Description

This is a buy recommendation for Jennifer Convertibles, Inc. (“JEN”), the parent company of those ubiquitous Jennifer Leather and Jennifer Convertibles furniture showrooms. On November 22, JEN reported a stellar fourth quarter (as well as its full 2005 fiscal year results), reporting quarterly earnings of $2.6 million or $0.35 per diluted share (after an extraordinary item related to payment from a related private company, the reported quarterly earnings would have been about $0.28 per diluted store). At its current price of $4.25/share, JEN trades at a P/E of about six to seven times my projected fiscal 2006 earnings of $0.60 - $0.80 per share, a large discount to its furniture retailing peers. JEN has a proven model that relies on controlling costs, very efficient sourcing and logistics and catchy advertising, and I believe this model will continue to perform well and can be successfully expanded into other metropolitan-area markets.

JEN’s saga began in 1987 when the three founding partners sought outside capital to expand beyond their already highly successful New York metro-area model. The partners pursued two capital-raising routes, an IPO and geographically-specific limited partnerships. For its first seven years as a public company, the stock enjoyed growth-company success, rising from its $3.50 IPO price to over $20 in 1994 as the store count grew from just a handful to nearly 100 locations. At that point, the stock collapsed under a barrage of shareholder litigation and internal squabbles. As a result, JEN was abandoned by the investment community and has traded between $1 and $3 for most of the past decade.

At the time of the IPO in 1987 and the subsequent capital raise in the limited partnerships, the three founders and principal shareholders (their names are Greenfield, Love and Seidner) retained ownership of the company’s distribution facilities as well as the highly successful New York metro stores. This private company is called JARA Enterprises (“JARA”), and it is currently owned by Love’s estate.

In its public filings, JEN clearly and unequivocally disclosed these inter-company relationships and the potential for conflict.

In 1994, two events conspired to trigger the slew of lawsuits that consumed management’s attention for the next eleven years. First, the company was forced to disclose that it was financially responsible for certain liabilities (rent and inventory, for starters) at some of the stores owned by the various limited partnership; and second, allegations (among others) from outside directors that JARA’s profits from the warehouse and distribution operation exceeded what the Company would pay in an arm’s length third-party arrangement.

Around the time the 1994 lawsuits began, the three principals, realizing the gravity of the situation, took some concrete steps to resolve the conflicts. First, Fred Love (recently deceased) bought out Greenfield’s and Seidner’s equity in JARA for a $10 million note. Once Greenfield and Seidner were no longer involved in owning JARA, they planned to shift the management of the JARA enterprise (i.e., the warehouse-distribution facilities and the New York metro-area stores) to JEN. As time passed, however, Love, who was Greenfield’s brother-in-law, refused to surrender control over JARA or consider an outright acquisition of JARA by JEN and something of an internecine battle broke out between the factions.

Love passed away recently and JEN was finally able to settle the last of the lawsuits. Most importantly, as a result of the settlement of the lawsuits, JEN owns and has operating control of the warehouses and distribution facilities as well as virtual operating control of most critical aspects of JARA’s New York metro-area stores. JEN also has a long-term option to purchase JARA. I believe that with Love having passed away and his company essentially being run by his executor, it will not be long until JEN exercises its option to purchase the equity in JARA for $8 million. At that point, an estimated additional $20-$30M of profitable sales get added to the Company, and more importantly, the last vestige of the conflict that proved so problematic will be eliminated.

The Company
JEN operates the largest chain of sofabed specialty retail stores in the United States. Store count at fiscal year-end was 194, of which 170 are owned by JEN and the balance are owned or operated by JARA (the JARA stores operations are not consolidated on JEN’s financials). The description that follows is equally applicable to the New York metro-area JARA stores and the rest of the chain owned directly by the public company.

JEN sells a complete line of sofabeds and also sells sofas and companion pieces, such as loveseats, chairs and recliners. The merchandise is designed and priced to appeal to a broad range of consumers. Unlike a lot of furniture retailers who market exclusively to high, middle or low income consumers, JEN attempts to cover all income groups with a limited specialty product. The sofabeds and companion pieces are made by several manufacturers and range from high-end merchandise to relatively inexpensive models. In an interview some years ago, Greenfield said that JEN stores cater to both the bank president and the bank teller. JEN’s strengths are its showroom presentation, prompt delivery, competitive pricing and extensive advertising. I view the latter two factors, pricing and advertising, along with logistics (which is key when moving bulky couches) as most critical to the Company’s success.

Although each style of sofabed, loveseat, sofa, chair and recliner is generally displayed at stores in one color and fabric, samples of the other available colors and fabrics or leathers are available. To maximize the use of real estate and offer customers greater selection and value, JEN sells various sizes of sofabeds with various sizes of mattresses but displays only one size of sofabed at their stores. JEN also offers leather furniture in a number of different grades of leather and colors. The company generates additional revenue from sales of warranties and fabric protection, which is an important element of the marginal profits.



Operations

Operating expenses at JEN are under control after a two-year campaign. For the 2005 fiscal year, SG&A was $37.5 million, several million dollars below the levels of the past five years. The stores are very simple, efficient showrooms and annual capital expenditures are modest, ranging between $500K - $1 million.

Stores are typically staffed by a manager, one full-time salesperson and additional part-time salespersons (all of whose compensation is commission-based), depending on the sales volume and customer traffic of each particular store.

JEN has district managers throughout the United States. The district managers supervise store management and monitor stores within their assigned district to ensure compliance with operating procedures. District managers report to and coordinate operations in their district with executive management.

An inventory of approximately 70% of the items displayed in the stores, in the colors and fabrics displayed, is usually stocked at their warehouse facilities, which are described below. JEN typically, except in the case of financed sales, requires a minimum cash, check or credit card deposit of 50% of the purchase price when a sales order is given, with the balance payable upon delivery.

In fiscal 2005, JEN opened one new store and closed 20 stores. They do not anticipate opening any additional stores during fiscal 2006 and anticipate closing five to ten stores during fiscal 2006, including one, which was closed as of November 21, 2005. I believe this retrenchment is very positive going forward, as it eliminated markets where JEN could not achieve the economies of scale for its distribution and logistics and local advertising campaigns.

Marketing

JEN advertises in newspapers, radio and on television in an attempt to capitalize on marketplace concentration. This approach to advertising requires them to establish a sufficient number of stores in each area. This concentration of stores enables area-advertising expenses to be spread over a larger revenue base and to increase the prominence of the local advertising program.

Sources of Supply and Branding

The principal suppliers of Jennifer sofabeds are Klaussner Furniture Industries, Inc. of North Carolina and Caye Upholstery, LLC in China. Klaussner also manufactures furniture under the Sealy® brand name. Sealy® brand name sofabeds are their largest selling brand name item, and Sealy® brand name mattresses are one of the largest selling mattresses in the world and have the highest consumer brand awareness. Caye manufactures under the Simmons® brand name. As a result, JEN is the largest sofabed specialty retailer and the largest Sealy® and Simmons® sofabed dealer in the United States.

Shift in Source of Supply

In addition to taking the hard step of closing a substantial number of unprofitable stores, JEN has successfully shifted to new, less costly sources of supply in China. JEN began this shift late fiscal (summer) 2003, and has steadily increased the volume of product as management became more comfortable with the quality of the merchandise and consistency of delivery and ironed out supply-chain glitches. As CEO Greenfield stated in the recent press release, “Our supply chain is now producing its expected results, allowing us to continue our strategic marketing direction in which we provide customers with incredible value at low prices without impacting our margins. This strategy incorporates our decision to provide customers the lowest prices rather than providing them long-term deferred payments which drive up retail prices to consumers. We continue to see the benefit of this strategy by increases in written sales.” Previously, JEN was highly dependent on North Carolina-based Klaussner Furniture Industries, Inc. (“Klaussner”). The shift to Chinese factories over the last 2 years has been critical to controlling COGS and getting back to consistent ~30% gross margins.


Store Closures

During fiscal 2005, the Company closed twenty stores and opened one. I believe the stores that were closed were in markets where management felt they could not achieve critical mass for distribution logistics or advertising. Critical mass is important for two reasons: First, logistics, because most of the supply of merchandise arrives in containers from China, it is necessary that each container be delivered full to a metropolitan area so it can be cost effectively unloaded and delivered. It is also important to have a continuous flow of merchandise to a geographic area in order to maintain adequate inventory levels and thus insure timely delivery to the consumer. While smaller competitors can buy the less expensive Chinese goods, they cannot obtain anywhere near the full cost savings, in-stock inventory levels or efficiency of delivery to the customer unless full containers of merchandise are delivered frequently to the local distribution center. Second, as noted above, JEN needs at least 4-6 stores in an area (sometimes more) in order to cost-effectively advertise in that area.


Management

The management team is experienced and long-lived with the company. Greenfield and Seidner, in their early 60’s and 50’s respectively, have been in the furniture industry their entire careers and with the company since inception. The three other senior executives, including President Rami Abada, all started with JARA in 1982.


Trademarks

JEN owns the registered trademarks, Jennifer Convertibles®, Jennifer Leather®, Jennifer House®, With a Jennifer Sofabed, There’s Always a Place to Stay®, Jenni-Pedic®, Elegant Living®, Jennifer’s Worryfree Guarantee®, Jennifer Living Rooms®, Bellissimo Collection®, and Jennifer Sofas®. These trademarks are well known and their is no other well-known name in sofabeds and convertibles except for “Castro Convertibles”, which has gone bankrupt and been liquidated and has not been a competitive factor for many years.


JEN is now in a sound position to generate the quality of results exhibited in the quarter which just reported ($0.28/shr. on sales of $32.3 million and approximately 30% gross margin). The following building blocks are all in place for the first time in almost a decade:

- cost-effective purchasing of a majority of the inventory from Chinese factories;

- elimination of markets (through store closures) where JEN could not spread advertising costs over a sufficient number of stores and where full containers of merchandise from China could not be delivered;

- the reorganization of the relationship between the pubic and private companies such that the public company, which is five times larger, is essentially running the entire organization now; and

- final resolution of the myriad of lawsuits.

The last time JEN achieved mid-30%-type gross margins was in 2002, when it earned $11 million or $1.80/share. In fiscal 2006, JEN should earn .60-.80 per share. If it trades at a 20-30% discount to its peers because of its small size, it will still get at least an nine times earnings multiple, making it a $7 stock.

I believe that the recently reported fourth quarter will be the new norm for JEN in terms of COGS, SG&A and EBITDA margins. The money-losing stores have been closed, the Chinese supply chain is in place with its less costly merchandise and SG&A is very much in check. EBITDA margins of 6.5%-7% on sales of $115M-120M will produce $7M-8M EBITDA and close to $5M in reported income.

JEN is more than a turn-around story. It is emerging from hibernation. Having been abandoned many years ago by the investment community after being overwhelmed by conflicts of interest and resulting lawsuits, it is in many ways a phoenix rising from the ashes.

Catalyst

- Continued positive earnings momentum;
- Re-introduction of sell-side analyst coverage;
- Opening of new markets with sufficient critical mass;
- Acquisition of JARA, eliminating even the appearance of conflicts and all doubts on the part of even the most cynical, cautious investors and analysts. I have heard that some analysts would pick up JEN once the private company relationship and conflict was eliminated;
- A Chinese factory acquiring, or investing in, JEN.