Description

Purple Innovations is a GARP play. The company has a unique product that is patent protected, is growing sales at a 50% rate, and is showing incremental EBITDA margins of 32%, yet trades for only 8.6x 2020 EBITDA. I believe the company can trade to $13.50 per share in the next 12 months, which equates to 16x 2021 EPS on a fully diluted basis plus net cash. This equates to a 69% return in a year, so despite being a small cap the company is worth a look.

There are two main reasons that explain this low valuation. The first is the category. Purple is viewed as one of dozens of Bed-in-a-Box mattress sellers when in fact it is not. The second is the company went public as a SPAC. Like most SPACs, it was too soon, there was a big overhang of stock, and it was undercapitalized with a poor management team. Hopefully this brief write-up will explain why Purple is more than a Bed-in-a-Box company, and why the SPAC issues have been resolved.

Company Overview:

Note: for a fuller description of the company, you can read the prospectus filed last month, or read one of the initiation pieces that just launched this week. Raymond James did a pretty good job covering the main points. I just intent to cover some more value-add points on why I think Purple is cheap and misunderstood.

Prospectus Nov 2019

Purple started out life as a science project, morphed into a hyped up kickstarter campaign, became a SPAC with growing pains, and is now a well run consumer products company. Effectively, the company sells its patented mattresses called Purple Mattress. The material itself (called Hyper-Elastic Polymer) is what is unique and special, and this is patent protected for many years. The material lends itself very well for mattresses, and the selling points are exhibited in Purples famous egg test ad. Purple manufactures all of their products out of their facility in Utah.

Here’s the original  KickStarter campaign

Here’s their youtube ad with over 180mm views that gives a good demo of the product. This ad also launched the company into the mainstream 3 years ago. 

Purple Egg Test

With this the company began selling directly to consumers first on kickstarter and then on their own website, purple.com. As the company had no brick and mortar distribution, you could see why it would be mistaken for one of many bed-in-a-box companies. In fact, the company is much more similar to Tempur Pedic. The ASP for their mattress is targeted at a much higher price point that then majority of bed-in-a-box companies that compete on price. In Q2 2019 it was disclosed to be $1,701. This is up from $1,390 the year before, due to the company having expanded their product offering in late 2017/early 2018 to include thicker (in my opinion better) mattresses at higher prices points.

In late 2017 the company began testing with MattressFirm in select locations. Results were positive and the relationship expanded. Today Purple mattresses are sold at 1400 retail locations, and that number should end the year at 1600 at chains such as MattressFirm, Macys, Bed Bath and Beyond and Bloomingdale’s. 

You can see that Wholesale B&M has become the growth driver since that time, in the most recent quarter representing 42% of sales.

Its not surprising that the company’s results improved dramatically this year alongside the wholesale rollout. A few reasons why:

• ASP increase: Having 3-4 slots per floor, Purple is able to showcase their base mattress as well as their higher end mattresses. It is easier to get people to buy a $2,000 mattress when they can test it first rather than just see an ad with a good return policy.

• Better shipping rates: Shipping big mattresses across country from Utah is expensive. Especially when return rates are high and you have to pay for that expense. Shipping from 1400 retail locations is easy.

• Lower marketing spend: While wholesale has lower gross margins than DTC, Purple marketing spend as a percentage of sales will be 32% this year, 800bps lower than in 2017 as wholesale requires a lot less direct marketing investment than DTC.

• Lower return rates: Again, consumers are happier and exhibit lower return rates when they can try the mattress first.

I don’t want to say the entire DTC model is bad. There are advantages, like the higher gross margin. However, it is easy to see a two track distribution model being a better long term fit for this industry. Management gets that, and has guided to revenue eventually being evenly split between the two channels.

Casper is attempting to do brick and mortar themselves, with a goal of opening up to 200 of their own stores. WSJ article Capser store rollout

Honestly this makes no sense to me vs leveraging an existing retailers network and fixed cost structure. Purple intends to open a few showroom type stores in major GMAs, perhaps ending 2019 with 5 showrooms, but this is more for brand building purposes than to ever be a major channel.

Financials:

Here’s a quick snapshot of Purples financials and margins

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A couple points to discuss.

Revenue:

 I model Purples wholesale revenue based on a doorcount basis. I have the doorcount growing from 1600 at the end of 2019 to 2400 at the end of 2021. This may prove conservative. Tempur Pedic was sold in 7900 North American locations prior to the acquisition of Sealey. I also have a slight decline built into my sales per doorcount metric as they saturate the market. 

 DTC revenue is now growing again after the new management team made a conscious effort to pull back in early 2019. Last quarter DTC revenue showed 10% yoy growth. I have that continuing for 2020 and decelerating to 5% for 2021.

Margins:

Margins have improved dramatically since the new management team took over in late 2018. They brought with them a more professional background and the results are obvious. Part of the improvement as well is driven by the build up of the wholesale channel. Some main points:

Gross margin initially dropped off when wholesale was launched as the retailer needs their cut. However, given the improving operating performance and easy fixes management implemented in manufacturing it has recently been brought back up to 45%, with indications that it should stay there or move higher. As a sanity check TempurSealey currently does 40-42% gross margins with a greater weighting in wholesale. And when Tempur Pedic was a stand alone product, there were doing gross margins just above 50%. With an ASP of $1700 for Purple, 45% is attainable. 

Marketing expenses have come down as a percent of sales given the push into wholesale. In fact, stripping out some non cash charges this year, marketing would be about 31% of sales. Having it decline to 29% of sales in 2021 is in line with the wholesale segment continuing to grow as a percentage of sales.

Stock comp: I have it expensed above EBITDA (no EBITDAS here), and theres an unusual amount in 2019 driven by some behind the scenes movement in the founders holdings and linked holdings. It doesn’t actually increase the share count or add to future dilution, but the effect is a 12mm charge this year, which should drop to 3mm next year. 

Taxes: The company has NOLs that they will likely run through by the end of 2020.

EBITDA: These numbers get you to a company that was -17mm in EBITDA in 2018 (-5.1% margin) to positive 68mm EBITDA in 2021 (10.7% margin). 

EPS: On a dully diluted basis the company should do 69c in GAAP earnings in 2021. This assumes full conversion of the many warrants outstanding (SPAC warrants). The company will also have $2.50 a share in cash after that conversion.

SPAC structure:

The company went public in February 2018, only 2.5 years after their first kickstarter campaign. As with most SPACS, there was trouble from the get-go. The company was under capitalized with negative net working capital of 19mm for a business that generally needs positive working capital. This created issues with inventory not being sufficient and Purple quickly began missing their initial guidance.

The company also had no float. The 2 founders still controlled 80% of the stock held as non-trading stock. As well, hedge fund Coliseum capital bought up a large part of that 20% that was public, leaving true free float at a miniscule level.

Management was lousy. In fact the CEO quit a month after the SPAC listing occurred to pursue other opportunities, and the company was rudderless for 5 months until current CEO Joe Megibo was hired. In fact here’s Joe’s assessment of the state of Purple from his first conference call in November 2018

“So, what have I learned in my first 45 days on the job? Not surprisingly, like many high-growth companies still in their infancy, there are a lot of things that needed to be fixed, things that never had a chance to mature. Fortunately, we believe they are mostly execution-related and not core to brand or product. Nearly every operational part of the business has opportunities for maturing, which we believe means there's a ton of low-hanging fruit.

From a high level, Purple's issues have to do with operational inefficiencies that have put unnecessary pressure on   gross margins. This includes poor inventory management, shipping and delivery missteps, excess waste throughout the supplychain and immature corporate controls. And I don't say any of this lightly. Nearly all of my time so far has   been digging into the weeds in these areas.

And in addition to these core concerns, Purple's performance has also been negatively impacted by a lack of systems and processes a company of our size now need to operate successfully. For manufacturing and finance to sales andmarketing, the teams don't have all the tools required to properly plan and execute critical tasks”

New Management:

Here is a list of new people added to management in the past 13 months, finally equipping the company with proper leadership.

Joe Megibo: CEO, started Oct 2018. Formerly chief digital officer for American Eagle Outfitters. Prior to that senior roles at Expedia.

John Legg. COO, started January 2019. Formerly SVP logistics  and supply chain for Zales. Prior to that logistics Tory Burch.

Craig Phelps. CFO, started January 2019. Formerly MD at FTI consulting.

Verdi White. Chief Retail Officer, started April 2019. Prior work focused on real estate and construction for Ashley Furniture and others.

James Drake. SVP E-Commerce started July 2019. Formerly director E-commerce at American Eagle Outfitters. 

So far the year over year operational improvement is impressive and there should be more to come. From the Q3 2019 call a few weeks ago:

“Yeah. So, on the gross margin basis, a lot of the pickup that we've had this year has been from primarily efficiencies in production, some improvements in our delivery methods and our delivery partners. So, we've been able to increase production substantially without having a dramatic increase in labor, certainly not in overhead at the manufacturing facility. So, we expect the gross margin percentage to hold pretty strong or hold where it is now at a minimum.”

Valuation:

To start off, it is worth mentioning there are a large number of warrants outstanding due to the SPAC structure. Most of them are convertible at $11.50 and good until February 2023. There are also some warrants deep in the money with a $5.74 strike price that were issued to Coliseum capital. Ill use basic sharecount for current valuation, and diluted sharecount for the price target as I expect the warrants to be in the money. 

On my 2020 numbers Purple is trading at 8.6x EBITDA and 10.25x EPS 

On my 2021 numbers Purple is trading at 5.7x EBITDA and 8.8x EPS

This seems extremely cheap for a company posting 50% revenue growth in 2019 and expected to grow at 30%+ in 2020. 

Factset has Tempur Sealey trading at 10.6x 2020 EBITDA and 15.5x EPS with 11% revenue growth in 2019.

Factset has SleepNumber trading at 10x 2020 EBITDA and 16.4x EPS with 10% revenue growth in 2019. 

Given I expect Purple to be posting a 30% growth rate in 2020, it seems reasonable to apply these multiples to Purples 2021 estimates to come up with a year end 2020 price target.

10.3x 2021 EBITDA would lead to a $12 target on a fully diluted share count. 16x EPS would lead to a $13.50 price target when including the cash from the warrant exercise. I believe Purple would likely trade above 16x earnings should they exhibit these types of growth rates. 

Upside:

Casper has hired bankers to go public, likely in early 2020.

Casper IPO

Casper’s last valuation was for 1.1 billion off a funding round in March 2019.

Its also worth mentioning that the 2019e is an estimate that leaked in march 2019, and we have no idea how actuals have been coming in. Based on website traffic from similarweb.com Purple.com has had consistently higher website traffic than casper.com. 

That 50% expected growth rate for 2019 is the same as Purples, yet Purple will have a 7-8% EBITDAS margin whereas Casper has a stated goal to breakeven by the end of 2019. If Casper IPOs at a flat valuation (likely to be higher) that would be at 2x TTM sales.

 I would argue Purple deserves a higher sales multiple given their profitability, but lets just use Caspers 2x trailing sales. On Purples projected 427mm in sales that gets us to $14 today, good for a 75% increase from here. 

I think the Casper IPO would do a good job highlighting how cheap Purple truly is.

Liquidity:

The stock is actually buyable now after a secondary was completed 2 weeks ago. The founders sold down their ownership from an 80% position to a 60% position, effectively doubling the float. This was their first share sale since the IPO almost 2 years ago. I don’t begrudge them for selling shares, if anything the increased float and liquidity should be a positive for the stock. However, it did drive the stock down from around $9 post earnings report to the $7 clearing price for the new share issue.

Biggest public holder Coliseum capital participated on the deal and increased their position size.

Conclusion:

 Despite being lumped into the unattractive, competitive market of bed-in-a-box, Purple is actually a consumer products company with a pretty unique technology. The new management team has had an immediate impact improving margins and sales, driving Purple to be omni channel. The company is trading cheaply on a relative and absolute basis despite high levels of growth. With a long runway in front of them and a capital light business structure, purple makes for an interesting small cap. The potential IPO of Casper in 2020 provides for a catalyst to highlight how cheap the value really is. 

Catalyst

Casper IPO early 2020

Financial Results, 2020 Guidance in March