Description

MFRM trades for ~14x forward P/E while the company can compound EPS at more than 30% per year. The stock has dropped ~30% over the last month following a disappointing earnings report, and the short-term issues are presenting a very compelling long-term buying opportunity.

The Case

           MFRM is the #1 player and leading consolidator within the mattress retail industry. The mattress industry grew at a ~6% annual CAGR over the 25 years predating the housing bubble, supported by 2% unit and 4% ASP growth. After softer results in recent years, current sales are well below this trend, suggesting pent up demand and a potential catch up to normal levels in the coming years.

            As the largest player by far in an industry comprised of many mom-and-pop operators, MFRM enjoys scale advantages over smaller players. The company’s business model is focused on achieving local density within each market, leading to the ability to leverage advertising and distribution costs better than peers, and creating a competitive advantage. We do not dispute that the mattress industry has low barriers to entry (limited capital for stores and ample vendor product financing), but we do believe that there are meaningful barriers to success for new entrants given MFRM’s dominant national scale and local density. MFRM simply buys products cheaper than new entrants and leverages its advertising spend and distribution network in a way a new entrant cannot.

MFRM has a well-defined growth strategy to build out existing markets and move into adjacent ones that lack a dominant incumbent. New stores have strong unit economics and prior to the Sleep Train acquisition which has distorted the figures, MFRM was generating ~20% after-tax ROIC.

The EPS compounding breaks down as follows: MSD comps (assuming modest catchup of pent-up demand) and new store growth should lead to LDD revenue growth. Margin expansion from leveraging fixed costs and reaping Sleep Train deal synergies will drive EBITDA growth in the high teens to low 20%s. With financial leverage and use of excess FCF, this translates to EPS growth of 30%+ per year. For this growth profile, you pay ~14x forward P/E.

At the company’s analyst day last week, management laid out a case for 20%+ EPS compounding. Even on these numbers, which we think are highly discounted and overly conservative, the stock is compelling at the current level. Having just been burned by a disappointing quarter and guidedown, we believe management set the bar quite low in the case it laid out. For instance, their case assumes no release at all of pent-up demand, no recovery in troubled oil markets, and margins in 2018 below the levels they achieved a couple of years ago while a much smaller company. And even on these assumptions, they get to 20%+ EPS compounding.

The causes of the recent stock decline were weak performance in oil-related markets, mistakes made in key sales events in the company’s fiscal second quarter, and losses incurred from a failed new value banner called Mattress Pro. The sales mistakes are correctable and we believe were simply part of the ebb and flow of managing the business; Mattress Pro is being shuttered and the losses will be behind us within a quarter. The oil markets may remain soft for some time, but we do not view this as a structural issue. Bottom line, we think the market is giving us an opportunity to own a best-in-class market-leading retailer at a very attractive price for the long-term due to these short-term issues.

Company Background Info

            MFRM was founded in 1986. In 2002, Sun Capital bought the business from Sealy/Bain. In 2007, Sun sold to JW Childs for $450mm. In November 2011, JWC took MFRM public, maintaining 66% ownership in the Co. Note that the mattress industry has a lot of PE involvement (i.e. Serta/Simmons owned by Advent, Sleepy’s owned by Calera). Today JWC owns 37% of the company, and mgmt/insiders own another 6%.

            The company has a strong reputation within the industry as a best-in-class operator. They are known to employ a heavily data-focused approach to the business – see the recent analyst day presentation for detailed discussion of even how they approach talent management. CEO Stephen Stagner has been in his role since 2010 and was previously COO from 2005-2010.

Industry

            Overview: The mattress industry has been a stable and steady grower over time; population growth and a replacement cycle of ~10 years are basic underlying growth drivers. Since 1980, the industry has compounded revenue at a +5.4% CAGR, which had run at >6% prior to the downturn that began in 2008. The cycle-to-cycle growth rate of the cycles predating the housing bubble also comes in around 6%.

            Growth Drivers: Historical growth has been comprised of roughly +2% units and +4% ASP. Units have grown in excess of population for a few reasons: higher divorce rates, people buying 2^nd homes, and people buying bigger homes (guest bedrooms, etc). ASP drivers beyond inflation include mix shift to specialty foam-based mattresses and to larger mattresses. There continues to be an increased focus on how sleep quality improves health, which has contributed to people spending more on their mattresses. The favorable mix shifts appear to still have runway for growth.  Specialty was ~16% of units in recent years (vs 8% in 2004), while in many European markets Specialty has 40-50% unit share. Queen and King mattresses represent ~50% of units (vs 46% in 2008), while 76% of the US population is over 18 years old.  

            Where we are in the cycle: In short, we are below normal. From 1980-2003, the industry compounded revenue at +6.2% CAGR. Applying this growth rate to the 2003-2014 period implies that 2014 industry revenues were >25% below normal. Units sold in 2014 were roughly equivalent to the units sold in 1998 and imply a 0.3% CAGR from the midpoint of the prior cycle despite ~1% population CAGR over the period.

            OEMs: The OEM side is reasonably concentrated, and has recently become more so with Tempur buying Sealy a couple years ago. The two largest (Serta/Simmons and Tempur-Sealy) control 68% market share by revenue (37% and 31% respectively). Select Comfort is a distant third with 8% share. The majors have been share gainers over time; Tempur-Sealy and Serta/Simmons had only 55% of the market 10 years ago. Due to high shipping costs and relatively low direct labor expenses, the industry is largely domestic with minimal foreign import competition. Upstart online competitors like Casper and Tuft and Needle have miniscule market share currently, although they generate outsized attention from the news media.

            Retailers: The relationship between OEMs and retailers strikes a delicate balance; each critically needs the other (SCSS is the only major OEM that sells exclusively direct). More than 95% of mattresses sales occur in brick-and-mortar retail; 47% are sold in specialty mattress retailers, 34% at furniture stores, 5% in department stores, 9% other retail and 5% online.  Specialty has been the major share gainer; 20 years ago the mix was 19% specialty, 56% furniture, 11% department stores, 14% other.            

            On the retail side, the industry is much more fragmented than it is for OEMs, but MFRM is the largest, with mid-teens share of industry revenues. The top 5 retailers combined have about 35% share. MFRM has been a consistent share gainer both organically and through acquisitions.

Business Model

            Core Approach/Competitive Advantages: MFRM’s model is based on A) being the largest retailer nationally which affords strong purchasing power/negotiating leverage with OEMs, and B) achieving strong local density and dominant relative market share within a given market. Local density/high share allows for meaningful operational leverage of advertising and distribution costs. ~70% of MFRM stores are in what mgmt considers “fortress” markets in which there is at least one store per 90k population and MFRM is the #1 player. In the most penetrated of these markets, MFRM has historically been able to achieve >20% market-level EBITDA margin (company-wide margin is ~10%).

            ROIC/Unit Economics: In FY10-FY13 (prior to Sleep Train acquisition), MFRM achieved ~20% after-tax ROIC. Stores are leased and there is relatively minimal capital needed (small receivables balance and vendors support inventory – there is actually negative net working capital). Unit economics on new stores are attractive. The maturity curve is steep – in year 1 the stores generate ~$1mm in sales (>90% of a mature store). Stores require minimal capital (~$210k/store) given the vendor support and minimal build out. On a 4-wall basis, stores return initial cash back within first year.

            Cost Structure: MFRM should be able to generate margin expansion as it grows given some fixed cost components (rent, distribution and corporate overhead). Advertising expense is partially subsidized by OEMs through cooperative ad campaigns (ie a Tempur ad that highlights a deal available at MFRM). MFRM’s relatively low OPM, even given its purchasing and local density advantages, suggests that smaller players may find it difficult to generate profits competing with MFRM.  

            Company Overview: MFRM has ~2,300 stores (>90% owned, minority franchised) in 42 states.  Texas represents 19% of the store base, Florida 13% and California 8%. Stores do ~$1.1mm of annual revenue per store on average. Mattresses comprise 91% of sales, furniture/accessories 7%, and delivery fees 2%.

            Store Specifics: Typical stores carry 75 different conventional and specialty mattresses, with the two major OEMs supplying ~78% of mattresses sold. MFRM has a small private label business that it is attempting to grow. Products range from a $49 twin spring mattress to a $9,000+ king specialty set. MFRM overindexes on specialty (~45% of MFRM revenue vs ~30% for industry). In nearly all markets a single distribution center services all stores. A high percentage of deliveries are made on the same-day as the mattress is purchased, and MFRM disposes of the customer’s old mattress.  

            Acquisitions: MFRM has grown from a combination of acquisitions and organic store openings. Acquisitions are both to increase existing local density and to expand into new markets. MFRM completed nine separate acquisitions between December 2013 and December 2014 and seems to have bit off more than it could chew. These deals included Sleep Train, previously the third largest specialty retailer in the country with significant presence on the West Coast, Back to Bed (primarily Chicago), and Sleep Experts (Texas). The Chicago deal has been particularly problematic though management now appears to be stabilizing these stores. By all accounts, Sleep Train (the company’s largest deal ever) has been progressing well. The company has a self-imposed moratorium on new deals through the end of this year as it digests all of these past deals. We don’t count on future deals for our case but they could represent additional incremental upside.

            Balance Sheet/Cash Flow: MFRM has $715mm of gross debt, all of which is in a credit facility that matures in 2021 (L+425). This represents 3.1x debt/EBITDA (~5.6x adj debt/EBITDAR) and there is ~7x EBITDA/interest coverage. Despite the rapid organic store growth, FCF has been positive the last six years.

Risks

            Online/Showrooming: ~5% of mattress sales today are done online, and this figure has grown from roughly zero ten years ago. As a high price, seemingly commoditized item, on the surface mattresses appear ripe for online competition. There are a few reasons why although online is likely to continue to take share, the rate of change should be relatively slow and ultimate share not substantially damaging for MFRM. A) Customers like to lie on and test out the products, so they are drawn into stores – and buying a $1,000 mattress is fundamentally different from buying a $60 pair of shoes; B) Customers cannot find the same product cheaper online. This is because both the OEMs enforce MAP pricing and because OEMs develop specific product names for each retailer, so there is limited direct product comparison transparency. C) Delivery costs can be 10x or more for a retailer without a local DC; D) It is much harder to return a mattress you buy online (especially if you threw out your old mattress when you got the new one); E) MFRM can do same-day delivery for a significant percentage of orders.

Brick & Mortar Competition: With high ROIC and low capital intensity, the industry appears susceptible to new competition. The local density CA is a strong barrier against small new entrants; however it is possible that a well-capitalized competitor could encroach on MFRM’s markets or more likely their future growth markets. We think MFRM’s scale benefits vastly advantage it in the long-term though, and accordingly view any threats along these lines as temporary challenges.

OEM Consolidation/Vendor Support: The delicate balance of the retailer/OEM relationship and particularly the standing of MFRM as the market leader provide support here. If an OEM pushes too hard on MFRM, MFRM moves their mattresses to the back of store and directs customers to competition. We consistently heard from OEMs that they can only push so far, especially with their #1 retailer partner MFRM. We also consistently heard that OEMs are not in favor of any structural change in ad spend to move away from cooperative advertising with retailers; in fact, many are moving in the opposite direction.  

Macro: Although a steady industry over time, mattress purchases are high ticket and largely discretionary (at least the timing). In 2008 and 2009, the industry fell 9% each year and MFRM saw SSS down 24% in 2008 (due largely to overindexing on specialty). Thus a difficult macro environment can have material negative ramifications on the business in the short term. 

Disclaimer: This write up is not investment advice or a recommendation or solicitation for any fund or person to buy or sell any securities now or at any time. The author and related persons may hold a position in the securities discussed above and makes no representation that it will continue to hold long or short positions in the securities and disclaims any obligation to notify the market of any changes. You should not assume that an investment in the securities identified was or will be profitable.

Catalyst

Resolution of short term issues including Mattress Pro and merchandising errors