Description

MFRM was founded in 1986 and has since expanded "across four time zone, with the goal of becoming the premier national mattress specialty retailer."   With its recent acquisitions, Mattress Firm has surpassed Sleepy's and Select Comfort as the nation's largest specialty bedding/mattress retailer.  Management expects to have nearly 1000 stores by the end of 2012, up from around 300 stores 6 years ago.  This rapid expansion has been achieved under the ownership of two separate private equity owners, Sun Capital from 2002 to 2007 and then JW Childs from 2007 to the 2011 IPO.  MFRM's growth has indeed been impressive and it's business no doubt benefitted from the expertise and pockets of its PE sponsors during the recent great recession that put many competitors into bankruptcy - which in turn gave MFRM the opportunity to rapidly acquire and expand into new markets.  The large drop in sales across the industry in 2008 and 2009 also provided a low comp base that has allowed MFRM to deliver a remarkable headline growth in the last couple years.  These and other factors led MFRM to price at the top of its IPO range in November; it's stock then proceeded to more than  double over the next 5 months. 

While their growth over the past decade has been impressive, the market seems to be missing the fact that this is still ultimately a low margin, undifferentiated, highly cyclical, capital intensive, and extremely competitive business and that MFRM's rapid growth and expansion occurred at an opportune time and that it will be increasingly difficult to replicate going forward.  The poor underlying fundamentals of the business have been masked recently by MFRM's aggressive new store openings and large acquisitions.  However, MFRM is already running into capex issues and despite management claims that all their growth will require no additional capital , their 10K filed in April states their 2012 capex plans are contingent on MFRM raising additional capital or amending their existing credit facility.  Insider lock-ups of over 27mm shares (80%+ of S/O) recently expired on May 15 and should provide additional downward pressure on the stock.

Bull Thesis

• MFRM is the superior operator in the space and will be able to achieve management's target of 2,500 stores by growing its existing markets and expanding into new markets through organic growth and acquisitions 
• Specialty mattress retailers have taken market share from traditional furniture retailers and department stores  - went from 19% market share in 1993 to 43% in 2010 - and will likely continue due to customer's preference for a wider selection and higher quality service
• More than 24 months of positive comp store sales growth with guidance for 10-12% growth in 2012 and remarkable growth in top-line revenue: 14% in 2010, 42% in 2011, and 50%+ in 2012E
• Recent Mattress Giant acquisition will solidify their market share dominance in Texas and Florida

• Low capex growth requirements: cash on cash payback on new stores of less than a year

• Not susceptible to "Best Buy showroom effect" because of the product's "touch and feel" nature

Short Thesis

• The market is highly competitive with low/no barriers to entry

MFRM's recent expansion has not gone unnoticed and competitors aren't happy as furniture retailers love mattresses.  They are typically higher margin than other pieces of furniture and are easier to store in warehouses and deliver.  There is actually a growing trend where furniture stores are opening their own mattress only specialty store to make sure they are getting a piece of the pie too. 

One aspect management regularly touts is their cash-on-cash payback on new stores of less than 1 year.  The low cost of opening mattress stores is actually the opposite of a competitive advantage because it lowers barriers to entry and its one of the major reasons that the market is so fragmented and also explains why mattress stores have been able to gain 43% market share.  In many cases, suppliers will help carry inventory and provide advertising while manufactures will provide up front cash to help mattress stores expand so that they can gain placement in new stores. 

These huge incentives are what have caused many  major markets to become saturated with multiple bedding stores literally right down the street from one another.  MFRM's former CEO Gary Fazio was actually quoted saying, “It’s not expensive to open a specialty (mattress) store, and, if you do some volume, the payback is fairly quick—certainly under two years,” Fazio said. “Since most retail doesn’t have that kind of return, you have a proliferation of specialty stores.”

In addition, MFRM's claim of earning back its investment in less than a year is misleading as it uses a metric they call 4-wall profitability which includes one-time vendor incentives for opening a new store and excludes a variety of costs that are crucial to a store's operations including advertising, warehousing and other management and overhead related costs.   

• MFRM's recent acquisition of Mattress Giant is in a completely different league than their previous acquisitions

Regardless of whether management's claims of having a long track record of successful acquisitions is true or not (their overall rapid store growth makes it hard to isolate the impact of prior acquisitions), the Mattress Giant acquisition is a completely different beast.  First, the sheer number of stores acquired completely eclipses any previous transaction:  55 stores acquired in November 2011 plus 180 acquired in April 2012 = 235 Mattress Giant stores to integrate vs. their next largest acquisition of 36 Mattress Pro stores in November 2007.  Second, MFRM previously used acquisitions to branch out into new markets, but the most recently acquired 180 stores are in Texas and Florida, which are already oversaturated markets where they have 240 existing stores.  Third, the last two large acquisition targets that MFRM was interested in ended up going bankrupt.  To their credit, MFRM pulled out of both deals but those examples further highlight the inherent risks in this Mattress Giant deal that we believe the market is ignoring.

• The industry is extremely cyclical and brand value, name recognition, and long operating histories have proven to be of questionable value and haven't prevented some of the biggest names from going bankrupt

Ultimately, there is nothing proprietary about Mattress Firm's stores - they sell pretty much the same brands of mattresses that other stores sell, their size and layout are comparable, and their salespeople are just as highly motivated as any other commissioned salesperson.  Management has even admitted that consumers are becoming more prepared and knowledgeable for the shopping experience by researching online beforehand; and because comfort is so subjective everything will come down to each person's personal preferences and price.

MFRM has a book value of 224mm but zero tangible book value as it has over 375mm in goodwill and intangibles.  So if there's no brand loyalty and no proprietary technology, what exactly is the value in all that goodwill/intangibles?

In March 2007, MFRM signed a letter of intent to acquire Mattress Discounters ("MD") and its 140 stores for as much as $80mm.  This was shortly after MFRM had changed PE owners from Sun Capital to JW Childs and MFRM had its eye set on becoming the nation's largest mattress retailer.  MD was the market leader in most of the areas where it had stores including Baltimore, Boston, Providence, Richmond, D.C. and New Hampshire.

Gary Fazio, the CEO at the time, declared "This acquisition allows Mattress Firm to enter several new, fast-growing markets and is another step in our overall expansion strategy that includes both organic and acquisition growth.  Mattress Discounters has developed a solid reputation and loyal customer following throughout the Northeast, and Mattress Firm is committed to carrying on this tradition." (emphasis added)

In May 2007, as sales began to slow, Mattress Firm pulled out saying the deal was not right for the company.  This was just 2 months after MFRM said that no layoffs were planned and that MFRM wanted to maintain all of Mattress Discounters' stores.  About a year later, Mattress Discounters began closing 50 of its stores in the New England area and by September had to file for Chapter 11 bankruptcy for the second time in the company's history.  A few months later, Mattress Discounters was sold to Roomstore for $4.5mm.  It turns out that the "new and fast-growing markets" and "solid reputation and loyal customer (base)" weren't all that valuable after all.

In September 2007, MFRM signed a letter of intent to acquire Mattress Gallery, a 53 store chain in LA.  This would be the companies first entry into the California market.  Again, CEO Gary Fazio extolled the "fast-growing Southern California market" and how fortunate it was that "Mattress Gallery has an established reputation in the markets it serves and has developed a loyal customer base by offering great products and exceptional customer service." In October, MFRM again pulled out of the deal and in November, Mattress Gallery filed for bankruptcy as well. 

There were obviously greater macro events unfolding at the time that contributed to Discounter and Gallery's declines and to be fair, MFRM did end up avoiding both those disasters.  My point here is that a "fast growing market" can quickly turn and that a "solid reputation" and "loyal customers" won't affect where consumers buy their mattresses.  A "loyal customer" doesn't even have much meaning considering the one-time nature of a mattress purchase.  So unless you think there's something extraordinarily unique in the Mattress Firm brand, or that they've really hit a goldmine with their brilliant "Comfort by Color" concept or their revolutionary "Racetrack" style store layout then a prudent investor would need to seriously question the economic value of MFRM's goodwill and intangibles. 

• Best Buy Showroom Effect

The CEO recently dismissed the idea that their stores could become susceptible to the "Best Buy showroom effect" where consumers come in to try out of the product and later just go buy it online for cheaper.  His argument was that mattresses are "a $1,000 ticket item, on average...It’s really a touch-and-feel product...So it’s not something that is easily sold like a book on the Internet."   I'm sorry but isn't that EXACTLY why I would go use your showroom to touch and feel and lie on the bed to decide what I wanted and then check my smartphone for a better price?  If I'm looking to buy a $20 book and see it while I'm at Barnes & Noble, the convenience factor of buying it and being able to read it immediately might prompt me to pay the extra $4 rather than wait for Amazon to ship it to me.  That's a completely different dynamic than saving $200 on a $1,000 mattress.  And how often does a person so urgently need to buy a new mattress that they won't shop around - the high ticket price makes it even MORE likely that buyers will do price comparisons online before buying.  It boggles my mind that his go-to example was a book because the urgency/convenience factor of buying a book vs. buying a mattress in store is completely in favor of the book.  I didn't even have to try to find an example where I could save 50% off a $1,000 mattress by buying it online vs. through MFRM:

$999 Serta Apple Valley King Set from MattressFirm.com: http://tinyurl.com/7sturpk

$499 Exact same set from MattressJoint.com: http://tinyurl.com/7tf99hg

I didn't even cherry pick that example.  I just went to mattressfirm.com and clicked their front page deal "ULTIMATE REBATE SALE" mattress.  Then I googled "Serta Apple Valley" and clicked on the first hit. 

• Insider lockup expiry

The insider lock up expired on May 15, 2012.  Management and JW Childs collectively own over 27mm shares or over 80% of total shares outstanding.  JW Childs has made ~10x its investment and is probably looking to exit and I'd bet management probably won't wait around either.  The increased liquidity should also alleviate borrow availability issues.  I suspect another reason the share price has remained inflated is that there are very few shares available to borrow. 

• Difficult to reconcile reported store metrics with recent Mattress Giant deal

MFRM claims that new stores require a net investment of only $170K and they expect net sales in the first year of $1mm. 

Management estimates "4-wall profitability" of 30% in the first year (but as mentioned that metric excludes multiple operating expenses) so lets assume net cash profitability is at least 17% so as to make back the CEO's "cash on cash payback of 1 year or less."  Then 2nd year net sales are estimated at $1.2mm - assuming similar net cash profitability - that means that the store generated a 220% return on capital in just 2 years.  If that's truly the case, why are they paying double ($340K) to acquire and rebrand 180 Mattress Giant stores that  have 75% of the net sales of the average MFRM store?  This wasn't a push into a new market as all the acquired stores are in Texas and Florida which are already MFRM dominated territories.  This reinforces our view that their actual operations are nowhere near as profitable as the reported "average" store metrics.  A 700+ store base is more than enough to demonstrate efficiencies and economies of scale and 2011 was a record year for MFRM with 20.5% comps but net profitability was still only in the mid to low single digits.  We believe this deal was an attempt to keep the market focused on their projected revenue growth while masking the low net profitability of the business as the deal makes very little sense from a return on capital perspective.  It's also noteworthy that management comp is focused not on ROC or actual profitability but on adjusted EBITDA which excludes goodwill impairments and any losses on store closings.  This incentivizes management to close deals like the recent Mattress Giant deal because they won't be penalized by future write-downs and store closure costs resulting from their overzealous expansion.  The easiest way to hit their adj. EBITDA bonus targets is to continuously acquire and open new stores which is exactly what they plan to do in 2012.  However...

• It will be increasingly difficult to grow as rapidly on a percentage and even absolute basis going forward

Much of their recent growth has been due to the resurgence in mattress sales over the past couple years coming off of an industry low in 2009.  During the great recession, MFRM was able to issue PIK bonds to fund its capex requirements and take share from undercapitalized competitors who were going bankrupt.  The recent Mattress Giant deal and plans to open another 100 new stores has led management to guide for a 50% increase in revenues in 2012 which can be attributed to a nearly 40% increase in store count and management estimates of 12% comp store sales growth.  2011 capex requirements were over 57% of 2011 EBITDA and management has guided to 2012 capex requirements that will exceed our estimates for 2012 EBITDA with $47mm already committed to the Mattress Giant acquisition plus $68mm planned for new store growth and rebranding costs.  Although the CEO has repeatedly stated that MFRM will not need external capital to expand, MFRM's planned capex in 2012 already exceeds the $40mm limit governed by their 2007 credit facility which means MFRM will need to either raise equity or renegotiate those terms.  This is less than a year after the amendment entered into in June 2011 that doubled the permitted capex limit from $20mm to $40mm. 

Valuation

Sleepy's is obviously the best comp to MFRM but is privately held.  The peers in the table are a mix of bed and furniture manufacturer and retailers.  MFRM trades at more than double the EV/EBITDA of its comp set while having significantly lower margins.  Bulls would argue that MFRM has greater growth opportunities than this peer set but as discussed we believe their current undisciplined growth strategy is actually an added risk to the business.  Their margins suggest that either the economics of their business are much worse than they claim or that they have been unable to effectively manage their growth and capture efficiencies thus far which would mean they should NOT be charging forward with even more expansion.

An example of where this expansion has resulted in quite literally mattress stores on every corner is Tampa, FL where MFRM will soon have well over 60 stores including the recently acquired Giant stores.  The explanation Tim Horton, the owner of Tampa Bay Discount Mattress, gave to the Tampa Bay Times was that so far "It makes economic sense to them. They've got to constantly keep opening stores to show growth. So as long as the store sells enough to cover the costs . . ." 

He also pointed out that the larger chains had locations with higher rents but could spread any potential losses over more stores. 

Risks

MFRM is able to keep the game going longer by acquiring another large retailer (Mattress Discounters is a possibility as their majority owner Roomstore recently filed for Ch. 11 and may be forced to divest its stake)

• However, Sleepy's was recently recapitalized by PE firm Calera Capital and should be prepared to bid against MFRM assuring us that the eventual victor will likely be plagued by the winner's curse of overpaying

The mattress industry delivers another record year in sales which allows MFRM to show big growth numbers and further justifies more aggressive expansion

• Only delays the inevitable this doesn't resolve their underlying profitability issues and mattress sales are notoriously cyclical and strong sales will only attract more and more competitors

Catalyst

Insider lockup expiry

Equity raise if credit facility isn't renegotiated

Mattress Giant stores not performing as expected due to oversaturation/cannibalization

Catalyst