Description

Description

We know what you’re thinking … I need more volatility in my life right now! Can we interest you in revisiting a controversial stock that routinely trades +/- 5% per day, is up over 300% since the last time it was posted on VIC, but we think could still double again from here over the next 3 years?

Purple Innovation (PRPL) has been posted here twice in the past but we think it’s worth doing a quick refresh on the situation and an outline of our thesis as things stand today.

Rather than use this section to rehash an extensive business description/industry overview, you should read ahnuld’s well-timed Nov. 2019 write-up here for additional context: https://www.valueinvestorsclub.com/idea/PURPLE_INNOVATION_INC/9011508863

 And phn19’s original write-up from 2018 on the warrants here: https://www.valueinvestorsclub.com/idea/Purple_Innovation_Warrants/3195830816

Overview

Purple experienced a rocky start to life as a public company but 2020 marked a key turning point (for reasons we discuss below) and we think 2021 will prove to be another, ultimately resulting in an earnings inflection for the business in 2022+ that is still being (vastly) underestimated by the Street.

 First, a quick review of a few key things that have happened/changed since ahnuld’s late 2019 write-up:

1)      COVID … resulted in a massive (and still ongoing) acceleration of demand through PRPL’s DTC channel and the near complete shut-down of its wholesale/retail channel for several months

2)      Capacity expansions … PRPL brought online 2 new MaxMachines in 2020 and announced plans for a new manufacturing facility in Georgia where it will ultimately bring online 6 more MaxMachines (roughly 1 per quarter starting now in Q121). When fully ramped, we think this will take PRPL’s manufacturing from ~220k mattresses per year in 2019 to ~600k per year run-rate in 2022

3)      New retail partners … announced it had added Raymour & Flanigan (138 stores) in February and subsequently announced a big expansion in Canada by adding Sleep Country Canada in Q420 (280 stores) … PRPL ended this past year with product in nearly 2200 partner stores

4)      Industry supply constraints … Surging mattress demand and COVID-related disruptions left Leggett short on mattress coils; certain bedding foams were also in very tight supply during Q3 and into Q4, stretching out delivery times for nearly every major manufacturer except TPX and PRPL

5)      Patent transaction … PRPL announced it had acquired all the key patents for the Gel Matrix technology used in its  products from its founders (who held them in a separate entity). Now with the ability to exercise control over the patent enforcements, PRPL turned around and sued Intellibed for unauthorized infringements

6)      Share structure clean-up … announced a series of transactions that resulted in the warrants + Class B (Founder Class) shares being nearly all converted into Class A shares

Why does it matter?

The story is cleaner, the business momentum is clearer, the key constraint on growth (capacity) is lifting. At its core, our PRPL thesis from here comes down to just two things: (1) attractive growth runway and (2) underappreciated margin upside. On top of that, we’d suggest there are a few sources of upside optionality which we’ll briefly mention but don’t incorporate into our estimates – they would just be icing on the cake if any actually hit.

 We will bullet the key points below:

 (1)    Growth runway

a.       Retail door runway

  i.      PRPL started its life as a reasonably successful DTC-only mattress brand but it’s differentiated technology + premium price-point ($1000+) + still-low brand recognition + % of industry sales still driven by B&M specialty mattress retail convinced the company they had to have an in-store presence as well to gain trial/mass adoption

ii.      Largest specialty mattress retailer (Mattress Firm) took PRPL from a 50 store initial test in early 2018 to 850 stores today … total opportunity at MFRM alone is ~2500 stores

 iii.      Why did MFRM want to grow Purple? Our math suggest PRPL’s retail partners sold ~2 Purple mattresses/store/week in 2019

1.      This probably understates the true sales velocity if we were to look at just specialty mattress retail (MFRM is going to be better at selling Purple than Macy’s will be)

2.      According to our VAR w/ former MFRM Division President, that compares to a “very good” MFRM store selling ~14 total mattresses in a week (i.e. ~15% of the existing baseline) …

3.      Same VAR contact said PRPL had been a “home run” for MFRM (drove traffic; brought in attractive buyer demographic; high conversion rates; low return rates) and any mattress company that could drive ~2 incremental units per store week should be added to every store ASAP

 iv.      Overall, PRPL is now in ~1850 US stores (+280 Canada stores) vs. US specialty mattress/furniture store TAM of ~10k doors (<20% penetration); if we also include mass/club/department stores, total TAM is ~20k+ doors

 v. Conversations with management + subsequent VAR checks suggest that it could easily be more but PRPL is: (1) capacity constrained to add more and (2) wants to manage the mix of wholesale/DTC growth

 vi.      Over time, we think PRPL could end up in 4-5k+ doors (i.e. 2x+) and will continue to expand its own retail footprint as well (PRPL ~5 “showrooms” vs. SNBR ~580 stores, CSPR ~59, TPX ~38)

b.      Supply constraints are being resolved

  i.      Unlike all of its other DTC competitors, PRPL actually makes its own mattresses and even makes the equipment that manufactures that mattress (“MaxMachine”)

 ii.      Up until this year, PRPL had just one manufacturing facility in Utah, which had 5 machines capable of making ~40-50k mattresses each per year (~225k capacity)

iii.      While it may sound odd to call a business that will grow ~60% this year “constrained”, we think capacity has become a key limiting factor for the business

 iv.      In response, PRPL added 2 more machines to its Utah facility in 2020 (+40% incremental capacity) – ended the year with 7 machines

v. Management has publicly discussed adding 4 more machines in 2021 after they bring online their 2nd manufacturing facility in Georgia this month; if all goes to plan, they will bring online 2 more machines in 2022… all told this will result in 8 incremental machines added since 2019 or a ~160%+ increase in total capacity vs. 2019 YE capacity

vi.      Management has publicly said in the past that each new machine is capable of supporting $80-100mm of incremental revenue (with potential upside if mix improves)

1.      Math triangulates: ~50k mattresses per machine * $1800 ASP = ~$90mm revenue

2.      Furthermore, the payback math on these machines seems exceptional … our estimate is that they require ~$3-5mm of capex each … at $90mm of revenue per machine, ~45% gross margins, that implies a ~10x cash-on-cash return

vii.      These capacity additions provide visibility for PRPL to become a $1bn+ revenue business within the next 3 years

 (2)    Margin upside

a.       Gross margin% … ~45% today; up from ~40% in 2018 … we believe this can still go higher for several reasons:

                     i.      LfL product margins (industry typically takes some pricing every 1-2yrs)

  ii.      Product mix (PRPL is focused on stretching the product mix at the premium end … highest price mattress for PRPL is ~$3k today vs. peers at $5k+ … new model introductions have higher margins and we would not be surprised to see a new announcement on this during 2021)

 iii.      Lower returns (returns are a margin killer given the cost of removal/shipping/reselling … PRPL has been focused on driving down % of orders that are returned via customer service + manufacturing improvements … we think they are still ~10% today vs. best-in-class type benchmarks of ~4-5%)

iv.      Shorter shipping distances / lower freight costs (new plant in GA will significantly cut down the time/distance/cost needed to ship to East Coast customers)

v. Operating leverage on fixed costs of manufacturing (PRPL owns the assets … incremental volumes on that capacity will flow through to its bottom line at a much higher rate than most DTC peers who outsource all of their manufacturing to 3P providers)

vi.      Channel mix (+ / -)

1.      We estimate wholesale GM% are in the high 30s vs. DTC margins ~50% today … mix of wholesale vs. DTC growth is a big swing factor on margins

2.      One partial offset … there is probably room for wholesale channel margins to improve as PRPL gains scale with its retail partners

 vii.      Competitor GM% benchmarking (TPX 43-44%, SNBR 60-62%, CSPR 51-53%, EVE.LN 53-55%)

       1.      Something in the 45-50% range assuming a DTC mix of 60/40 or 70/30 seems achievable for PRPL

b.      EBITDA % … 8% margins in 2019, ~13-14% for 2020 (estimated)

 i.      Given its vertical integration strategy, we think “normalized” incremental margins should end up in the 30%+ range (2019 actual incrementals = 33% when there was no capacity being added)

ii.      We model 2021 incrementals to be well below this given the start-up costs to ramp the new Georgia facility but we see this trend improving into 2022 and normalizing into 2023

iii.      We think 2023+ EBITDA margins in the 17%+ range are not crazy

Risk/Reward Framing

If we’re right on most of the above, we see the potential for 2023 EPS of $1.80+ (vs. Street numbers closer to $1.25 today). If we get lucky, we see an upside path to $2+. The Street is expecting ~70c for 2020 by comparison.

Optionality

(1)    New product categories (already in progress … mattresses today are ~80% total revenue)

(2)    New channel opportunities (schools, hotels, etc.)

(3)    International opportunity … have talked about Europe previously but probably not on the near-term agenda

Catalyst

• "Clean" start-up of new Georgia facility
• Incremental new retailer placement announcements
• News on new production introductions (mattress and non-mattress)