Description

Lovesac Short

Summary: Lovesac (“LOVE”) is a recent JOBS Act IPO with material China manufacturing exposure and sales growth driven through opening mall-based showrooms. The company sells luxury beanbag chairs (“Sacs”) and high-end sectional sofas (“Sactionals”). The stock is pitched by management and bankers as an e-commerce/tech company, thus justifying an enterprise value to sales multiple as the appropriate valuation metric. However, e-commerce makes up only 20% of sales. Valuing this business like a traditional furniture retailer brings things back down to earth. We expect future equity raises, further selling by PE backers and possible inventory write downs. The transition to manufacturing outside of China will likely create additional stress on cash flows and the business. While the short was clearly more compelling in the $30s earlier this year, we still believe the fundamental issues have not changed. To us, Lovesac at $18 looks like a good short.

History

Lovesac was started by current CEO Shawn Nelson in 1995. Nelson went on to win reality TV show “Rebel Billionaire” with Richard Branson in 2005. Branson cut him a check for $1M to grow Lovesac. That likely wasn’t enough money, as the company filed for Chapter 11 in 2006. At the time, the company was primarily focused on high end beanbag chairs, or Sacs.

Fast-forward to 2018, and the company went public with Roth and Canaccord handling the offering.

Nelson owns minimal stock in this company. At the time of the IPO, over half of the stock was owned by two PE firms: Satori Capital and Mistral Equity. Combined, these two own 38% of the shares outstanding, after adjusting for the May 2019 secondary offering.

Business

Lovesac is a vertical retailer of luxury beanbag chairs and sectional sofas. They do not sell through wholesalers. The beanbag chairs retail for $350-$1300 depending on size, and their 3-seat sectional sofas retail for over $2,000. These are luxury items, with the targeted demographic being millennials making $100,000 or more.

Sactionals made up 72% of sales in 2018, with Sacs and other at 25% and 3%, respectively. The exposure to sactionals is increasing, thus increasing the risk for the company, as Sactionals are more expensive and are predominantly manufactured in China.

Despite generating $165M in revenue and $90M in gross profit, the company is currently not profitable.

The company does a pretty good job of trying to position themselves as a “tech” play. They frequently cite their “LTV to CAC” ratios being north of 4x. Good luck trying to reconcile how exactly they are calculating this metric.

We should also mention that Lovesac is currently paying management fees, to the tune of about $650,000 per year, to their PE sponsors. This (naturally) is added back to their adjusted EBITDA calculation.

At the end of the day, Lovesac is like any other cyclical furniture retailer, but worse. They are a two-product company: sectional sofas and beanbag chairs. The only way to continue to show growth is by opening more showrooms and spending more on marketing (targeted at 10-12% of sales). We believe they may already be approaching saturation within malls where their target demographic shops. They have 80 showrooms now, with plans to end the year at roughly 94.

China

There is a heighted risk of production issues in the near term. The company manufactures the Sactional product in China. They are actively trying to move production to Vietnam or other countries. The company is anticipating a 300-bps hit to gross margin this year, further accelerating cash burn. They expect full production to be out of China by the end of 2020. This will almost certainly create near-term issues, as moving furniture production is not easy. Furthermore, from what we gather, Vietnam is having major capacity issues. There is the potential for structurally lower gross margins going forward.

The Bull Case

Lovesac is growing topline, to be sure. However, under the rosiest projections and scenarios, this business is no different than any other furniture retailer.

Under a bullish scenario, we assume sales compound at 25% per year for the next 4 years, exiting fiscal 2023 at $404M in sales. At-scale peers (WSM, BSET, RH) generate EBIT margins around 7.5%. At a 7.5% margin, Lovesac would generate $30M in EBIT. At 10x that number, we’re at $300M in enterprise value. Its probably safe to assume they do nothing but burn cash between now and then, so EV = equity value.

$300M with 15M shares and warrants outstanding gets us to a $17 stock price…in 2023.

The bull case is clearly priced in. Layer on whatever discount rate you want to get a present value today. At a 10% discount rate, the present value today – again, under the bull case – would be $12, or 36% downside.

The Base Case

The base case is they continue to push on a string to try and grow sales. Cash burn accelerates as they attempt to open and remodel showrooms, spend aggressively on marketing and roll out new products.

Customer interest in their sactional sofas wanes, as millennials opt to buy nicer furniture made in the US or in other styles for equal or lower price points.

Sometime in calendar 2021, the company raises more equity. Yes, we recognize this is far off and cash does give them some protection. But again, to meet their aggressive growth targets, they have to raise and spend.

At a 15% sales CAGR and 5% EBIT margins, we think 2023 EBIT comes in somewhere around $15M. A 10x multiple, we’re at $150M. Shares rise from 15M to 17M on the back of an equity raise, getting us to a fair value of $8. Again, at a 10% discount rate, we’re at $5.60 in value today.

The Bear Case

The bear case is the most obvious. At the end of the day, this is a mall-centric retailer of two expensive, and possibly faddish, products. Consumers ultimately realize they can get something of much higher quality for the same or lower price. Again, a sectional sofa from Lovesac is $2,700! This is not a cheap product for value-conscious millenials.

With the CEO’s prior history, we think Chapter 22 could be a possibility down the road. Again, they have the cash now – which helps them. However, they have large – and growing – lease liabilities in their malls as well as continued cash burn.

Summary

In summary, Lovesac is a short for three reasons:

1.       The business is not driven by ecommerce, but instead through the opening of new mall-based showrooms. 68% of sales in the most recent quarter were from their mall-based showrooms. The company is also not profitable and will likely continue to need to raise capital. They have raised equity capital twice in the past 18 months. There are multiple capital needs for the business, all required to keep it growing.

2.       The valuation is very aggressive. Peers such as Williams-Sonoma or Bassett, in a good year, do around 8-10% EBIT margins. Even our most bullish projection still gets us a fair value – today – of $12. 

3.       The PE and warrant overhang will likely put near-term pressure on shares. Satori and Mistral, after a recent secondary, still own 38% of the shares outstanding. There are 1M warrants outstanding with a $16.83 strike price that will also lead to some overhang on the stock. And again, despite founding the company, Shawn Nelson owns practically no stock.

Bonus

CEO Shawn Nelson has a pretty interesting Youtube channel. For an illuminating look into the IPO process with Roth, see this: https://www.youtube.com/watch?v=9eDgUWX6xgE

Catalyst

• Continued gross margin compression as production shifts out of China
• Slower growth
• Continued cash burn
• Additional secondary offerings from PE insiders
• Recession/further mall traffic declines