Description

Executive Summary

Mattress Firm (“MFRM”) is the #1 mattress retailer in the US with 3,500+ stores (including Sleepy’s) and is a growth stock about to hit a wall. Led by an aggressive management team, the company pursued a very aggressive M&A roll-up strategy that tripled their store count in just 4 years with underwhelming results to show for it. In addition, underlying fundamentals are deteriorating, the mattress industry is reaching normalized levels and the emergence of new disruptive competitors (Casper) are all negative to the earnings power of the business. Coupled with an over-levered balance sheet of (4x ebitda or 6.2x lease-adjusted EBITDAR) and lofty valuation multiple, there is significant downside risk to MFRM’s equity value. I recommend shorting MFRM for 42% return and an attractive risk/reward of 4-to-1.

Bull Thesis: MFRM is a unit growth story where the company grows its store count and attains operating leverage on its overhead and advertising expenses causing EPS to hockey-stick upwards. Mattress sales have yet to return to pre-recession levels implying a long runway for growth. Growth stocks deserve a growth multiple of 20x or more P/E. 

Reality: store unit growth story mostly driven by expensive acquisitions rather than organic growth. MFRM has spent $1.3B+ on acquiring competitors that are margin dilutive and a troubled track record of integrating them and creating shareholder value.  Since 2011, the company has more than tripled revenue and store count yet ebitda margins have declined from 12.4% to 10.5% demonstrating negative operating leverage, not positive. Also, productivity of new stores is declining demonstrating that MFRM is running out of room to grow and is saturating its markets and cannibalizing itself. Lastly, the mattress market in the US is getting toppy leaving little runway for growth. Over-levered balance sheet leaves no room for error.

Investment Thesis Details:

1.       MFRM’s “unit growth story” is hitting a ceiling and store-level fundamentals are declining. The two are related.

a.       “Same store sales comps” are driven by price, not unit sold. Units have actually been flat to negative for the last 5 quarters. (-3.6%, -6.4%, -0.5%, 0.0% and -4.9% in 4Q 2015).

b.       In 2Q and 3Q, management raised revenue guidance on new store additions but not earnings admitting that new stores are not profitable.

c.       MFRM is running out of room to grow and beginning to cannibalize itself.

                                                               i.      Productivity of new stores are declining (rev per new store: $910k in 2013, $835k in 2014, $814k in recent 3Q 2015).

                                                             ii.      17% of stores are within 1-minute drive from each other, 63% within 5 minutes.

                                                           iii.      Management admitted that at 3,500 stores, MFRM is 80% of the way to max capacity of 4,500.

                                                           iv.      On 4Q 2015 call, mgmt announced plans to evaluate closing stores due to oversaturation.

2.       Market underestimates MFRM’s profit exposure to oil related geographies that are experiencing slowing sales.  These stores are 8% of revenue but are higher margin, so ~15-20% of company-wide profits.

3.       Industry is reaching normalized levels: Bulls view MFRM as a levered play on housing which has yet to return to pre-recession normalized levels, however, I believe we’re already there. In 2015, 21.1m mattresses were sold vs. my estimate of normalized mattress sales of ~23.2m mattresses (10-year average plus population growth) so we are already 90% there. The remaining 10% can be explained away as industry sources cite that the lower-end mattresses segment has been slow to recover. Other industries cite the same trend (lower end consumer spending yet to rebound from recession). Even if this does snap back, MFRM participates in the higher end so won’t capture this benefit.  

4.       Poor M&A Track record:

a.       2014 deals: spent $500+m to buy 9 companies and 668 stores. Acquired companies were earning 400bp lower margins than MFRM. Integrating these stores have been problematic (e.g. Chicago banner issues, Mattress Pro failure) and have yet to yield results and are only diluting margins.

b.       Sleepy’s deal: expensive price tag for underperforming asset, adds significant balance sheet risk and huge execution risk. Deal pricing issues are symptomatic.

- Deal details: $780m deal (closed Feb 5, 2016) for $70m ebitda and 1,055 stores.

- Lofty price: ~11x pre-synergy ebitda (7x post $40m synergies), $740k/store (vs. previous deals ~$500k).

- Underperforming asset: Sleepy’s has experiences zero same store sales growth since 2010, stores are 10% less productive than MFRM stores ($1m vs $1.1m) despite being 20% larger foot print (5,600 sq ft  vs 4,800 sq ft) and located in more affluent demographics (NYC and Boston footprint). Stores are only earning 6.5% EBITDA margin too so deal is also margin dilutive.

- Deal pricing issues: management had been offered committed financing when announcing the deal November but didn’t take it. They ended up closing the deal at higher cost of capital (repriced the entire term loans up by 100bps and issued 1.7m shares of equity). Ouch.

5.       Online disruption risk is real. Casper, Tuft & Needle, Leesa, Saatva, etc. have all entered the mattress industry with a direct-to-consumer (“DTC”) product offering designed to disrupt the cumbersome mattress retailing business while earning the same 60% product margins but with less overhead and rent expense. They’re offering foam mattresses (no spring) shipped in a box to your door no hassle free returns for only ~$800-1,000 per mattress. Combined, their market share is only ~2% or so but are growing at 40% q/q or ~300% per year. If they keep this up, they will have 10% share in just a few years. This is real for MFRM as ~35% of their mattress sales are in the sub $1,000 range. Online surveys show strong customer satisfaction for these products (appendix). The push back on online is that buyers need to try the bed in person before buying, however, a recent Stifel survey showed that 20% of mattress purchases were made online and 24% of customers made their purchase decision based on online reviews. Lastly, a few months ago, both Tempurpedic and MFRM acknowledged this DTC risk by announcing their own DTC mattress offering: Coccoon and Dream Bed. The bigger risk is if these competitors move up market and begin to offer premium mattresses to compete directly with MFRM’s pricier and higher margin dollar mattresses. 

6.       Other thesis points:  

a.       Misleading store economics: management brags about stores earning 100%+ ROIC and 1-year cash payback ($232k capex + $24k floor inventory vs $950k yr 1 revenue and 23-26% four wall margin). However, these figures do not take into consideration advertising expenses, overhead expenses and taxes. Given that they have not been able to gain operating leverage on these expenses I think it’s prudent to add them in bringing store pre-tax ROIC down to only 20-25%.

b.       Very aggressive management team:  they’re aggressive in growing the company and are “empire builders”. Rumor is that they always wanted to buy Sleepy’s to become the first nationwide mattress chain. They’re also very aggressive with their accounting in adding back a number of “one-time” items to calculate “adjusted eps” and “adjusted ebitda”. They recently took this one step further by reporting “cash eps” where they add back all depreciation and amortization. The root of this is the fact that they’re compensation plans are based on growing “adjusted ebitda”. People will usually do what they’re incentivized to do and in this case they’re incentivized to build an empire and play accounting games.

c.       Corporate Governance concerns: In December 2015, a member of the Board of Directors, Ronald Mittelstaedt (CEO of Waste Connections) very publicly resigned signed citing concerns about the Board’s relationship with minority shareholder J.W.Childs and the true independence of its “independent directors”. In addition, in Feb 2015, three shareholders (Berkshire Partners, Stockbridge Investors and 40 North Management) whom own ~20% of the stock have voiced concerns about corporate governance and MFRM has recently appointed representatives of 2 of them onto the Board.

Business Description: MFRM operates 2,400+ stores plus another 1,000+ from recently acquired Sleepy’s across the entire country. They have a high concentration in the Southeast. The average MFRM store is ~4,800 sq ft and generates $1.1m revenue. As mentioned above, Sleepy’s stores are a little less productive but bigger. All stores are leased with average 5yr term. 90% of sales are mattresses, 10% are bedding, etc. Average mattress out the door ASP ~$1,000 and product margins ~60% so high markups. ~40% of sales are financed to consumers through a 3^rd party lending program.

Mattress Industry Info: The US mattress industry ~$14b in retail value and is expected to grow 6% next year. Since 2000, the industry has grown 5% a year mostly due to pricing. Mattress sales are cyclical and unit volumes declined 25% peak-to-recession-trough as mattresses are a large but deferrable purchase. There are a few key trends in the industry, more expensive specialty mattresses (ie. Memory foam) have been taking share from cheaper traditional mattresses and specialty retailers like MFRM have been taking share from traditional retailers like dept stores. In addition, advertising dollars is the major driver of sales as it creates urgency for customers to buy since it is a deferrable purchase.

Investment Risks: Heavily shorted (16% SI, 12 days-to-cover). Low take-out risk (no strategic buyer, can’t LBO)

Path-to-Value: Economic slowdown -> customers defer purchases -> weak mattress sales. Reports miss and guide down.

Valuation:

I modeled 3 scenarios (Bull, Base, Bear) and valued the stock using both a P/E and EV/EBITDA basis. See below. I believe a multiple of 12-14x P/E is conservatively warranted for a company that has hit a “growth wall” with significant balance sheet risk. This is a discount to historic average of 19x but appropriate for the aforementioned reasons. Looking at other specialty retailers that have tripped over themselves with an over-levered acquisition of a competitor (e.g. Tailored Brands), I can see this stock trade down 10-11x. So relatively speaking, my valuation multiples are conservative. 

Model output:

Bull 2017 eps and ebitda: $3.27, $413m. P/E and EV/EBITDA multiple: 14x, 7.5x. Pricew Target: $46

Base: $2.760, $375m. 13x, 7x. $34

Bear: $2.20, $342m. 12x, 6.5x. $24 for 42%  downside. 

Finally, in a draconian scenario I can see MFRM stock price decline below my Bear case price target. If consumer spending really slows, same store sales can turn negative. Then, advertising and promotion expenses will increase to help combat this issue causing gross margin and operating margin to decline erode drastically. In these conditions, ebitda could decline dramatically and dangerously close to the 5.25x debt-to-ebitda covenant in their term loan. MFRM stock will nose dive. 

Catalyst

Economic slowdown -> customers defer purchases -> weak mattress sales. Reports miss and guide down.