**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

| **ý**                                                                                                                            | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                  |
| **For the quarterly period ended: August 29, 2004**                                                                                   |
|                                                                                                                                  |
| **OR**                                                                                                                                |
|                                                                                                                                  |
| **o**                                                                                                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                            |
| **For the transition period  from        to        ** |

 

**Commissionfile number 333-117081-27**

 

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**SEALY MATTRESS CORPORATION**

(Exactname 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         |

 

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

 

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

 

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

 

 

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**PART I.  FINANCIAL INFORMATION**

 

**Item 1.  *Financial Statements***

 

**SEALYMATTRESS CORPORATION**

 

**CondensedConsolidated Statements of Operations**

**(Inthousands)**

**(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 tocondensed consolidated financial statements.

 

2

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**SEALYMATTRESS CORPORATION**

 

**CondensedConsolidated Statements of Operations**

**(Inthousands)**

**(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 tocondensed consolidated financial statements.

 

3

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**SEALYMATTRESS CORPORATION**

 

**CondensedConsolidated Balance Sheets**

**(Inthousands)**

**(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 |   |

 

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*                      Condensedfrom audited financial statements.

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**SEALYMATTRESS CORPORATION**

 

**CondensedConsolidated Statements of Cash Flows**

**(Inthousands)**

**(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 tocondensed consolidated financial statements

 

5

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**SEALYMATTRESS CORPORATION**

**Notes toCondensed Consolidated Financial Statements**

 

**Note 1:   *Basis of Presentation***

 

Thecondensed consolidated financial statements are unaudited, and certaininformation and footnote disclosures related thereto normally included infinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America have been omitted in accordancewith Rule 10-01 of Regulation S-X.  Inthe opinion of management, the accompanying unaudited consolidated financialstatements were prepared following the same policies and procedures used in thepreparation of the audited financial statements and reflect all adjustments(consisting of normal recurring adjustments) necessary to present fairly thefinancial position of Sealy Mattress Corporation and its subsidiaries (“theCompany”).  The results of operations forthe interim periods are not necessarily indicative of the results for theentire fiscal year.  These condensedconsolidated financial statements should be read in conjunction with the AnnualReport of Sealy Corporation on Form 10-K for the year ended November 30, 2003.

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the amount of assets and liabilities and disclosures on contingentassets and liabilities at quarter end and the reported amounts of revenue andexpenses during the reporting period. Actual results may differ from theseestimates.

 

On April 6,2004, Sealy Corporation, owner of 100% of the Company’s common stock, completeda 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 previousstockholders, including affiliates of Bain Capital, LLC and others, retained an8% interest in Sealy Corporation’s stock. The merger was accounted for as a recapitalization.  SeeNote 2 for further details on the recapitalization.  Subsequent to the recapitalization, theCompany received as contributed capital all of Sealy Corporation’s 100%interest in Sealy Mattress Company.  TheCompany 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 reportingguarantor-parent company and as a result of being an entity under commoncontrol has reflected the operation of Sealy Corporation prior to April 6, 2004in a manner similar to a pooling-of-interests. Additionally, all assets, liabilities, and stockholders’ deficit of SealyCorporation 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 ofAugust 29, 2004.  Therefore, all reportedamounts as of and for the three and nine months ended August 29, 2004 arecomparable in all material respects to those for the prior periods presentedherein except as to common stock and additionalpaid-in capital, which reflect the respective outstanding shares of the Companyand Sealy Corporation.  Subsequent to therecapitalization, none of the activity of Sealy Corporation will be included inthe consolidated financial statements of the Company and its subsidiaries (seeNote 17).

 

**Note 2:   *****Merger and Recapitalization***

 

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

 

 
| **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 |   |

 

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

 

6

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Corporation issued new Class ACommon Stock to KKR and the Rollover Stockholders retained their Class A CommonStock in proportion to their respective ownership interests.  All outstanding amounts under the existingSenior Credit Agreement were repaid.  OnApril 6, 2004, the Company closed tender offers with respect to the outstanding$300 million aggregate principal amount of the 9.875% Senior Subordinated Notesand the outstanding $128 million aggregate principal amount of 10.875% SeniorSubordinated 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 and10.875% Senior Subordinated Discount Notes were tendered, respectively, and theremaining amount was called and paid by the Company on May 6, 2004 forapproximately $31.2 million including approximately $1.1 million of accruedinterest and prepayment premiums of approximately $1.0 million. The Companyalso repaid the $50 million outstanding balance of its existing 10% JuniorSubordinated Notes.

 

The Companyentered into new senior credit facilities consisting of a $125 million seniorsecured revolving credit facility with a six-year maturity and a $560 millionsenior secured term loan facility with an eight-year maturity.  Annual maturities will be 1% of the originalprincipal amount for the first seven years, with the balance of the facility tobe repaid at final maturity.  Subsequentto the Recapitalization, the Company has prepaid all annual maturities dueprior to the final maturity. The Company will also be required to prepay theterm loans to the extent of 50% of excess cash flow (as defined in the creditagreement).  The senior credit facilitiesbear interest at a floating rate. The Company also borrowed $100 million undera senior unsecured term loan.  This loanwill be due in nine years and bears interest at a floating rate.  There are required prepayment provisions inthe event of a change in control or to the extent of certain excess proceedsfrom any asset sales.  The Company alsoissued $390 million aggregate principal amount of new Senior Subordinated Notesdue 2014.  The notes bear interest at8.25% payable semi-annually on June 15 and December 15.  The Company incurred approximately $36.4million of costs associated with establishing the new senior credit facilitiesand the senior unsecured term loan and the issuance of the new SeniorSubordinated Notes.  Such costs areincluded in the above total amount for estimated fees, expenses and other costsand will be amortized as interest expense over the term of the respective debt.

 

All stockoptions to purchase the Sealy Corporation’s common stock outstandingimmediately prior to the merger, whether or not vested, other than certainoptions held by members of management that those members elected to rollover(the “Rollover Options”) were cancelled and converted into a right to receivecash 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 acharge to expense during the quarter ended May 30, 2004.  The Rollover Options, which had intrinsicvalue of approximately $24.6 million upon the completion of the merger, nowhave an expiration date which was extended beyond that of the previouslyexisting options, resulting in a new measurement date. Consequently, a non-cashcharge to expense of $24.6 million was recorded during the quarter ended May30, 2004.

 

The Companyincurred approximately $78.2 million of other cash costs primarily associatedwith debt breakage costs, merger advisory fees, management retention bonusesand other costs, of which $70.6 million was charged to expense, with theremaining $7.6 million of direct costs related to the repurchase of sharescharged against paid-in capital.  TheCompany also incurred non-cash charges of approximately $11.8 million primarilyrelated to the write-off of previous debt issuance costs, and various othernon-cash charges of approximately $5.1 million related to the recapitalization.  Included in the amounts disclosed above arelosses associated with the extinguishment of the previously-existing debttotalling $32.2 million.

 

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

 

**Note 3:   *Stock Option and Restricted Stock Plans***

 

Certain employees of theCompany have been granted options to purchase the common stock of the Company’s100% owner, Sealy Corporation.  Suchoptions are accounted for by the Company and reported herein as if granted bythe Company.  As permitted by FAS 123,“Accounting for Stock-Based Compensation”, the Company continues to account forits stock option and stock incentive plans in accordance with AccountingPrinciples 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 forStock-Based Compensation-Transition and Disclosure an Amendment of FASBStatement No. 123” does however require interim disclosure of pro formainformation regarding net income and earnings per share determined as if theCompany had accounted for its stock options under the fair value method.

 

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

 

7

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associated with stock optionsfor the three and nine months ended August 31, 2003 as all options were grantedat 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 ninemonths ended August 31, 2003 the Company recognized stock-based compensationexpense of $0.5 million and $1.5 million, respectively, to revalue anobligation to repurchase common stock from a former officer of theCompany.  This obligation was retired inconnection with the recapitalization.

 

**Note 4:   *Inventories***

 

The major components ofinventories were as follows:

 

| ** **      | ** ** | **August  29, 2004** | ** ** | **November  30, 2003** | ** ** |
|-----------------|------------|----------------------|------------|------------------------|------------|
| ** **      | ** ** | **(In thousands)**   | ** ** |
| Raw materials   |       | $                    | 24,033     |                   | $          | 26,575 |   |
| Work in process |       | 17,016               |       | 14,699                 |       |
| Finished goods  |       | 9,178                |       | 8,139                  |       |
|            |       |                 |       |                   |       |
|            |       | $                    | 50,227     |                   | $          | 49,413 |   |

 

**Note 5:   *Warranty Costs***

 

The Company’swarranty policy provides a 10-year non-prorated warranty service period on allcurrently manufactured Sealy Posturepedic, Stearns & Foster and Bassettbedding products and some other Sealy-branded products. The Company’s policy isto accrue the estimated cost of warranty coverage at the time the sale isrecorded. The change in the company’s accrued warranty obligations fromNovember 30, 2003 to August 29, 2004 was as follows:

 

| ** **                                         | ** ** | **August 29,  2004** | ** ** |
|----------------------------------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **(In thousands)**   | ** ** |
| Accrued warranty obligations at November  30, 2003 |       | $                    | 9,135      |   |
| Warranty claims                                    |       | (10,989              | )          |
| 2004 warranty provisions                           |       | 13,400               |       |
|                                               |       |                 |       |
| Accrued warranty obligations at August 29,  2004   |       | $                    | 11,546     |   |

 

**Note 6:   *Plant Closure***

 

On May 1, 2004,the Company closed its manufacturing facility at Randolph, Massachusetts.  Accordingly, the Company incurredrestructuring 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 alsoincurred additional period costs during the year as the business was primarilyshifted to the new Albany facility.

 

8

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**Note 7:   *Goodwill and Other Intangible Assets***

 

The Companyperforms an annual assessment of its goodwill for impairment as of thebeginning of the fiscal fourth quarter. The Company also assesses its goodwill and other intangible assets forimpairment when events or circumstances indicate that their carrying value maynot be recoverable from future cash flows.

 

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

 

| Balance as of November 30, 2003               |   | $      | 381,891 |   |
|-----------------------------------------------|--------|--------|---------|--------|
| Decrease due to foreign currency  translation |   | (178   | )       |
|                                          |   |   |    |
| Balance as of August 29, 2004                 |   | $      | 381,713 |   |

 

Total otherintangibles of $4.6 million (net of accumulated amortization of $15.1 million)as of August 29, 2004 primarily consist of acquired licenses, which areamortized 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 thethree and nine months ended August 29, 2004 and $0.2 million and $1.3 millionfor the three and nine months ended August 31, 2003, respectively.

 

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

 

**Note 9:   *Long-Term Obligations***

 

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

 

| ** **                                            | ** ** | **August 29,  2004** | ** ** | **November  30, 2003** | ** ** |
|-------------------------------------------------------|------------|----------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **(in thousands)**   | ** ** |
| Senior  Secured Term Loan                             |       | $                    | 535,000    |                   | $          | — |   |
| Senior  Revolving Credit Facility                     |       | —               |       | —                 |       |
| Senior  Unsecured Term Loan                           |       | 100,000              |       | —                 |       |
| Senior  Subordinated Notes                            |       | 390,000              |       | —                 |       |
| Senior AXELs  Credit Agreement                        |       | —               |       | 259,139                |       |
| Senior  Subordinated Notes (net of premium of $2,816) |       | —               |       | 302,816                |       |
| Senior  Subordinated Discount Notes                   |       | —               |       | 128,000                |       |
| Junior  Subordinated Notes                            |       | —               |       | 49,989                 |       |
| Other                                                 |       | 8,989                |       | 7,309                  |       |
|                                                  |       |                 |       |                   |       |
|                                                  |       | 1,033,989            |       | 747,253                |       |
| Less current  portion                                 |       | 8,203                |       | 47,623                 |       |
|                                                  |       |                 |       |                   |       |
|                                                  |       | $                    | 1,025,786  |                   | $          | 699,630 |   |

 

Subsequent to the quarter ended August 29, 2004, theCompany made additional prepayments of $20 million and $25 million on September8, 2004 and October 7, 2004, respectively, partially funded by net borrowingsof approximately $10.5 million under the revolving credit facility.

 

 

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

 

**Note 10:    *Recently Issued Accounting Pronouncements***

 

In January 2003, the Financial Accounting StandardsBoard issued FASB Interpretation No. 46, “Consolidation of Variable InterestEntities” (“FIN 46-R”, as revised December 2003 with respect to effectivedates).  The primary objectives of FIN46-R are to provide guidance on the identification of entities for whichcontrol is achieved through means other than through voting rights (“variableinterest entities” or “VIEs”) and how to determine when and which businessenterprise should consolidate the VIE (the “primary beneficiary”). This newmodel for consolidation applies to an entity which either (1) the equityinvestors (if any) do not have

 

9

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acontrolling financial interest or (2) the equity investment at risk isinsufficient to finance that entity’s activities without receiving additionalsubordinated financial support from other parties. In addition, FIN 46-Rrequires that both the primary beneficiary and all other enterprises with asignificant variable interest in a VIE make additional disclosures. FIN 46-R iseffective for the Company’s second quarter of 2004 with transitional disclosurerequired with these financial statements. The Company adopted these provisionsin its second quarter, however the Company does not believe it is a primarybeneficiary of a VIE or holds any significant interests or involvement in aVIE, therefore adoption of FIN 46-R did not have an impact on the Company’sconsolidated financial statements.

 

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

 

**Note 11:   *Hedging Strategies***

 

In 2000, the Company entered into an interest rateswap agreement that effectively converted $236 million of its floating-ratedebt to a fixed-rate basis through December 2006, thereby hedging against theimpact of interest rate changes on future interest expense (forecasted cashflows). Use of hedging contracts allows the Company to reduce its overallexposure to interest rate changes, since gains and losses on these contractswill offset losses and gains on the transactions being hedged. The Companyformally documents all hedged transactions and hedging instruments, andassesses, both at inception of the contract and on an ongoing basis, whetherthe hedging instruments are effective in offsetting changes in cash flows ofthe hedged transaction. The fair values of the interest rate agreements areestimated by obtaining quotes from brokers and are the estimated amounts that theCompany would receive or pay to terminate the agreements at the reporting date,taking into consideration current interest rates and the currentcreditworthiness of the counterparties. Effective June 3, 2002, the Companydedesignated the interest rate swap agreement for hedge accounting. As a resultof the dedesignation, $12.9 million previously recorded in accumulated othercomprehensive loss as of the date of dedesignation was being amortized intointerest expense. During the quarter ended May 30, 2004, the remaining $4.7million previously recorded in accumulated other comprehensive loss was chargedto recapitalization expense (see Note 2). Prior to the recapitalization, $0.9million was amortized into interest expense. For the three and nine monthsended August 31, 2003, $0.6 million and $2.7 million, was amortized intointerest expense, respectively. Prior to June 3, 2002, the changes in the fairmarket value of the interest rate swap were recorded in accumulated othercomprehensive income (loss). Subsequent to June 3, 2002, changes in the fairmarket value of the interest rate swap are recorded in interest expense. Forthe 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 ofthe cash requirements of the swap net of the non-cash interest associated withthe change in its fair market value.  AtAugust 29, 2004 and November 30, 2003, the fair value carrying amount of thisinstrument was $(8.8) million and $(14.9) million, respectively, which isrecorded as follows:

 

| ** **                   | ** ** | **August 29, 2004** | ** ** | **November 30, 2003** | ** ** |
|------------------------------|------------|---------------------|------------|----------------------------|------------|
| ** **                   | ** ** | **(in thousands)**  | ** ** |
| Accrued interest             |       | $                   | 1,535      |                       | $          | 2,207 |   |
| Other accrued expenses       |       | 4,751               |       | 6,464                      |       |
| Other noncurrent liabilities |       | 2,524               |       | 6,198                      |       |
|                         |       |                |       |                       |       |
|                         |       | $                   | 8,810      |                       | $          | 14,869 |   |

 

During the second quarter of 2002, the Company enteredinto another interest rate swap agreement that has the effect of reestablishingas floating rate debt the $236 million of debt previously converted to fixedrate debt through December 2006. This interest rate swap agreement has not beendesignated for hedge accounting and, accordingly, any changes in the fair valueare recorded in interest expense. For the three and nine months ended August29, 2004, $0.9 million and $1.3 million, and for the three and nine monthsended August 31, 2003, $(2.9) million and $4.3 million, respectively, wasrecorded as a reduction of net interest expense as a result of the cashinterest received on the swap net of the non-cash interest associated with thechange in its fair market value. At August 29, 2004 and November 30, 2003, thefair value carrying amount of this instrument was $3.7 million and $6.8million, respectively, with $3.5 million and $5.1 million recorded in prepaidexpenses and other current assets, and $0.2 million and $1.7 million recordedin noncurrent assets.

 

10

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The Company also entered into an interest rate capagreement during the second quarter of 2002 with a notional amount of $175.0million that capped the LIBOR rate on which certain of its previousfloating-rate debt was based at 8% through June 2005. This agreement has notbeen designated for hedge accounting and, accordingly, any changes in the fairvalue are recorded in interest expense. The fair value of this instrument isnot material.

 

In June 2004, the Company entered into an additionalswap agreement that has the effect of converting $200 million of thefloating-rate debt under the Company’s new senior credit facilities to a fixed-ratebasis, declining to $150 million through November 2007.  The Company has formally designated this swapagreement as a cash flow hedge and expects the hedge to be highly effective inoffsetting fluctuations in the designated interest payments resulting fromchanges in the benchmark interest rate. Accordingly, the effective portion of changes in the market value of theswap 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:

 

| ** **                   | ** ** | **August 29, 2004** | ** ** |
|------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **(In Thousands)**  | ** ** |
| Accrued interest             |       | $                   | 720        |   |
| Other accrued expenses       |       | 2,397               |       |
| Other noncurrent liabilities |       | 422                 |       |
|                         |       |                |       |
|                         |       | $                   | 3,539      |   |

 

At August 29, 2004 and November 30, 2003, accumulatedother 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 forecastedforeign currency cash flows resulting from purchases in a foreign currency, theCompany has instituted a forecasted cash flow hedging program. The Companyhedges portions of its purchases denominated in foreign currencies with forwardand option contracts. At August 29, 2004, the Company had forward contracts tosell a total of 6.0 million Mexican pesos with expiration dates ranging fromSeptember 24, 2004 through November 24, 2004, and forward contracts to sell atotal of 39.5 million Canadian dollars with expiration dates ranging fromSeptember 7, 2004 through November 15, 2005. At August 29, 2004, the fair value of the Company’s net obligation underthe forward contracts was $0.3 million.

 

In the accompanying statements of cash flows, the cashflows from hedging activities are included in the same categories as the hedgeditems.  Cash flows from operatingactivities include increases in cash balances due to foreign exchange ratefluctuations.  The effect of such foreignexchange rate fluctuations for the nine months ended August 29, 2004 was notmaterial. For the nine months ended August 31, 2003 the effect of such foreignexchange rate fluctuations was $0.2 million.

 

**Note 12:   *Defined Benefit Pension Expense***

 

The components of net periodic pension cost recognizedfor the Company’s defined benefit pension plan for the three and nine monthsended 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 costsrecognized for the three and nine months ending August 29, 2004 are based uponpreliminary estimates pending the final actuarial determination of such costsfor fiscal 2004.  Similarly, net periodicpension costs for the three and nine months ended August 31, 2003 were basedupon preliminary estimates.

 

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

 

**Note 13:   *Stockholders’ Deficit***

 

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

 

Activity in Stockholders’ equity (deficit) is asfollows (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 Corporationcommon stock consists of 1,000 shares $0.01 par value stock, all of which isowned 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 ofthese matters is currently not determinable, management does not expect thatthe ultimate costs to resolve these matters will have a material adverse effecton the Company’s consolidated financial position, results of operations or cashflows.

 

12

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The Company iscurrently conducting an environmental cleanup at a formerly owned facility inSouth Brunswick, New Jersey pursuant to the New Jersey Industrial Site RecoveryAct. The Company and one of its subsidiaries are parties to an AdministrativeConsent Order issued by the New Jersey Department of Environmental Protection.Pursuant to that order, the Company and its subsidiary agreed to conduct soiland groundwater remediation at the property. The Company does not believe thatits manufacturing processes were the source of contamination. The Company soldthe property in 1997. The Company and its subsidiary retained primaryresponsibility for the required remediation. The Company has completedessentially all soil remediation with the New Jersey Department ofEnvironmental Protection approval, and has concluded a pilot test of thegroundwater remediation system. The Company has received approval from the NewJersey Department of Environmental Protection to implement a remediation planfor the sediment in Oakeys Brook adjoining the site.  The Company expects to begin that remediationeffort shortly.

 

The Company isalso remediating soil and groundwater contamination at an inactive facilitylocated in Oakville, Connecticut. Although the Company is conducting theremediation voluntarily, it obtained Connecticut Department of EnvironmentalProtection approval of the remediation plan. The Company has completedessentially all soil remediation under the remediation plan and is currentlymonitoring groundwater at the site. The Company believes the contamination isattributable to the manufacturing operations of previous unaffiliated occupantsof the facility.

 

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

 

While theCompany 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 notbelieve the resolution of these matters will have a material adverse effect onthe financial position or future operations of the Company; however, in theevent of an adverse decision, these matters could have a material adverseeffect. The state of California adopted new flame retardant regulations relatedto manufactured mattresses and box springs which will be effective January 1,2005. The Company expects to be in full compliance with those regulations bythe effective date. The Company does not expect the impact of those regulationsto be significant to the Company’s results of operations or financial position.

 

In 2000,Montgomery Ward, a customer of Sealy, declared bankruptcy and filed forprotection under Chapter 7 of the U.S. Bankruptcy Code. In 2003, the bankruptcytrustee filed a claim of $3.7 million associated with certain allegedpreferential payments by Montgomery Ward to Sealy. Currently, the case is inthe discovery phase and the Company believes it has significant defensesagainst such claims. While the Company cannot predict the ultimate outcome, theCompany believes it has adequate accruals recorded with respect to this claimand does not believe the resolution of these matters will have a materialadverse effect on the financial position or future operations of the Company.

 

**Note 15:   *Related Party Transactions***

 

The Companypreviously contributed cash and other assets to Mattress Holdings InternationalLLC (“MHI”), a company which was controlled by the Company’s previous largeststockholder, Bain Capital, LLC (“Bain”), in exchange for a non-voting interest.MHI was formed to invest in domestic and international loans, advances andinvestments in joint ventures, licensees and retailers. The equity ownership ofMHI was transferred from Bain to the Company in November 2002. In 1999, MHIindirectly through a Bain controlled holding company acquired a minorityinterest in Mattress Holdings Corporation (“MHC”). MHC owns an interest inMattress Discounters Corporation (“Mattress Discounters”), a domestic mattressretailer. In addition, MHC sold all of its equity interest in an internationalretailer on April 15, 2003. This international retailer had been an affiliateof the Company since MHC’s acquisition in 2000.

 

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

 

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

 

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

 

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

 

| ** **                          | ** ** | **Three  months ended  August 29,  2004** | ** ** | **Three  months ended  August 31,  2003** | ** ** | **Nine  months  ended  August  29, 2004** | ** ** | **Nine  months  ended  August  31, 2003** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **($’s in thousands****)**           | ** ** |
| Mattress Discounters Corporation(1) |       | $                                         | —     |                                      | $          | 6,615                                     |       | $                                         | 7,030      |   | $ | 21,636 |   |
| International retailer              |       | —                                    |       | —                                    |       | —                                    |       | 4,044                                     |       |
|                                |       |                                      |       |                                      |       |                                      |       |                                      |       |
| Total sales to affiliates           |       | $                                         | —     |                                      | $          | 6,615                                     |       | $                                         | 7,030      |   | $ | 25,680 |   |

 

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(1) Through April 6, 2004

 

The Company believes thatthe terms on which mattresses were supplied to these affiliates were notmaterially more or less favorable than those that might reasonably be obtainedin a comparable transaction on an arm’s length basis from a person that is notan affiliate or related party.

 

Included infees, 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 BainCapital, LLC.  During the three monthsended August 29, 2004, the Company paid management fees of $0.2 million toKKR.  Also during the quarter endedAugust 29, 2004, the Company incurred $1.1 million for consulting servicesprovided by Capstone Consulting LLC, the chief executive officer of which is onthe Company’s board of directors.  Duringthe nine months ended August 31, 2003, the Company paid $1.5 million to BainCapital, LLC for management fees.

 

**Note 16:   *Segment Information***

 

The Company operatespredominately in one industry segment, that being the manufacture and marketingof conventional bedding.

 

**Note 17:   *Parent Company Financing***

 

On July 16,2004, Sealy Corporation, the 100% owner of the Company, issued $75.0 millionaggregate principal amount of senior subordinated pay-in-kind (PIK) notes (the “PIKNotes”) and $37.5 million of Sealy Corporation common stock to certaininstitutional investors in transactions exempt from registration under theSecurities Act of 1933.  This transactionwas executed and recorded by Sealy Corporation and, accordingly, is notreflected in the financial statements of the Company.

 

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

 

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

 

14

----

 

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

 

The $112.5million in gross proceeds from the transactions was returned to existinginvestors in Sealy Corporation by a combination of cash distributions toshareholders and option holders as well as share repurchases of SealyCorporation common stock.  In connectionwith the distribution to option holders, the Company recorded an expense ofapproximately $4.0 million in the fiscal third quarter of 2004 since theholders of the Sealy Corporation options are employees of the Company.  This charge, net of approximately $0.5million of deferred financing costs related to the issuance of the PIK Noteswhich were paid on behalf of Sealy Corporation by a subsidiary of SealyMattress Corporation, has resulted in an approximately $3.5 million liabilityowed by the Company to Sealy Corporation at August 29, 2004.  This obligation does not bear interest andhas no scheduled repayment terms. Management anticipates that the balance will be gradually reduced overtime as the Company pays for various expenses of Sealy Corporation in theordinary course of business.

 

**Note 18:   *Guarantor/Non-Guarantor Financial Information***

 

The Parent (asdefined 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, theobligation to pay principal and interest with respect to the 8.25% SeniorSubordinated Notes due 2014 (the “Notes”) of the Issuer. Substantially all ofthe 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 areprovided in part by distributions or advances from its subsidiaries. Undercertain circumstances, contractual and legal restrictions, as well as thefinancial condition and operating requirements of the Issuer’s subsidiaries,could limit the Issuer’s ability to obtain cash from its subsidiaries for thepurpose of meeting its debt service obligations, including the payment ofprincipal and interest on the Notes. Although holders of the Notes will bedirect creditors of the Issuer’s principal direct subsidiaries by virtue of theguarantees, the Issuer has subsidiaries (“Non-Guarantor Subsidiaries”) that arenot included among the Guarantor Subsidiaries, and such subsidiaries will notbe obligated with respect to the Notes. As a result, the claims of creditors ofthe Non-Guarantor Subsidiaries will effectively have priority with respect tothe assets and earnings of such companies over the claims of creditors of theIssuer, including the holders of the Notes.

 

The following supplementalconsolidating condensed financial statements present:

 

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

 

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

 

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

 

Separate financialstatements of each of the Guarantor Subsidiaries are not presented becauseManagement believes that these financial statements would not be material toinvestors.

 

15

----

 

**SEALY MATTRESSCORPORATION**

 

**SupplementalConsolidating Condensed Balance Sheet**

**August 29,2004**

**(inthousands)**

 
| ** **                                                            | ** ** | **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 |   |

 

16

----

 

**SEALYMATTRESS CORPORATION**

**SupplementalConsolidating Condensed Balance Sheet**

**November30, 2003**

**(inthousands)**

 
| ** **                                                            | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-  Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|---------------------------------------------|------------|------------------|------------|------------------|------------|
| **Assets**                                                            |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Current assets:                                                       |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Cash and cash equivalents                                             |       | $                                | —     |                         | $          | 31                                    |       | $                                           | 90,985     |             | $          | 10,084           |       | $ | — |   | $ | 101,100 |   |
| Accounts  receivable—Non-affiliates, net                         |       | 15                               |       | —                       |       | 103,320                               |       | 57,649                                      |       | —           |       | 160,984          |       |
| Accounts receivable—Affiliates, net                              |       |                             |       |                         |       | 1,758                                 |       |                                        |       | —           |       | 1,758            |       |
| Inventories                                                           |       | —                           |       | 1,774                        |       | 33,258                                |       | 14,381                                      |       | —           |       | 49,413           |       |
| Prepaid expenses, deferred income taxes and  other current assets     |       | (63                              | )          | 6,510                        |       | 31,794                                |       | 5,163                                       |       | —           |       | 43,404           |       |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
|                                                                  |       | (48                              | )          | 8,315                        |       | 261,115                               |       | 87,277                                      |       | —           |       | 356,659          |       |
| Property, plant and equipment, at cost                                |       | —                           |       | 6,485                        |       | 231,966                               |       | 61,267                                      |       | —           |       | 299,718          |       |
| Less accumulated depreciation                                         |       | —                           |       | 3,339                        |       | 111,777                               |       | 13,777                                      |       | —           |       | 128,893          |       |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
|                                                                  |       | —                           |       | 3,146                        |       | 120,189                               |       | 47,490                                      |       | —           |       | 170,825          |       |
| Other assets:                                                         |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Goodwill                                                              |       | —                           |       | 14,816                       |       | 314,698                               |       | 52,377                                      |       | —           |       | 381,891          |       |
| Other intangibles, net                                                |       | —                           |       | —                       |       | 4,415                                 |       | 949                                         |       | —           |       | 5,364            |       |
| Net investment in and advances to (from)  subsidiaries and affiliates |       | (18,896                          | )          | 613,359                      |       | (349,653                              | )          | (91,683                                     | )          | (153,127         | )          | —           |       |
| Long-term notes receivable                                            |       | —                           |       | —                       |       | —                                |       | 13,323                                      |       | —           |       | 13,323           |       |
| Debt issuance costs, net, and other assets                            |       | 96                               |       | 17,946                       |       | 10,535                                |       | 2,427                                       |       | —           |       | 31,004           |       |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
|                                                                  |       | (18,800                          | )          | 646,121                      |       | (20,005                               | )          | (22,607                                     | )          | (153,127         | )          | 431,582          |       |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Total assets                                                          |       | $                                | (18,848    | )                            | $          | 657,582                               |       | $                                           | 361,299    |             | $          | 112,160          |       | $ | (153,127 | ) | $ | 959,066 |   |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| **Liabilities And Stockholders’ Equity  (Deficit)**              |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Current liabilities:                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Current portion—long-term obligations                            |       | $                                | —     |                         | $          | 41,918                                |       | $                                           | —     |             | $          | 5,705            |       | $ | — |   | $ | 47,623 |   |
| Accounts payable                                                      |       | —                           |       | 204                          |       | 51,851                                |       | 33,423                                      |       | —           |       | 85,478           |       |
| Accrued interest                                                      |       | 847                              |       | 1,028                        |       | 21,109                                |       | 581                                         |       | —           |       | 23,565           |       |
| Accrued customer incentives and advertising                           |       | —                           |       | 1,369                        |       | 29,045                                |       | 5,132                                       |       | —           |       | 35,546           |       |
| Accrued compensation                                                  |       | —                           |       | 102                          |       | 21,675                                |       | 5,806                                       |       | —           |       | 27,583           |       |
| Other accrued expenses                                                |       | 10                               |       | 7,842                        |       | 31,385                                |       | 5,602                                       |       | —           |       | 44,839           |       |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
|                                                                  |       | 857                              |       | 52,463                       |       | 155,065                               |       | 56,249                                      |       | —           |       | 264,634          |       |
| Long-term obligations                                                 |       | 49,989                           |       | 648,056                      |       | 44                                    |       | 1,541                                       |       | —           |       | 699,630          |       |
| Other noncurrent liabilities                                          |       | 6,998                            |       | 6,202                        |       | 29,095                                |       | 6,556                                       |       | —           |       | 48,851           |       |
| Deferred income taxes                                                 |       | (530                             | )          | (1,202                       | )          | 19,590                                |       | 4,255                                       |       | —           |       | 22,113           |       |
| Stockholders’ equity (deficit)                                   |       | (76,162                          | )          | (47,937                      | )          | 157,505                               |       | 43,559                                      |       | (153,127         | )          | (76,162          | )          |
|                                                                  |       |                             |       |                         |       |                                  |       |                                        |       |             |       |             |       |
| Total liabilities and stockholders’ equity  (deficit)            |       | $                                | (18,848    | )                            | $          | 657,582                               |       | $                                           | 361,299    |             | $          | 112,160          |       | $ | (153,127 | ) | $ | 959,066 |   |
|                                                                       |            |                                  |            |                              |            |                                       |            |                                             |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

17

----

 

**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidated Condensed Statements of Operations**

**ThreeMonths Ended August 29, 2004**

**(inthousands)**

 
| ** **                                           | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net sales—Non-affiliates                        |       | $                                | —     |                         | $          | 14,156                                |       | $                                         | 279,163    |             | $          | 69,360           |       | $ | (5,416 | ) | $ | 357,263 |   |
| Net sales—Affiliates                            |       | —                           |       | —                       |       | —                                |       | —                                    |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total net sales                                      |       | —                           |       | 14,156                       |       | 279,163                               |       | 69,360                                    |       | (5,416           | )          | 357,263          |       |
| Costs and expenses:                                  |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cost of goods sold— Non-affiliates              |       | —                           |       | 8,578                        |       | 147,698                               |       | 43,085                                    |       | (5,416           | )          | 193,945          |       |
| Cost of goods sold— Affiliates                  |       | —                           |       | —                       |       | —                                |       | —                                    |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total cost of goods sold                             |       | —                           |       | 8,578                        |       | 147,698                               |       | 43,085                                    |       | (5,416           | )          | 193,945          |       |
| Gross profit                                         |       | —                           |       | 5,578                        |       | 131,465                               |       | 26,275                                    |       | —           |       | 163,318          |       |
| Selling, general and administrative                  |       | —                           |       | 3,876                        |       | 97,379                                |       | 18,630                                    |       | —           |       | 119,885          |       |
| Recapitalization expense                             |       | —                           |       | —                       |       | —                                |       | 394                                       |       |             |       | 394              |       |
| Amortization of intangibles                          |       | —                           |       | —                       |       | 73                                    |       | 224                                       |       | —           |       | 297              |       |
| Royalty income, net                                  |       | —                           |       | —                       |       | (4,128                                | )          | 253                                       |       | —           |       | (3,875           | )          |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income from operations                               |       | —                           |       | 1,702                        |       | 38,141                                |       | 6,774                                     |       | —           |       | 46,617           |       |
| Interest expense                                     |       | 60                               |       | 17,431                       |       | (408                                  | )          | 241                                       |       | —           |       | 17,324           |       |
| Other (income) expense, net                          |       | (4                               | )          | —                       |       | (1                                    | )          | (97                                       | )          | —           |       | (102             | )          |
| Loss (income) from equity investees                  |       | (21,231                          | )          | (21,035                      | )          | —                                |       | —                                    |       | 42,266           |       | —           |       |
| Loss (income) from nonguarantor equity  investees    |       | —                           |       | (277                         | )          | (4,314                                | )          | —                                    |       | 4,591            |       | —           |       |
| Capital charge and intercompany interest  allocation |       | (56                              | )          | (16,595                      | )          | 16,006                                |       | 645                                       |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) before income taxes                    |       | 21,231                           |       | 22,178                       |       | 26,858                                |       | 5,985                                     |       | (46,857          | )          | 29,395           |       |
| Income tax (benefit) expense                         |       | 839                              |       | 947                          |       | 5,823                                 |       | 1,394                                     |       | —           |       | 9,003            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net income (loss)                                    |       | $                                | 20,392     |                         | $          | 21,231                                |       | $                                         | 21,035     |             | $          | 4,591            |       | $ | (46,857 | ) | $ | 20,392 |   |

 

18

----

 

**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidated Condensed Statements of Operations**

**ThreeMonths Ended August 31, 2003**

**(inthousands)**

 
| ** **                                           | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net sales—Non-affiliates                        |       | $                                | —     |                         | $          | 13,687                                |       | $                                         | 248,354    |             | $          | 60,479           |       | $ | (4,194 | ) | $ | 318,326 |   |
| Net sales—Affiliates                            |       | —                           |       | —                       |       | 6,615                                 |       | —                                    |       | —           |       | 6,615            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total net sales                                      |       | —                           |       | 13,687                       |       | 254,969                               |       | 60,479                                    |       | (4,194           | )          | 324,941          |       |
| Costs and expenses:                                  |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cost of goods sold—  Non-affiliates             |       | —                           |       | 9,267                        |       | 142,125                               |       | 37,972                                    |       | (4,194           | )          | 185,170          |       |
| Cost of goods sold— Affiliates                  |       | —                           |       | —                       |       | 3,797                                 |       | —                                    |       | —           |       | 3,797            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total cost of goods sold                             |       | —                           |       | 9,267                        |       | 145,922                               |       | 37,972                                    |       | (4,194           | )          | 188,967          |       |
| Gross profit                                         |       | —                           |       | 4,420                        |       | 109,047                               |       | 22,507                                    |       | —           |       | 135,974          |       |
| Selling, general and administrative                  |       | 38                               |       | 3,954                        |       | 84,200                                |       | 17,425                                    |       | —           |       | 105,617          |       |
| Stock based compensation                             |       | 492                              |       | —                       |       | —                                |       | —                                    |       | —           |       | 492              |       |
| Amortization of intangibles                          |       | —                           |       |                         |       | 72                                    |       | 215                                       |       | —           |       | 287              |       |
| Royalty income, net                                  |       | —                           |       | —                       |       | (3,323                                | )          | 259                                       |       | —           |       | (3,064           | )          |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (Loss) from operations                        |       | (530                             | )          | 466                          |       | 28,098                                |       | 4,608                                     |       | —           |       | 32,642           |       |
| Interest expense                                     |       | 1,493                            |       | 15,809                       |       | 1                                     |       | 359                                       |       | —           |       | 17,662           |       |
| Other (income) expense, net                          |       | 1                                |       | —                       |       | (81                                   | )          | (166                                      | )          | —           |       | (246             | )          |
| (Income) loss from equity investees                  |       | (8,973                           | )          | (8,099                       | )          | —                                |       | —                                    |       | 17,072           |       | —           |       |
| Loss (income) from nonguarantor equity  investees    |       | —                           |       | 322                          |       | (2,274                                | )          | —                                    |       | 1,952            |       | —           |       |
| Capital charge and intercompany interest  allocation |       | (1,531                           | )          | (17,376                      | )          | 17,940                                |       | 967                                       |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) before income taxes                    |       | 8,480                            |       | 9,810                        |       | 12,512                                |       | 3,448                                     |       | (19,024          | )          | 15,226           |       |
| Income tax (benefit) expense                         |       | (217                             | )          | 837                          |       | 4,413                                 |       | 1,496                                     |       | —           |       | 6,529            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net income (loss)                                    |       | $                                | 8,697      |                         | $          | 8,973                                 |       | $                                         | 8,099      |             | $          | 1,952            |       | $ | (19,024 | ) | $ | 8,697 |   |

 

19

----

 

**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidating Condensed Statements of Operations**

**Nine MonthsEnded August 29, 2004**

**(in thousands)**

 
| ** **                                           | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net sales—Non-affiliates                        |       | $                                | —     |                         | $          | 37,433                                |       | $                                         | 768,705    |             | $          | 193,122          |       | $ | (14,275 | ) | $ | 984,985 |   |
| Net sales—Affiliates                            |       | —                           |       | —                       |       | 7,030                                 |       | —                                    |       | —           |       | 7,030            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total net sales                                      |       | —                           |       | 37,433                       |       | 775,735                               |       | 193,122                                   |       | (14,275          | )          | 992,015          |       |
| Costs and expenses:                                  |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cost of goods sold— Non-affiliates              |       | —                           |       | 23,573                       |       | 423,502                               |       | 120,648                                   |       | (14,275          | )          | 553,448          |       |
| Cost of goods sold— Affiliates                  |       | —                           |       | —                       |       | 4,035                                 |       | —                                    |       | —           |       | 4,035            |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total cost of goods sold                             |       | —                           |       | 23,573                       |       | 427,537                               |       | 120,648                                   |       | (14,275          | )          | 557,483          |       |
| Gross profit                                         |       | —                           |       | 13,860                       |       | 348,198                               |       | 72,474                                    |       | —           |       | 434,532          |       |
| Selling, general and administrative                  |       | 26                               |       | 10,489                       |       | 260,553                               |       | 56,190                                    |       | —           |       | 327,258          |       |
| Recapitalization Expense                             |       | 41,753                           |       | 36,871                       |       | 50,224                                |       | 4,286                                     |       | —           |       | 133,134          |       |
| Amortization of intangibles                          |       | —                           |       | —                       |       | 217                                   |       | 670                                       |       | —           |       | 887              |       |
| Royalty income, net                                  |       | —                           |       | —                       |       | (11,378                               | )          | 800                                       |       | —           |       | (10,578          | )          |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) from operations                        |       | (41,779                          | )          | (33,500                      | )          | 48,582                                |       | 10,528                                    |       | —           |       | (16,169          | )          |
| Interest expense                                     |       | 1,951                            |       | 48,860                       |       | (404                                  | )          | 775                                       |       | —           |       | 51,182           |       |
| Other (income) expense                               |       | —                           |       | —                       |       | (327                                  | )          | (517                                      | )          | —           |       | (844             | )          |
| Loss (income) from equity investees                  |       | 18,796                           |       | (4,977                       | )          | —                                |       | —                                    |       | (13,819          | )          | —           |       |
| Loss (income) from nonguarantor equity  investees    |       | —                           |       | (3,521                       | )          | (2,786                                | )          | —                                    |       | 6,307            |       | —           |       |
| Capital charge and intercompany interest  allocation |       | (1,973                           | )          | (46,416                      | )          | 46,425                                |       | 1,964                                     |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) before income taxes                    |       | (60,553                          | )          | (27,446                      | )          | 5,674                                 |       | 8,306                                     |       | 7,512            |       | (66,507          | )          |
| Income tax (benefit) expense          |       | (10,048                          | )          | (8,650                       | )          | 697                                   |       | 1,999                                     |       | —           |       | (16,002          | )          |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net income (loss)                                    |       | $                                | (50,505    | )                            | $          | (18,796                               | )          | $                                         | 4,977      |             | $          | 6,307            |       | $ | 7,512 |   | $ | (50,505 | ) |
|                                                      |            |                                  |            |                              |            |                                       |            |                                           |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

20

----

 

**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidating Condensed Statements of Operations**

**Nine MonthsEnded August 31, 2003**

**(inthousands)**

 
| ** **                                           | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net sales—Non-affiliates                        |       | $                                | —     |                         | $          | 39,721                                |       | $                                         | 665,404    |             | $          | 164,295          |       | $ | (12,072 | ) | $ | 857,348 |   |
| Net sales—Affiliates                            |       | —                           |       | —                       |       | 21,636                                |       | 4,044                                     |       | —           |       | 25,680           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total net sales                                      |       | —                           |       | 39,721                       |       | 687,040                               |       | 168,339                                   |       | (12,072          | )          | 883,028          |       |
| Costs and expenses:                                  |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cost of goods sold— Non-affiliates              |       | —                           |       | 27,314                       |       | 382,349                               |       | 103,600                                   |       | (12,072          | )          | 501,191          |       |
| Cost of goods sold— Affiliates                  |       | —                           |       | —                       |       | 12,419                                |       | 2,662                                     |       | —           |       | 15,081           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Total cost of goods sold                             |       | —                           |       | 27,314                       |       | 394,768                               |       | 106,262                                   |       | (12,072          | )          | 516,272          |       |
| Gross profit                                         |       | —                           |       | 12,407                       |       | 292,272                               |       | 62,077                                    |       | —           |       | 366,756          |       |
| Selling, general and administrative                  |       | 113                              |       | 11,721                       |       | 228,483                               |       | 50,673                                    |       | —           |       | 290,990          |       |
| Stock based compensation                             |       | 1,482                            |       | —                       |       | —                                |       | —                                    |       | —           |       | 1,482            |       |
| Amortization of intangibles                          |       | —                           |       | —                       |       | 217                                   |       | 603                                       |       | —           |       | 820              |       |
| Royalty income, net                                  |       | —                           |       | —                       |       | (9,349                                | )          | 724                                       |       | —           |       | (8,625           | )          |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) from operations                        |       | (1,595                           | )          | 686                          |       | 72,921                                |       | 10,077                                    |       | —           |       | 82,089           |       |
| Interest expense                                     |       | 4,356                            |       | 46,134                       |       | 5                                     |       | 1,119                                     |       | —           |       | 51,614           |       |
| Other (income) expense                               |       | —                           |       | 2,531                        |       | (300                                  | )          | (976                                      | )          | —           |       | 1,255            |       |
| Loss (income) from equity investees                  |       | (17,623                          | )          | (19,543                      | )          | —                                |       | —                                    |       | 37,166           |       | —           |       |
| Loss (income) from nonguarantor equity  investees    |       | —                           |       | 834                          |       | (4,920                                | )          | —                                    |       | 4,086            |       | —           |       |
| Capital charge and intercompany interest  allocation |       | (4,469                           | )          | (46,087                      | )          | 47,740                                |       | 2,816                                     |       | —           |       | —           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Income (loss) before income taxes                    |       | 16,141                           |       | 16,817                       |       | 30,396                                |       | 7,118                                     |       | (41,252          | )          | 29,220           |       |
| Income tax (benefit) expense          |       | (631                             | )          | (806                         | )          | 10,853                                |       | 3,032                                     |       | —           |       | 12,448           |       |
|                                                 |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net income (loss)                                    |       | $                                | 16,772     |                         | $          | 17,623                                |       | $                                         | 19,543     |             | $          | 4,086            |       | $ | (41,252 | ) | $ | 16,772 |   |
|                                                      |            |                                  |            |                              |            |                                       |            |                                           |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |

 

21

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**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidating Condensed Statements of Cash Flows**

**Nine MonthsEnded August 29, 2004**

**(inthousands)**

 
| ** **                                                                        | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net cash operating activities                                                     |       | $                                | —     |                         | $          | (21,713                               | )          | $                                         | (6,929     | )                | $          | 9,217            |       | $ | — |   | $ | (19,425 | ) |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cash flows from investing activities:                                             |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Purchase of property, plant and equipment,  net                                   |       | —                           |       | (362                         | )          | (15,808                               | )          | (2,536                                    | )          | —           |       | (18,706          | )          |
| Cash received from affiliate note and  investment                                 |       | —                           |       | —                       |       | —                                |       | 13,573                                    |       | —           |       | 13,573           |       |
| Proceeds from the sale of property, plant  and equipment                          |       | —                           |       | —                       |       | 1,499                                 |       | —                                    |       | —           |       | 1,499            |       |
| Net activity in investment in and advances  to (from) subsidiaries                |       | 362,017                          |       | (278,912                     | )          | (62,194                               | )          | (20,911                                   | )          | —           |       | —           |       |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net proceeds provided investing activities                                        |       | 362,017                          |       | (279,274                     | )          | (76,503                               | )          | (9,874                                    | )          | —           |       | (3,634           | )          |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cash flows from financing activities:                                             |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cash flows associated with financing of the  recapitalization (Note 2): |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Proceeds from issuance of common stock                                            |       | 436,050                          |       | —                       |       | —                                |       | —                                    |       | —           |       | 436,050          |       |
| Treasury stock repurchase (including direct  expenses of $7,608)                  |       | (748,141                         | )          | —                       |       | —                                |       | —                                    |       | —           |       | (748,141         | )          |
| Proceeds from the issuance of new long-term  debt                                 |       | —                           |       | 1,050,000                    |       | —                                |       | —                                    |       | —           |       | 1,050,000        |       |
| Repayment of existing long-term debt                                              |       | (49,989                          | )          | (687,139                     | )          | —                                |       | —                                    |       | —           |       | (737,128         | )          |
| Debt issuance costs                                                               |       | —                           |       | (36,403                      | )          | —                                |       | —                                    |       | —           |       | (36,403          | )          |
| Debt issuance costs or other deferred  finance charges                            |       | —                           |       | (500                         | )          | —                                |       | —                                    |       | —           |       | (500             | )          |
| Borrowings (repayments) of other long-term  obligations, net                      |       | —                           |       | (25,000                      | )          | —                                |       | 1,680                                     |       | —           |       | (23,320          | )          |
| Equity contributions from exercise of stock  options                              |       | 63                               |       | —                       |       | —                                |       | —                                    |       | —           |       | 63               |       |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net cash used in financing activities                                             |       | (362,017                         | )          | 300,958                      |       | —                                |       | 1,680                                     |       | —           |       | (59,379          | )          |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Change in cash and cash equivalents                                               |       | —                           |       | (29                          | )          | (83,432                               | )          | 1,023                                     |       | —           |       | (82,438          | )          |
| Cash and cash equivalents:                                                        |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Beginning of period                                                               |       | —                           |       | 31                           |       | 90,985                                |       | 10,084                                    |       | —           |       | 101,100          |       |
|                                                                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| End of period                                                                     |       | $                                | —     |                         | $          | 2                                     |       | $                                         | 7,553      |             | $          | 11,107           |       | $ | — |   | $ | 18,662 |   |
|                                                                                   |            |                                  |            |                              |            |                                       |            |                                           |            |                  |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

22

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**SEALYMATTRESS CORPORATION**

 

**SupplementalConsolidating Condensed Statements of Cash Flows**

**Nine MonthsEnded August 31, 2003**

**(inthousands)**

 
| ** **                                                         | ** ** | **Sealy  Mattress  Corporation** | ** ** | **Sealy  Mattress  Company** | ** ** | **Combined  Guarantor  Subsidiaries** | ** ** | **Combined  Non-Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|------------------|------------|------------------|------------|
| Net cash (used in) provided by operating  activities               |       | $                                | —     |                         | $          | (2,388                                | )          | $                                         | 23,004     |             | $          | 8,698            |       | $ | — |   | $ | 29,314 |   |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cash flows from investing activities:                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Purchase of property, plant and equipment,  net                    |       | —                           |       | (224                         | )          | (8,074                                | )          | (1,039                                    | )          | —           |       | (9,337           | )          |
| Cash received from affiliate note and  investment                  |       | —                           |       | —                       |       | —                                |       | 13,611                                    |       | —           |       | 13,611           |       |
| Net activity in investment in and advances  to (from) subsidiaries |       | (88                              | )          | 18,308                       |       | 2,901                                 |       | (21,121                                   | )          | —           |       | —           |       |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net proceeds provided by (used in)  investing activities           |       | (88                              | )          | 18,084                       |       | (5,173                                | )          | (8,549                                    | )          | —           |       | 4,274            |       |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Cash flows from financing activities:                              |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Proceeds from issuance of long-term  obligations                   |       | —                           |       | 51,500                       |       | —                                |       | —                                    |       | —           |       | 51,500           |       |
| Prepayment of Tranche debt                                         |       | —                           |       | (49,000                      | )          | —                                |       | —                                    |       | —           |       | (49,000          | )          |
| Repayment of long-term obligations, net                            |       | —                           |       | (14,333                      | )          | (13                                   | )          | (410                                      | )          | —           |       | (14,756          | )          |
| Equity issuances                                                   |       | 88                               |       | —                       |       | —                                |       | —                                    |       | —           |       | 88               |       |
| Debt issuance costs                                                |       | —                           |       | (3,860                       | )          | —                                |       | —                                    |       | —           |       | (3,860           | )          |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Net cash (used in) financing activities                            |       | 88                               |       | (15,693                      | )          | (13                                   | )          | (410                                      | )          | —           |       | (16,028          | )          |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Change in cash and cash equivalents                                |       | —                           |       | 3                            |       | 17,818                                |       | (261                                      | )          | —           |       | 17,560           |       |
| Cash and cash equivalents:                                         |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| Beginning of period                                                |       | —                           |       | 28                           |       | 21,881                                |       | 5,534                                     |       | —           |       | 27,443           |       |
|                                                               |       |                             |       |                         |       |                                  |       |                                      |       |             |       |             |       |
| End of period                                                      |       | $                                | —     |                         | $          | 31                                    |       | $                                         | 39,699     |             | $          | 5,273            |       | $ | — |   | $ | 45,003 |   |

 

23

----

 

**SEALYMATTRESS CORPORATION**

 

**Item 2.   *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

***Merger and Recapitalization***

 

As more fullydiscussed in Note 2 to the Condensed Consolidated Financial Statements (Part I,Item 1 included herein), on April 6, 2004, Sealy Corporation completed a mergerwith affiliates of Kohlberg Kravis Roberts & Co. L.P. (“KKR”) whereby KKRacquired approximately 92% of Sealy Corporation’s capital stock.  Certain of Sealy Corporation’s currentstockholders, including affiliates of Bain Capital, LLC and others (the“Rollover Stockholders”), retained approximately an 8% interest in SealyCorporation’s stock.

 

In connectionwith the merger, Sealy Corporation paid off substantially all of itsoutstanding debt and accrued interest as of April 6, 2004 totaling $751.1million.  Sealy Corporation’s capitalstock outstanding immediately prior to the merger, except with respect to thoseshares to be retained by the Rollover Stockholders, was cancelled and exchangedfor aggregate cash consideration of approximately $740.5 million plus directcosts of $7.6 million.

 

SealyCorporation issued new Class A common stock to KKR in exchange for cash in theamount of $436.1 million, and the Rollover Stockholders retained their Class ACommon Stock in proportion to their respective ownership interests.  The Company issued new debt totaling $1,050million consisting of a new $125 million floating rate senior secured revolvingcredit facility with a six-year maturity (under which no amounts were drawn atthe time of the recapitalization), a new $560 million floating rate seniorsecured term loan facility with an eight-year maturity, $100 million under afloating rate senior unsecured term loan with a nine-year maturity, and $390million aggregate principal amount of new Senior Subordinated Notes bearinginterest at 8.25% due June 15, 2014.  OnSeptember 29, 2004, the Company completed an exchange offer whereby all of theSenior Subordinated Notes were exchanged for publicly traded, registeredsecurities with identical terms (other than certain terms relating toregistration rights and certain interest rate provisions otherwise applicableto the original senior subordinated notes).

 

In connectionwith the recapitalization, the Company incurred related costs and pre-taxexpenses totaling $177.1 million, including $36.4 million capitalized asdeferred debt issuance costs to be amortized over the respective terms of thenew debt, and $7.6 million of costs charged against additional paid-in capitalassociated with the repurchase of previously outstanding shares as notedabove.  The remaining $133.1 million ofexpenses resulted in a pre-tax charge against earnings for the nine monthsended August 29, 2004.  Included in thecharge were compensation expenses of approximately $53.8 million for the cashsettlement or non-cash rollover of stock options, management retention bonusesand the cancellation of an executive’s contract.  Also included were $11.8 million for thewrite-off of debt issuance costs and premiums associated with the previousdebt, and $20.4 million for the payment of premium and consent fees associatedwith the repayment of the previous public debt. The remaining charges represent other non-recurring charges primarily associatedwith advisory fees and expenses paid in connection with the merger andrecapitalization.  Of the total pre-taxcharge of $133.1 million, approximately $41.3 million were non-cashcharges.  Cash costs and pre-tax expensesconnected with the recapitalization, including the payment of certainpreviously accrued expenses of approximately $1.1 million, totaledapproximately $136.9 million.

 

***Quarter Ended August 29, 2004 compared with Quarter Ended August 31,2003***

 

*Net Sales.*    Net sales for thequarter ended August 29, 2004, were $357.3 million, an increase of $32.4million, or 9.9% from the quarter ended August 31, 2003. Total domestic saleswere $285.7 million for the third quarter of 2004 compared to $262.7 millionfor the third quarter of 2003. The domestic sales increase of $23.0 million wasattributable to an 11.5% increase in average unit selling price partiallyoffset by a 2.5% decrease in volume primarily attributable to higher shipmentsof floor samples during the third quarter of 2003. The increase in average unitselling price is due primarily to price increases implemented by the Company inMay 2004 to offset the effects of rising steel costs and an improved sales mixfrom the Company’s new Unicased® Posturepedic andTripLCased® Stearns & Foster lines.  Also, net sales for the quarter ended August31, 2003 were reduced by the effects of price roll-backs on existing productsin conjunction with the roll-out of the new product lines.  Total international sales were $71.5 millionfor the third quarter of 2004 compared to $62.2 for the third quarter of 2003.The increases of $9.3 million,or 15.0%, was primarily attributable to volume gains in Canadian, European, andLatin American markets and favorable currency fluctuations in the Canadian andEuropean markets.

 

*Cost ofGoods Sold.*    Costof goods sold for the quarter, as a percentage of net sales, decreased 3.8percentage points to 54.3%. Cost of goods sold for the domestic business, as apercentage of net sales, decreased 4.7 percentage points to 52.3%. Thisdecrease (as a percentage of net sales) is due to the increase in average unitselling price as discussed above, as well as improved manufacturing efficiencyand cost-effective design for the new product lines, partially offset byincreased steel costs. Cost of goods sold for the international business, as apercentage of net sales, decreased 0.9 percentage points to 62.1%. Thisdecrease is primarily due to manufacturing efficiencies in the Canadian andEuropean operations.

 

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*Selling, General, and Administrative.*    Selling,general, and administrative expenses increased $14.3 million to $119.9 millionfor the quarter ended August 29, 2004 compared to $105.6 million for thequarter ended August 31, 2003.  As apercentage of net sales, selling, general, and administrative expensesincreased 1.1 percentage points to 33.6% for the quarter ended August 29, 2004compared with 32.5% for the quarter ended August 31, 2003.  An increase of 1.1 percentage points was dueto a $4.0 million one time management bonus paid to the holders of SealyCorporation stock options in lieu of the cash dividend which was paid tostockholders in association with Sealy Corporation’s financing transaction (seeNote 17 to the CondensedConsolidated Financial Statements (Part I, Item 1 included herein)).  Other increases include: 0.7 percentagepoints due to higher incentive compensation for selling and administrativepersonnel resulting from improved performance against budgeted targets; 0.3percentage points for higher incremental consulting fees associated with a newproduct development process and Sarbanes-Oxley compliance; and 0.3 percentagepoints arising from increased workers compensation costs on closed plants.  These increases were offset in part by certaindecreases which include: 1.1 percentage points related to promotional and co-opadvertising and 0.2 percentage points for bad debt expense.

 

*Recapitalization Expense.*  TheCompany incurred approximately $0.4 million of additional recapitalizationexpenses in the quarter ended August 29, 2004 for the settlement of stockoptions and retention bonuses in connection with its merger with affiliates ofKohlberg Kravis Roberts & Co., L.P., completed April 6, 2004 (see *Merger and Recapitalization*).

 

*Royalty Income, net of royalty expense.*Royaltyincome for the three months ended August 29, 2004 increased $0.8 million overthe three months ended August 31, 2003. This increase was primarily due to anincrease in international royalty revenues.

 

*InterestExpense.*    Interestexpense decreased $0.3 million with lower effective interest rates offsettingincreased debt levels.  See also theprevious discussion in *Merger andRecapitalization* related to the recapitalization and its effects onthe Company’s debt structure.

 

*IncomeTax.*    TheCompany’s effective income tax rate generally differs from the federalstatutory rate due to the effects of certain foreign tax rate differentials andstate and local income taxes. In 2004, the rate has also been affected by certainnon-deductible expenses associated with the recapitalization.  The Company’s effective tax rate for thequarter ended August 29, 2004 was 30.6%. Excluding the effects of therecapitalization, the effective tax rate would have been 40.9%.  The Company’s effective tax rate for thequarter ended August 31, 2003 was 42.9%.

 

***Nine Months Ended August 29, 2004 compared with Nine Months EndedAugust 31, 2003***

 

*Net Sales.*    Net sales for thenine months ended August 29, 2004, were $992.0 million, an increase of $109.0million, or 12.3% from the nine months ended August 31, 2003. Total domesticsales were $793.0 million for the nine months of 2004 compared to $710.3million for the nine months of 2003. The domestic sales increase of $82.7million was attributable to a 5.0% increase in volume and a 6.4% increase inaverage unit selling price. The increase in average unit selling price is dueprimarily to price increases implemented by the Company in May 2004 to offsetthe effects of rising steel costs, and an improved sales mix from the Company’snew Unicased® Posturepedic and TripLCased® Stearns & Foster lines. Also, net sales for the nine months ended August 31, 2003 were reducedby the effects of price roll-backs on existing products in conjunction with theroll-out of the new product lines.  Totalinternational sales were $199.1 million for the nine months ended August 29,2004 compared to $172.7 for the nine months ended August 31, 2003. The increaseof $26.4 million, or 15.3% wasprimarily attributable to volume gains in Canadian, European, and LatinAmerican markets and favorable currency fluctuations in the Canadian andEuropean markets.

 

*Cost ofGoods Sold.*    Costof goods sold for the nine months ended August 29, 2004, as a percentage of netsales, decreased 2.3 percentage points to 56.2% compared to the same period in2003. Cost of goods sold for the domestic business, as a percentage of netsales, decreased 2.7 percentage points to 54.6%. This decrease (as a percentageof net sales) is due to the increase in average unit selling price as discussedabove, as well as improved manufacturing efficiency and cost-effective designfor the new product lines, partially offset by increased steel costs. Cost ofgoods sold for the international business, as a percentage of net sales,decreased 0.7 percentage points to 62.5%. This decrease is primarily due tolower material costs in Canada and manufacturing efficiencies in the Europeanand Canadian markets.

 

*Selling, General, and Administrative.*    Selling,general, and administrative expenses increased $36.3 million to $327.3 millionfor the nine months ended August29, 2004 compared to $291.0 million for the nine months ended August 31,2003.  As a percentage of net sales,selling, general, and administrative expenses were unchanged at 33.0% for thenine months ended August 29, 2004 and August 31, 2003.  An increase of 0.4 percentage points was dueto a $4.0 million one time management bonus paid to the holders of SealyCorporation stock options in lieu of the cash dividend which was paid tostockholders in association with Sealy Corporation’s financing transaction (seeNote 17 to the Condensed Consolidated Financial Statements (Part I, Item 1included herein)).  Other increasesinclude: 0.5 percentage points due to higher incentive compensation for sellingand administrative personnel resulting from improved performance againstbudgeted targets and 0.2 percentage points for higher incremental consultingfees associated with a new product development process and Sarbanes-Oxley compliance.  These increases were offset in part bycertain decreases which include:

 

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0.5 percentage points relatedto promotional, co-op advertising and national advertising; and 0.3 percentagepoints for bad debt expense.

 

*Recapitalization Expense.*  TheCompany incurred approximately $133.1 million of recapitalization expenses inthe nine months ended August 29, 2004 in connection with its merger withaffiliates of Kohlberg Kravis Roberts & Co., L.P., completed April 6, 2004(see *Merger and Recapitalization*).

 

*Royalty Income, net of royalty expense.*Royaltyincome for the nine months endedAugust 29, 2004 increased $2.0 million over the nine months ended August 31,2003. The Company’s domestic royalty revenues and international royaltyrevenues increased $0.9 million and $1.1 million over the first nine months of2003, respectively.

 

*InterestExpense.*    Interestexpense decreased $0.4 million with lower effective interest rates offsettingincreased debt levels.  See also theprevious discussion in *Merger andRecapitalization* related to the recapitalization and its effects onthe Company’s debt structure.

 

*IncomeTax.*    TheCompany’s effective income tax rate generally differs from the federalstatutory rate due to the effects of certain foreign tax rate differentials andstate and local income taxes.  In 2004,the rate has also been affected by certain non-deductible expenses associatedwith the recapitalization.  The Company’seffective tax rate for the nine months ended August 29, 2004 was 24.1%.  Excluding the effects of therecapitalization, the effective tax rate would have been 40.8%.  The Company’s effective rate for the ninemonths ended August 31, 2003 was 42.6%.

 

***Liquidity and Capital Resources***

 

The Companyintends to fund its ongoing operations through cash generated by operations andavailability under our new senior secured credit facilities. As part of therecapitalization, the Company has incurred substantial debt, including underour new senior secured credit facilities, the senior unsecured term loan andthe senior subordinated notes, with interest payments on this indebtednesssubstantially increasing our liquidity requirements.

 

The Company’snew senior secured credit facilities consist of $535 million outstanding undera term loan facility due in 2012 and a $125 million revolving credit facilitydue in 2010. At August 29, 2004, the Company had no outstanding borrowingsunder the revolving credit facility with approximately $95.3 million availableafter taking into account letters of credit issued totaling $29.7 million. TheCompany will be permitted to incur up to an additional $100.0 million of seniorsecured debt at the option of participating lenders, so long as no default orevent of default under the new senior secured credit facilities has occurred orwould occur after giving effect to such incurrence and certain other conditionsare satisfied.

 

Borrowingsunder the Company’s new senior secured credit facilities bear interest at theCompany’s choice of the Eurodollar rate or adjusted base rate (“ABR”), in eachcase, plus an applicable margin, subject to adjustment based on a pricinggrid.  On August 6, 2004, the Companyamended the senior secured credit facility to reduce the applicable margin by25 basis points.  On June 3, 2004, theCompany entered into an interest rate swap agreement effective July 6, 2004effectively fixing the floating portion of the interest rate at 3.725% on $200million of the outstanding balance under the senior secured term loan throughNovember 2005, declining to $150 million through November 2007.  To retain the designation of this swap as ahedging instrument, the Company must select the Eurodollar rate on the hedgedportion of the senior secured term loan during the term of the swap.  The term loan facility provides for quarterlyprincipal payments of approximately $1.4 million, beginning six months from theclosing of the facility with a two-quarter payment, with the balance of thefacility to be repaid at maturity in 2012. As of August 29, 2004, the Company had prepaid $25 million of the termdebt. Subsequent to the quarter ended August 29, 2004, the Company madeadditional prepayments of $20 million and $25 million on September 8, 2004 andOctober 7, 2004, respectively, partially funded by net borrowings ofapproximately $10.5 million under the revolving credit facility.  The Company has now effectively pre-paidsubstantially all principal payments due prior to the final maturity of thedebt in 2012.

 

The $100million senior unsecured term loan will mature in 2013 and will bear interestat the Company’s choice of the Eurodollar rate or ABR, plus an applicablemargin, subject to adjustment based on a pricing grid. All principal amountsoutstanding under the senior unsecured term loan are to be repaid at maturity.

 

Theoutstanding Senior Subordinated Notes consist of $390 million aggregateprinciple amount maturing June 15, 2014, bearing interest at 8.25% per annumpayable semiannually in arrears on June 15 and December 15, commencing onDecember 15, 2004.  On September 29,2004, the Company completed an exchange offer whereby all of the SeniorSubordinated Notes were exchanged for publicly traded, registered securitieswith identical terms (other than certain terms relating to registration rightsand certain interest rate provisions otherwise applicable to the originalsenior subordinated notes).

 

The Company’sfuture debt service requirements with respect to the total debt incurred inconnection with the recapitalization and outstanding at August 29, 2004 are asfollows (interest is estimated based on rates in effect at October 7, 2004):

 
| **Fiscal Year** | ** ** | **Interest** | ** ** | **Principal**     | ** ** | **Total**  | ** ** |
|-----------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **      | ** ** | ** **   | ** ** | **(in millions)** | ** ** | ** ** | ** ** |
| 2005            |       | $            | 61.6       |              | $          | —     |       | $ | 61.6 |   |
| 2006            |       | 61.6         |       | —            |       | 61.6       |       |
| 2007            |       | 61.6         |       | —            |       | 61.6       |       |
| 2008            |       | 61.6         |       | —            |       | 61.6       |       |
| 2009            |       | 61.6         |       | —            |       | 61.6       |       |
| 2010 and after  |       | 221.0        |       | 1,025.0           |       | 1,246.0    |       |
| Total           |       | $            | 529.0      |              | $          | 1,025.0    |       | $ | 1,554.0 |   |

 

As a result ofthe new capital structure, the Company’s*pro forma*estimatedannual interest cost is $68.7 million (including $4.3 million of amortizationof deferred debt costs) as compared with historical interest cost of $68.5million for the most recent fiscal year

 

26

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ended November 30, 2003, and *pro forma* interest cost for the nine months ended August 29,2004 is $51.4 million, as compared with historical interest expense of $51.2million for the nine months ended August 29, 2004.  The Company’s weighted average borrowing costfor the three and nine months ended August 29, 2004 was 6.6% and 7.4%,respectively, compared with 9.4% and 9.2% for the three and nine months endedAugust 31, 2003.

 

Futureprincipal debt payments are expected to be paid out of cash flows fromoperations, borrowings on our new revolving credit facility, and futurerefinancing of our debt.

 

The Companyexpects to spend an aggregate of approximately $25 million for capitalexpenditures in fiscal 2004.  The Companybelieves that annual capital expenditure limitations in our new senior securedcredit facilities will not significantly inhibit us from meeting our ongoingcapital expenditure needs.

 

The Company’scash flow from operations for the nine months ended August 29, 2004 decreased$48.7 million from the nine months ended August 31, 2003 to $(19.4) million,primarily due to $90.7 million of cash payments for expenses associated withthe recapitalization.  Excluding theeffect of the recapitalization, cash flow from operations increased $41.9 millionover the same period in 2003. Contributing to the improvement, before theeffect of the recapitalization, were higher operating margins, significantlyimproved collections on accounts receivable over the prior year, and reducedinvestment in inventory.  Theseimprovements were partially offset by higher interest payments in the first sixmonths of 2004, due in part to the payoff of debt in connection with therecapitalization, and also to the prepayment of interest late in the 2002fiscal year.

 

As a result ofdeclines in the value of assets held in the Company’s defined benefit pensionplan, the Company has recognized a $3.1 million aggregate minimum pensionliability at August 29, 2004.  TheCompany will be required to make minimum funding contributions of $0.3 millionduring the remainder of 2004 and $1.0 million during fiscal 2005.  The annual actuarial valuation of the plan,expected to be completed during the second half of 2004, may indicate the needfor additional minimum funding contributions to be made in late 2004 and into2005.  Any change in the aggregateminimum liability, beyond that attributable to normal pension cost for 2004,will be determined at the end of the Company’s fiscal fourth quarter and mayresult in a non-cash charge to other comprehensive income at that time.

 

The Companyhas approximately $1.1 million of accrued expenses associated with therecapitalization remaining to be paid at August 29, 2004.  The Company’s year-to-date loss resultingfrom the recapitalization expenses has generated approximately $16 million ofrecoverable income taxes which the Company may use to reduce tax payments orapply for a carry back refund in 2004 or 2005.

 

The Company’sability to make scheduled payments of principal, or to pay the interest on, orto refinance our indebtedness, or to fund planned capital expenditures willdepend on the company’s future performance, which, to a certain extent, issubject to general economic, financial, competitive, legislative, regulatoryand other factors that are beyond the Company’s control. Based upon the currentlevel of operations and certain anticipated improvements, the Company believesthat cash flow from operations and available cash, together with borrowingsavailable under the Company’s new senior secured credit facilities, will be adequateto meet the Company’s future liquidity needs for the remainder of 2004 andthroughout 2005. There can be no assurance that the Company will generatesufficient cash flow from operations, that anticipated revenue growth andoperating improvements will be realized or that future borrowings will beavailable under the new senior secured credit facilities in an amountsufficient to enable the Company to service its indebtedness or to fund otherliquidity needs. In addition, there can be no assurance that the Company willbe able to affect any future refinancing of our debt on commercially reasonableterms or at all.

 

As more fullydiscussed in Note 17 to the Condensed Consolidated Financial Statements (PartI, Item 1 included herein), on July 16, 2004, Sealy Corporation, the 100% ownerof the Company, issued $75.0 million aggregate principal amount of seniorsubordinated pay-in-kind (PIK) notes (the “PIK Notes”) and $37.5 million ofSealy Corporation common stock to certain institutional investors in transactionsexempt from registration under the Securities Act of 1933.  The PIK Notes accrue interest in-kind at 10%per year, compounded semi-annually. Sealy Corporation is not required to payaccrued interest on the PIK Notes in cash until maturity. The PIK Notes matureon July 15, 2015, following the maturities of substantially all other existingindebtedness of the Company and its wholly owned subsidiaries, including its$535 million outstanding senior secured term loan, $125 million senior securedrevolving credit facility, $100 million senior unsecured term loan and $390million senior subordinated notes.  Atmaturity, the outstanding principal amount of the PIK Notes, along with anyaccrued and unpaid interest, will be paid in cash by Sealy Corporation.  The Company intends to evaluate all potentialfinancing alternatives available from time to time in both the debt and equitymarkets and to optimize the capital structure over time based upon thesealternatives.  Such alternatives mayresult in an increase to the Company’s debt leverage or that of its parentcompany, Sealy Corporation.

 

The Company’snew long-term obligations contain various financial tests and covenants.  The Company’s senior secured creditfacilities require the Company to meet a minimum interest coverage ratio and amaximum leverage ratio. The indenture governing the Company’s new seniorsubordinated notes also requires the Company to meet a fixed charge coverageratio in order to incur additional

 

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indebtedness, subject tocertain exceptions.  The specificcovenants and related definitions can be found in the applicable debtagreements, each of which has been previously filed by the Company with theSecurities and Exchange Commission.

 

The covenantscontained in the Company’s senior secured credit facilities are based on whatthe Company refers to herein as “Adjusted EBITDA”.  In the senior secured credit facilities,EBITDA is defined as net income plus interest, taxes, depreciation and amortizationand Adjusted EBITDA is defined as EBITDA further adjusted to exclude unusualitems and other adjustments permitted in calculating covenant compliance asdiscussed above.  Adjusted EBITDA ispresented herein as it is a material component of these covenants.Non-compliance with such covenants could result in the requirement toimmediately repay all amounts outstanding under such facilities. While thedetermination of “unusual items and other adjustments” is subject tointerpretation and requires judgment, the Company believes the adjustmentslisted below are in accordance with covenants discussed above.  In addition, the Company bases its assessmenton the recoverability of its indefinite-lived goodwill on a multiple ofEBITDA.  The Company’s Board of Directorsalso uses EBITDA as a basis for determining the fair market value of the stockat the grant date for stock option issuances.

 

EBITDA andAdjusted EBITDA are not recognized terms under GAAP and do not purport to bealternatives to net income as a measure of operating performance or to cashflows from operating activities as a measure of liquidity. Additionally, theyare not intended to be measures of free cash flow for management’sdiscretionary use, as they do not consider certain cash requirements such asinterest payments, tax payments and debt service requirements. Because not allcompanies use identical calculations, these presentations may not be comparableto other similarly titled measures of other companies.

 

The followingtable sets forth a reconciliation of net loss to EBITDA and EBITDA to AdjustedEBITDA for the three months ended August 29, 2004:

 

| ** **                                                               | ** ** | **Three Months Ended  August 29,  2004** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------|------------|
| Net Income                                                               |       | $                                        | 20.4       |   |
| Interest                                                                 |       | 17.3                                     |       |
| Income Taxes                                                             |       | 9.0                                      |       |
| Depreciation & Amortization                                          |       | 6.1                                      |       |
|                                                                     |       |                                     |       |
| EBITDA                                                                   |       | $                                        | 52.8       |   |
| Recapitalization expenses                                                |       | 0.4                                      |       |
| Management fees paid to KKR                                              |       | 0.2                                      |       |
|                                                                     |       |                                     |       |
| Unusual and nonrecurring losses:                                         |       |                                     |       |
| Post-closing residual plant costs                                        |       | 2.7                                      |       |
| Bonus to option holders related to parent  company financing transaction |       | 4.0                                      |       |
| Other (various)                                                          |       | 0.2                                      |       |
|                                                                     |       |                                     |       |
| Adjusted EBITDA                                                          |       | $                                        | 60.3       |   |

 

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The following table sets forth a reconciliation ofEBITDA to cash flow from operations for the nine months ended August 29, 2004and August 31, 2003:

 

| ** **                                                     | ** ** | **Nine Months  Ended  August 29, 2004** | ** ** | **Nine Months Ended  August 31, 2003** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| Net (loss) income                                              |       | $                                       | (50.5      | )                                      | $          | 16.8 |   |
| Interest                                                       |       | 51.2                                    |       | 51.6                                   |       |
| Income Taxes                                                   |       | (16.0                                   | )          | 12.4                                   |       |
| Depreciation & Amortization                                |       | 18.3                                    |       | 16.7                                   |       |
|                                                           |       |                                    |       |                                   |       |
| EBITDA                                                         |       | $                                       | 3.0        |                                   | $          | 97.5 |   |
| Adjustments to EBITDA to arrive at cash  flow from operations: |       |                                    |       |                                   |       |
| Interest expense                                               |       | (51.2                                   | )          | (51.6                                  | )          |
| Income taxes                                                   |       | 16.0                                    |       | (12.4                                  | )          |
| Non-cash charges against (credits to) net  income              |       | 36.6                                    |       | 6.4                                    |       |
| Changes in operating assets &  liabilities.                |       | (23.8                                   | )          | (10.6                                  | )          |
|                                                           |       |                                    |       |                                   |       |
| Cash flow from operations                                      |       | $                                       | (19.4      | )                                      | $          | 29.3 |   |

 

In addition,the new secured credit agreements and indenture contain certain otherrestrictive covenants which will, among other things, limit the incurrence ofadditional indebtedness, investments, dividends, transactions with affiliates,asset sales, acquisitions, mergers and consolidations, prepayments of otherindebtedness, liens and encumbrances and other matters customarily restrictedin such agreements. Each agreement also contains certain customary events ofdefault, subject to grace periods, as appropriate. The Company was incompliance with all covenants as of August 29, 2004 and expects to remain incompliance for the remainder of 2004.

 

***General Business Risk***

 

The Company’s customersinclude furniture stores, national mass merchandisers, specialty sleep shops,department stores, contract customers and other stores. In the future, theseretailers may consolidate, undergo restructurings or reorganizations, orrealign their affiliations, any of which could decrease the number of storesthat carry our products. These retailers are also subject to changes inconsumer spending and the overall state of the economy both domestically andinternationally. The Company is dependent upon a single supplier for certainkey structural components of its new Unicased® design. Such components are purchased under a four-year supplyagreement, and are manufactured in accordance with a proprietary designexclusive to the supplier. Any of these factors could have a material adverseeffect on business, financial condition or results of operations.

 

***Forward Looking Statements***

 

This document containsforward-looking statements within the meaning of the safe harbor provisions ofthe Private Securities Litigation Report Act of 1995. Although the Companybelieves its plans are based upon reasonable assumptions as of the currentdate, it can give no assurances that such expectations can be attained. Factorsthat could cause actual results to differ materially from the Company’s expectationsinclude: general business and economic conditions, competitive factors, rawmaterials pricing, and fluctuations in demand.

 

**Item 3.   *Quantitative and Qualitative Disclosures About MarketRisk***

 

Informationrelative to the Company’s market risk sensitive instruments by major categoryat November 30, 2003 is presented under Item 7a of Sealy Corporation’s Annual Report on Form 10-K for the fiscal year ended November 30,2003.

 

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***Foreign Currency Exposures***

 

The Company’s earnings areaffected by fluctuations in the value of its subsidiaries’ functional currencyas compared to the currencies of its foreign denominated purchases. Foreigncurrency forward, swap andoption contracts are used to hedge against the earnings effects of suchfluctuations. The result of a uniform 10% change in the value of the U.S.dollar relative to currencies of countries in which the Company manufactures orsells its products would not be material to earnings or financial position.This calculation assumes that each exchange rate would change in the samedirection relative to the U.S. dollar.

 

To protect against thereduction in value of forecasted foreign currency cash flows resulting frompurchases in foreign currency, the Company has instituted a forecasted cashflow hedging program. The Company hedges portions of its purchases denominatedin foreign currencies with forward and options contracts. See also Note 11 tothe unaudited condensed consolidated financial statements.

 

***Interest Rate Risk***

 

As more fully discussed inNote 11 to the Condensed Consolidated Financial Statements (Part I, Item 1included herein) the Company had entered into two interest rate swap agreementsassociated with debt existing prior to the recapitalization.  Although the related debt was repaid inconnection with the recapitalization, the related swaps remain in effect andare scheduled to expire in December 2006. Because the first swap converted a portion of the Company’s floatingrate debt to a fixed rate and a subsequent swap effectively re-established afloating rate on the same debt, the effect of the two instruments on both cashflows and earnings is largely off-setting. As a result of the recapitalization and repayment of the related debt,$4.7 million of changes in fair value previously recorded in accumulated othercomprehensive loss were included in recapitalization expenses charged againstearnings during the three and nine months ended August 29, 2004 (see *Merger and Recapitalization*).  The combined fair value carrying amount ofthese swap instruments at August 29, 2004 and November 30, 2003 was a netobligation of $8.6 and $8.1 million, respectively.

 

The Company had also enteredinto an interest rate cap agreement associated with previous debt that caps thefloating rate on the debt at 8% through June 2005. The agreement also remainsin effect following the repayment of the related debt. This agreement has notbeen designated for hedge accounting and, accordingly, any changes in the fair valueare recorded in interest expense. The fair value of this instrument is notmaterial.

 

A 10% increase or decreasein market interest rates that affect the Company’s interest rate derivativeinstruments would not have a material impact on earnings during the next fiscalyear.

 

On June 3,2004, the Company entered into an interest rate swap agreement effective July6, 2004 effectively fixing the floating portion of the interest rate at 3.725%on $200 million of the outstanding balance under the senior secured term loanthrough November 2005, declining to $150 million through November 2007.

 

Based on the Company’svariable rate debt outstanding at August 29, 2004, a 12.5 basis point increaseor decrease in variable interest rates would have an approximately $0.8 milliondollar impact on the Company’s annual interest expense.

 

***Worldwide Steel Prices***

 

The world demand for steelover the last two years has increased due to a number of factors, includingincreased steel imports into Asia. Worldwide production has not been able tokeep up with the increased demand, due in part to decreased productive capacityin the United States. Furthermore, the weakening of the U.S. Dollar has raisedthe relative price of steel imported into the United States. Consequently, theCompany believes that the cost of cold rolled steel and steel drawn wire whichare used in the production of the spring units and other components within themattress and box springs will continue to increase significantly during 2004.In response to these increases, effective May 1, 2004, the Company increasedthe prices charged to its customers.  TheCompany does not believe that world steel prices or this price increase to ourcustomers will materially impact its long-term operations and financial position.

 

**Item 4.   *Internal Control and Procedures***

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we conducted an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended, as of the end of the period covered by thisreport (the “Evaluation Date”). Based on this evaluation, our principalexecutive officer and principal financial officer concluded as of theEvaluation Date that our disclosure controls and procedures were effective suchthat the information relating to the Company, including our consolidatedsubsidiaries, required to be disclosed in our Securities and ExchangeCommission (“SEC”) reports (i) is recorded, processed, summarized and reportedwithin the time periods specified in SEC rules and forms, and (ii) isaccumulated and communicated to the Company’s management, including ourprincipal executive and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

 

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**PARTII.  OTHER INFORMATION**

 

**Item 1.   *Legal Proceedings.***

 

See Note 14 to the CondensedConsolidated Financial Statements, Part I, Item 1 included herein.

 

**Item 4.    *Submission of Matters to a Vote of Security Holders***

 

None

 

**Item 6.    *Exhibits and Reports on Form 8-K***

 

(a)          Exhibits:

 

10.1               Amended and Restated Credit Agreement,dated August 6, 2004 among Sealy Mattress Company, Sealy Canada, LTD./LTEE, theGuarantors named therein, Sealy Mattress Corporation, Sealy Corporation,JPMorgan Chase Bank, as administrative agent, J.P. Morgan Securities Inc., asjoint lead arranger, Goldman Sachs Credit Partners, L.P., as joint leadarranger, General Electric Capital Corporation, as co-documentation agent, andRoyal Bank of Canada, as codocumentation agent, and other lenders from time totime parties thereto.

 

31.1               Chief Executive Officer Certification of theQuarterly Financial Statements

 

31.2               Chief Financial Officer Certification of the Quarterly Financial Statements

 

32                        Certification Pursuant to 18 U.S.C. Section 1350

 

(b)         Reports on Form 8-K:

 

Press release dated July 16, 2004 announcing the issuance of seniorsubordinated pay-in-kind notes and common stock by Sealy Corporation filed onJuly 16, 2004; Press release dated July 14, 2004 announcing financial resultsfor the fiscal second quarter ended May 30, 2004, filed July 16, 2004.

 

Report dated September 23, 2004 announcing the dismissal ofPricewaterhouseCoopers LLP as the Company’s independent registered publicaccounting firm and the simultaneous appointment of Deloitte & Touche LLPas its new independent registered public accounting firm, dated September 29,2004.

 

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**SIGNATURES**

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, Sealy MattressCorporation has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

SEALYMATTRESS CORPORATION

 
| **Signature**                                  | ** ** | **Title**                                             |
|------------------------------------------------|------------|-------------------------------------------------------|
|                                           |       |                                                  |
| /S/    DAVID  J. MCILQUHAM |       | Chief Executive Officer and President                 |
| **David J. McIlquham**                         |       | (Principal Executive Officer)                         |
|                                           |       |                                                  |
| /S/    JAMES  B. HIRSHORN  |       | Executive Vice President and Chief Financial  Officer |
| **James B. Hirshorn**                          |       | (Principal Accounting Officer)                        |

 

Date:October 13, 2004

 

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