Description

Long: Purple Innovation Warrants (PRPLW)

Disclaimer:

Small float and not a lot of trading volume so this may just be a PA idea – the equity trades an average of $200k per day and the warrants trade even less.

Investment Overview:

Purple (PRPL) is a manufacturer of differentiated mattresses and related accessories that came public through a reverse-merger with a Special Purpose Acquisition Company (SPAC). The stock has underperformed due to operational issues and an optimistic valuation post IPO driven by bullish targets put out by the selling company that have been adjusted down since. The downward revision to guidance along with the market turning bearish on the commoditized, unprofitable “Bed in a Box” category has torpedoed the stock.

Despite the stock weakness and consensus negativity, we believe PRPL has a differentiated product and a market opportunity that should allow it to continue growing and generate positive EBITDA in the future. A much less “controversial” trade in our opinion are the SPAC warrants for ½ a share at $0.20. These are struck at $11.50 and offer significant upside (9x multiple of money) if the stock gets to our upside valuation case of $15 / share, even on a probability adjusted basis.

Capitalization:

Industry Overview:

Purple is currently focused on the US market, so we’ll spend the bulk of this section just discussing that (although we would note that the company plans to expand internationally in the medium term). The wholesale mattress industry in the US is roughly an $8B industry that has grown at a 7.6% CAGR since the cycle turned in 2008. Of that, roughly ~$1.2B of sales are DTC, up from effectively $0 in 2013.

*Note that the data above (from PRPL’s slides) includes a >2x gross-up on traditional channels for the estimate of retail sales markups*

The mattress industry is dominated by large manufacturers that sell through traditional retail channels (Tempur Pedic and Serta Simmons are roughly 70% market share). Over time most of the industry’s growth has come from price as the technology adoption (sleeping on a mattress instead of the floor) is obviously already quite high. This has come as a natural function of consumers moving to higher priced mattresses over time, and the industry has significant correlation to economic cycles given this dynamic.

Just a quick overview on types of mattresses (going to try to keep it short / to the point):

• Foam (~30% market share):

• There’s a variety of different foam applications with polyurethane and memory foam being the most popular

• Polyurethane is the “lowest quality” of foam used in mattresses; however, it is the easiest to compress and ship DTC. This is basically what Casper participates in, and it is fairly inexpensive but has a short lifespan

• Memory foam is typically what’s found in the “higher quality” TPX volumes, which is designed for comfort & contours the body

• Spring (~45% market share):

• Generally firmer mattresses that are durable and cheap

• Hybrid (~15% Share)

• Basically a mix of the contour of memory foam with springs supporting the mattress. Generally higher quality than traditional memory foam

• Air (~5% Share) – This is largely SNBR, which is a public company (they’re vertical and sell a variety of luxury products in their own stores)

Separately, it’s important to temper expectations for the real market opportunity for DTC. Currently, DTC is only 7% of overall market share, and hyper-bulls believe that this could grow to 25-30% of total industry revenues. We use more tempered numbers, largely because mattresses experience some level of brand loyalty for existing brands (the “if it ain’t broken, don’t fix it” consumer) and consumers out there just looking for the cheapest options, which we estimate to be 50-60% of the industry volume all together.

However, it is certainly still an opportunity, and equally as large, if not larger, is the growth opportunity we see for PRPL to grow within the DTC category vs. competitors like Casper, Saatva, Tuft & Needle, or Leesa. The chart below shows how PRPL has been rapidly gaining market share.

Product Overview:

Purple is a DTC mattress manufacturer (if it wasn’t obvious) that uses a proprietary “Hyper-Elastic Polymer” technology. The company was formed in 2015 by Terry & Tony Pearce, brothers who have a background in engineering, manufacturing, and design. The technology is innovative as it fits into none of the mattress categories highlighted above, and was originally used in wheelchairs. It technically fits into the category of hybrid mattresses as it uses both springs and high-density polyurethane foam, but adds in the “Hyper-Elastic Polymer” on top. This is basically what the product looks like today:

To summarize the difference in material detailed above, we’ve included this slide from the company’s investor presentation:

The company has 78 granted or pending patents as of the transaction date, and it owns 2 manufacturing facilities with 4 machines.

Product Reception:

So how has the differentiated product been performing? Our diligence work would imply that it’s been quite good so far. This has been part of the bull thesis for a while, so we won’t belabor this point as much. However, from what we can tell, a significant portion of product reviews have been fairly positive so far. Across the largest DTC mattress companies, Purple has by far the highest ratings between its own website, Amazon, and Sleep Advisor, across quite a few reviews.

We would note that Purple reviews (much like other mattresses) are very much like a barbell though – lots of very low and very high reviews. As discussed below, academic research shows that there is little consistency between what optimal mattresses are for different consumers.

Additionally, brand interest in Purple has increased exponentially relative to its competitors as of late, and the interest is now comparable to that in Casper. Per Google Trends data:

While we haven’t had the chance to use the product itself, personal anecdotes from people we know have also generally been positive, albeit after an adjustment period over the first few days.

Marketing Spend:

One thing that industry bears have liked to point to in the past has been the exorbitant level of marketing needed to gain traction for DTC brands in this industry. Purple currently spends 40% of revenue in marketing spend and has launched a variety of (viral) ad campaigns over time to try to compete with other brands. Costs per click / customer acquisition costs are also continuing to rise industry wide.

Purple also offers 120 day guarantees to its customers with 10Y warranties in its attempt to be disruptive, and while the level is unclear, management notes very high level of return rates over the past few quarters. Bears believe that the generous returns policy coupled with high marketing / customer acquisition costs make this business model unsustainable.

While we see merit to this argument (particularly on the increasing customer acquisition costs), we think this is solvable over time. Over time, as customers get over the “trial” period and figure out what they want / like, returns should drop over time. A word of caution is that we don’t expect the marketing spend to abate any time in the near future, so NT cash flow generation will still be challenged

One other interesting tidbit – Research commissioned by the Research Triangle Universities (UNC, Duke, NCSU) suggests that:

• There is statistical significance to the idea that the optimal type of mattress varies by consumer – what’s good for me may not be good for you

• There is minimal correlation between consumers choosing their own mattresses and their sleep quality (put simply, people aren’t good at picking what mattresses fit them best)

This leads us to believe that a real opportunity surrounds product marketing as well.

Mattress Firm Partnership:

Beginning in Nov. 2017, Purple’s mattresses were rolled out for testing at 51 Mattress Firm locations in Sacramento, Washington DC, and Austin. This testing proved to be extremely successful, as Mattress Firm has started to list Purple products on its website and the companies have expanded the retail partnership to 188 stores. A KeyBanc report in February did some channel checks that were useful, and Mattress Firm Associates’ had positive things to say about the beds. Here’s an excerpt from the report:

Mattress Firm is the largest US retailer of mattresses, and the fact that they are on board and seem to believe in the product gives us added comfort that the product is differentiated. There may also be an opportunity to pick up some share from lost TPX product at Mattress Firm, as TPX terminated their partnership with Mattress Firm last year and was 21% of Mattress Firm’s sales prior to that decision.

We are also optimistic that the company can do other placement transactions like this in the future, but Mattress Firm is by far the best place to start.

How We Got Here:

So those of you unfamiliar with the story may be wondering, if this is such a great product, how did we end up here with the stock down ~50% post-IPO?

Some quick background – for those unfamiliar with SPAC structures, basically a SPAC is formed for the purpose of buying another company. It’s often a way for private companies to backdoor IPO (among other reasons why they may way to be bought by a SPAC). When a SPAC finds a company to acquire, participating unitholders can vote for or against the transaction and can elect (independently of that decision) to redeem their shares.

GPAC, the sponsor here, was formed in 2015 by Paul Zepf, a career banker / PE guy. In July 2017, GPAC approached Purple with an LOI to buy the company for $1.1B TEV. There was a lot to like at the time, revenues were up 271% YOY, the old CEO, Sam Bernards, was highly respected, and Casper, an inferior product, had just raised a round of funding that implied that it was worth $750mm (roughly ~2.5x sales from what we can tell).

Investors and the company pushed back, and the purchase price was adjusted downwards to $894mm, which is 2.1x their original expectation of 2018 sales of $425mm. The company ultimately got the sense that many investors were going to redeem at the high valuations, and got the valuation adjusted down again (following some modestly disappointing Q3 numbers at Purple) to ~$500mm. Through a series of PIPE (private investments in public equities) transactions, the Company got some institutions (Coliseum being the most notable one, along with Greenhaven Road & Baleen) to buy enough shares to support the transaction being completed. From our best guess, post IPO, this was a classic case of overpromising and underdelivering to the market. Our skeptical lens believes that the sellers were incentivized to be promotional pre-deal, and while the long-term picture hasn’t changed in our view, the company took down its 2018 guidance from a midpoint of $425mm to $300mm. Prior guidance included a variety of aggressive assumptions, including international penetration and a continuation of their existing pace of growth vs. customer acquisition cost. Additionally, the CEO inexplicably resigned to pursue other interests after only a year and a half on the job, and the company has yet to hire a permanent replacement (and management did a poor job of explaining the situation / his departure). Q2 numbers had some scary signs as well, with higher return rates / lower gross margins from some new products, and increasing marketing spend. Additionally, the company has made some significant operational missteps, as they had machines not running at full capacity / a backlog of new demand, quality control issues from ramping new models too quickly, and issues dealing with poor freight management.

Our view is that in the long-run, these revisions to guidance and missteps are just noise as the true opportunity for this product hasn’t materially changed. We would note that the company is still a new company, and the self-inflicted wounds are likely a function of the growing pains of being relatively young in general.

Consensus View:

The company is relatively underfollowed, the only sellside analyst that actively covers it is Wedbush, but quite a few other analysts publish on the space in general. Industry analysts generally skew positive on the product but view it (and DTC brands in general) as only a potential disruptor for the existing brands and nothing more.

Buyside investor bearishness from what we can gather has to do with skepticism that the company can turn profitable given the high customer acquisition costs / brand loyalty they compete with and the high return rates today. For reasons we have addressed above, we think there’s merit to this argument (especially the former point) and it gives us some pause, but point to Google Trends data and strong reviews as an indication that the marketing is working, and the brand is getting traction.

Valuation:

Valuation is a little tricky, we are distressed investors by background so frankly we struggle with growth-y stories, but here is our cut at valuation and a variety of comps that we look at. We’re not really sure what the “right” multiple should be for this type of business, so we are open to feedback (our tech investor friends tell us something very different from our distressed investor friends).

Comps:

Of note, Eve isn’t the greatest comp, as they are currently going through a scale-back in operations (growth was previously too aggressive) and management turnover of their own. However, it is the only DTC industry participant that is publicly traded besides PRPL, as Tempur Sealy and Sleep Number are manufacturers, and Sleep Country is a retailer (Sleep Number also owns some retail stores).

Not listed here is the multiple of sales for which Casper received funding, which we estimate to be 2.5x.

Valuation:

The assumptions are explicitly laid out below. For revenue, we take a discount to management’s 3-5year expected growth-rate by growing the DTC category revenues at a slower pace than it has grown historically. Purple’s current DTC market share is 15%, but we believe that can grow over time, so our base case has it going to 20% over the next 4 years (which we view as conservative).

For valuation, we raise EBITDA margins significantly between now and then, as we think the company can ultimately start paring down marketing spend after the brand has more recognition over the next few years and return rates will ultimately begin to abate. However, our cases are still below management’s LT margin targets of 10-15% in our Bear case, and we use a lower gross margin than what management thinks they can achieve on a normalized basis (50%+). CapEx of 4% of sales is our estimate of maintenance capex (which is slightly below what they have reported for total capex in the LTM period).

One major issue for us (aside from figuring out the “right” multiple) is frankly our difficulty in attaching reasonable probabilities to these cases and the wide range of possible outcomes for something this growth-y. While we are constructive on the equity story over a long time horizon, a much easier trade here is to just own the public warrants (PRPLW), which is what our exposure actually is today. While the warrants require some aggressive assumptions that management has given in the past (and clearly failed to execute on thus far), if there’s a 20% probability of the story working the way management has depicted it, then there’s a 150% probability weighted average return over the investment horizon. The gearing here makes the warrants fairly attractive, especially when compared to the common stock which feels more cuspy. Note that the warrant valuation in 2021 should still have extrinsic value attached to it, as it is a 2023 maturity. So the actual warrant value could be even higher if management begins to execute on its stated targets.

Just some probability weighted returns for you folk - if we assume that the bear case here has a 40% probability and the upside case is only 15%, here are the probability weighted return profiles of the different securities:

One Final Investment Merit:

It’s always a nice touch is when mgmt. is highly incentivized to act in your favor – insiders currently own 80%+ of the company, and this looks to be the vast majority of the co-founders’ net worth.

Risks:

Besides the obvious risk of the company not gaining traction and not being able to execute on fixing some of these self-inflicted wounds, we’ve outlined a few other risks below:

Imports & Private Label: An existential risk to the industry has been Chinese foam imports, which have substantially grown over the past few years. These are usually low quality and could contain health risks, but have gained share with bargain-seeking customers. A mitigant is that this isn’t really the space within which Purple competes, as its mattress is priced at a premium to the bottom dwellers.

Private Label is also a fear for market participants, as Mattress Firm has purchased its own in-house manufacturer in 2017. However, the differentiation of the Purple technology and Mattress Firm’s continued willingness to partner with them is a positive sign that this may not be a huge issue for Purple.

Mattress Firm: Mattress Firm is owned by Steinhoff, which is a distressed South African retail conglomerate with very public short-seller accusations of fraud. There is a high probability that Steinhoff files for bankruptcy protection in the next few years, which could lead to them closing any Mattress Firm stores that are unprofitable through the bankruptcy process.

Warrants Illiquidity: Illiquidity is a material negative here, as the warrants trade infrequently and in chunky size, and there are only $3mm worth that are actually publicly traded

Catalyst

Nothing explicit but a few things can help:

Expansion of Mattress Firm partnership / roll-out to other retail formats

Actually hitting guidance for once

Finding a new CEO and being more transparent with investors on strategic plan / historical issues