact in the fourth quarter and into 2021 perhaps at least the first half. On optionality going forward, we've got a great relationship with our primary spring manufacturer normally outstanding from a quality and delivery standpoint. They've run into some issues not caused by their operations but caused by the global pandemic. We're exploring all options and looking at our flexibility and making sure that in the future we have all alternatives in case we have issues going forward, but we'll work closely with our current partner.

Thank you. Our next question or comment comes from the line of Carla Casella from JP Morgan. Your line is open.

Hi good morning. This is Sarah for Carla Casella. We just wanted to know how you think about a more normalized leverage and what's the right level and also if you have any interest in getting to an investment-grade rating level?

If you go back through the history of the company the last few years we've brought down our targeted leverage and we have kind of targeted two to three turns. Today as I think we mentioned we're running a little bit below that right now. I think we'll continue to run a little bit below our targeted range as long as we've got this pandemic and we're working through it. We'll continue to study the proper leverage. I don't see us wanting to be investment grade. I don't think that the cost is probably worth getting all the way to investment grade. But I would like to position the company conservatively financed so that we're in a position to take whatever opportunities happen to come to market. So the way I think about it is we've got a targeted range of two to three times, but we're probably going to run at the low end or a little bit lower than that for the foreseeable future, but no goal to be investment grade.

Thank you. Our next question or comment comes from the line of William Reuter from Bank of America. Your line is open.

Hi, just a little bit of a follow-up on that. You mentioned you're keeping an eye on the bond market and you redeemed a piece of the 2023 notes. What are you thinking about for the remainder of those and since you are running below your target leverage range it would stand to reason that free cash flow will be used towards either one-off tuck-in acquisitions or shareholder-friendly activities. Is that fair?

There is a lot in that question. Let me unpack it a little bit. First of all, we've redeemed a little bit of the bonds. Think about that as just liability management and cost-to-capital optimization and to the extent we end up with extra liquidity on the balance sheet, then we're going to go pay off the highest cost debt, which at this time ends up being those bonds. We hope with our continued strong financial performance and maybe a little more favorable leverage profile that our opportunity for new bonds will be re-priced to a more favorable level. When it comes to free cash flow, first it goes to operations and whatever operations need, operations get. If they have a high return on invested capital project we will fund it because operations are the most important things for the company. Then we're going to pay our dividend that we've talked about establishing and set it at what I'd call the lower end of payout ranges. Then money goes to tuck-in acquisitions and opportunities like that to the extent they come up. Don't feel like we have to do any, but to the extent they come up we get a call on capital. Then there would be buybacks—we've told the market we think 3% as a target for repurchases. Our cash flows on a projection certainly would indicate there is extra cash flow there and that would be a balancing act between stock buyback and other uses. I don't know if we would actually pay any more debt off immediately, but we continue to look at that based on what's going on in the world and the uncertainty in the world.

Thank you. Our next question or comment comes from the line of Seth Basham. Your line is open.

Thanks a lot and good morning and congrats on an outstanding quarter and reaching the aspirational comp plan. My question is two part. First as it relates to the fourth quarter EBITDA growth thinking, just confirming that includes additional incentive compensation from hitting your annual targets? And then second, as we think about growth in the fourth quarter I know you don't usually talk about individual customers, but you have talked about having some perspective on the relationship with mattress firm at this point and if you could give us some color on how that's expanding that would be great. Are you gaining additional floor space and share within the store and how do you expect that relationship to develop over time?

Sure Seth. I'll take the first part of that. Yes, as we think about the fourth quarter and our thinking about high teens growth, yes that does include the incremental compensation.

When we talk about individual retailers I'll answer your question but pivot to a bigger point about our large customers. Mattress Firm is certainly an important customer, but we've got quite a few large customers that are very important and the trend line is the same. I see the larger customers generally performing better than the industry. I see the larger customers becoming very adept at internet sales and that's positive for us and them. Our relationship with all the larger customers is positive. We think about our positioning not in number of beds on the floor, but total velocity because we want those beds to be productive for those customers as opposed to just trying to fill up their store with our product. I think that's healthier for us and it's healthier for the retailer and I think clearly from our numbers our productivity with large customers has been outstanding and I would expect them to continue to be outstanding.

Thank you. That concludes our question-and-answer session. I would like to turn the conference back over to Mr. Scott for any closing comments.

Thank you. To the over 8,000 employees around the world, thank you for what you do every day to make our company successful. To our retail partners, thank you for your outstanding representation of our brands. To our shareholders and lenders, thank you for your confidence in Tempur Sealy's leadership team and its Board of Directors. Operator that ends our call today.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.