Description

BUY: Sealy 3rd Lien Convertible Notes (NYSE: ZZC), $79.00/note

RECOMMENDATION:

ZZC provides the opportunity to own what is basically secured equity in a company that has successfully completed a financial restructuring and is in the middle of successfully executing upon an operational restructuring with macro headwinds likely turning into macro tailwinds.  The valuation is compelling and I think there is a good chance that the common equity (and thus the converts) could double within a year or two. The converts are especially attractive given their 3rd Lien security provides downside protection in the highly unlikely event of a Ch. 11, but their very high delta (basically 1) enables them to share all of the upside with the equity at a meaningful discount to the equity while enjoying a 2.5% yield at the current market price.  Unlike many converts, this one is listed on the NYSE (ZZC) which makes it easy to trade. In addition to this being an interesting place to play in Sealy's capital structure I think the company's fundamentals are poised for some decent upside, especially as the economy starts to show some signs of life.  Additionally, it is unlikely that KKR plans to hold their 51% stake in ZZ forever - so we could see a transaction down the road.

DESCRIPTION OF SEALY:

Sealy is the largest bedding manufacturer in the world. They are estimated to have over 21% of global market share, and they are #1 in U.S., Canada and Mexico market share - around 20% (trailed by Simmons at 15.8%, Serta at 15.7%, TempurPedic at 8.2% and Select Comfort at 4.9%).  They sell under the Sealy, Sealy Posturepedic, Stearns & Foster, Posturepedic True Form and Posturepedic Spring Free brands.

RECAPITALIZATION:

In May 2009, the company announced a comprehensive recapitalization plan that would basically take out the secured bank debt and eliminate all quarterly financial covenants (there was an outside risk that Sealy would trip the interest coverage covenant that stepped down in 3Q09 - though given how strong the numbers have been that would not have actually been an issue).  Sealy paid off the bank debt by issuing $350MM of sr. secured notes with a 10.875% coupon and offering equity holders the right to participate in a $177MM 3rd Lien convertible bond issue - which was backstopped by ZZ's largest equity holder, buyout firm KKR.  Each share received one right, and every thirteen rights gave the holder the right to participate in a $25 par value convertible note which would then be convertible into 25 shares.  The company's efforts were successful and the bank debt was taken out in July 2009 effectively eliminating any financial risk facing the company (for all intents and purposes). 

RECENT RESULTS:

Sealy reported fiscal 3rd quarter numbers (8/30/09) on 9/29/09 that were better than expected.  EBITDA came in at $53.7MM versus most published expectations of $45MM or so.  The company has had great success in expanding its margins during the downturn as EBITDA margins for the Americas came in at 16.2%.  Europe EBITDA margins of 0.82% obviously leave some room for improvement, but the company just began implementing operational reorganization plan similar to what they've been able to achieve in the Americas, so I do expect to see some improvement in Europe's profitability.   They're very well poised to have significant cash flow growth once the top line actually shows some growth again - which it eventually will.  They've done a good job keeping costs in line with SG&A as a % of sales down yoy 128bps in the last quarter, helping a 126bps increase in gross margins yoy.  Capital expenditures for the 3 months ended 8/30/09 were just $4.1MM and for the trailing 9 month period it was $8.7MM.  This probably represents a modest under-spend, but true "normalized" capex is not more than $20MM - or 1.5%-2% of net sales.   Sealy is looking like it will be able to do close to $170MM in 2009E EBITDA.  

BEDDING INDUSTRY DEMAND DRIVERS / RECENT DEVELOPMENTS:

Some things to watch for in terms of seeing a top line turnaround in the bedding industry:  GDP per capita (more is better - and hopefully we're coming off of a low), total home sales (new house, new bed...not making a call on housing, but sales have been coming off of the lows), population growth, replacement demand - 9-10 year replacement cycles - a lot likely has been deferred over the last 12-24 months - so there could be some nice pent-up demand.  Over the last 3 recessions, (1981-82, 1990-91 & 2001-02), the two years post recession have showed an average growth rate of revenues off of the lows of 20%.  All we really need to believe in is about 10% growth to think there is significant upside (will explain later).

Recent financial distress among Sealy's competitors has provided an avenue through which the company can take market share (they have been doing so).  The recent bankruptcies of Simmons (setting up for a sale to Ares & Ontario Teachers' Pension), Mattress Discounters and uncertainty at Select Comfort (NASDAQ: SCSS) are a few examples of the dislocation in the industry that will likely provide some opportunities for Sealy.  Additionally, Teachers' currently owns National Bedding, which is the largest bedding manufacturer under the Serta brand (Serta is basically a group of affiliated manufacturers) - while they intend to operate the two businesses as separate entities, having a greater concentration of market share in the hands of a rational, profit-focused player is unlikely to be a negative for the industry.

LIQUIDITY/DEBT MATURITIES

The company currently has $171MM of available liquidity from cash on the balance sheet and the ABL availability of $71MM.  There are no debt maturities until May 2013, when the undrawn ABL comes due.  The next maturity is in 2014 when the 8.25% sr. subs are due - $274MM outstanding.

CAPITALIZATION:

 *based on "mid-base" recovery EBITDA of $233MM

VALUATION INCLUDING COMPS AND RECENT TRASACTIONS:

KKR acquired Sealy in April of 2004 for $2.15BN or 13.2x EBITDA and 15.9x EBITDA-Capex.  Ares & Ontario Teachers' are buying Simmons in a pre-packaged Ch. 11 (announced in October, 2009) for a total consideration of $760MM. Simmons posted 2008 EBITDA of $84.2MM and their 2008 Capex was $17.1MM, so the acquirors are paying 9.0x EBITDA and 11.3x EBITDA-Capex for Simmons. 

UPSIDE:

The tables below show what EBITDA, Capex and common equity / convertible bond valuations look like under various scenarios.  Even under a reasonably conservative assumption of 10x EBITDA-Capex of $195MM, the convertible bonds would be worth around $129.00/bond or 63% upside from the recent price of $79.00/bond.   The upside case of 13.0x EBITDA-Capex of $225MM would get you to $216.00/bond or 175% upside.  

DOWNSIDE:

The downside should be well protected fundamentally (read below for more details on 3rd lien including guarantee structure etc).  There are a few ways of looking at the downside protection through the convert - either one represents a meaningful discount to the stock and is also cheap on an absolute basis.  It is worth noting that "Scenario 2" described below is  largely of an academic nature since the probability of Sealy running into real financial trouble anytime soon has largely been mitigated by this recapitalization...

 Scenario 1 - basically takes the current TEV of Sealy through the common stock and backs out the par value of the convertible bond - so you're essentially "creating" the equity under this scenario $177MM cheap to the stock - or a discount of little over 1.0x 2009E EBITDA - the TEV in Scenario 1 is about $1.15BN:

Scenario 2 - this assumes that in the extremely unlikely case of a Ch. 11 reorganization, you're "creating" the equity of the company through this security at the following implied valuations: (Please note that the below valuation assumes the 3^rd Liens would be the fulcrum security and receive all of the equity in a reorg - which may not turn out to be the case).  Under this case the "Implied 3^rd Lien TEV" represents just the current net secured debt + current market value of ZZC converts or right around $800MM.

The current valuation through the converts under either scenario represents a massive discount to just about any consumer-levered name I see out there.  Should the equity take a big hit (obviously I don't think it will), there is certainly mark to market risk with the converts, but fundamentally the downside should be well protected given the valuation. 

The company's free cash flow generation also protects the downside quite nicely.  With "normalized" capex of around $20MM (D&A is about $30MM), cash interest expense of $59MM, and a tax rate of about 38%, Sealy will generate meaningful free cash flow over the coming years.  Under my "upside" case EBITDA, Sealy should do over $130MM in after tax free cash flow, or a 16% FCF yield to the fully-diluted equity.  Under my "low-base" EBITDA assumption of $176MM (they probably do that this year) the FCF yield would be 9% and on my "mid-base" case EBITDA assumption of $230MM the company would do around $100MM of FCF or a 12% FCF yield here. It is reasonable to assume that the company will generate over $200MM in FCF in the next couple of years (which of course is not included in any valuation submitted here).  The low-capital intensity / high free cash flow generation of this business is one reason why they have been and will continue to be so popular with LBO firms and value investors alike (not to totally suggest those are mutually exclusive...).

SOME SECURITY SPECIFIC DETAILS FOR ZZC:

ISSUER OF 3^RD LIEN CONVERTS:

Sealy Mattress Company, who is also issuer of $350MM sr. secured notes, the $100MM sr. secured ABL (undrawn) and sr. subordinated notes.  The issuer owns the stock of all subsidiaries and is structurally senior to anything issued at the parent company, Sealy Corporation (issuer of ZZ common equity). 

SECURITY / GUARANTEE STRUCTURE:

The 3rd Lien notes rank ahead of existing and future unsecured and subordinated indebtedness (the $274MM of 8.25% sub notes) but junior to 1st Lien indebtedness (the $350MM of 10.875% secured bonds and undrawn $100MM ABL).  You basically only have the secured bonds ahead of you at this point - or net (of cash) secured debt of $250MM ahead of you. You're guaranteed by the wholly owned domestic subsidiaries of Sealy Mattress Company which represent almost 90% of the Sealy's EBITDA (for quarter ended 3/1/09) - so substantially all of the cash generating assets. As of 3/1/09, the non-guarantor subsidiaries held 12% of Sealy's consolidated assets and had liabilities of $96.3MM - likely holding residual value for 3rd liens if it ever came to a reorganization (very unlikely).

COVENANTS:

There are various negative covenants associated with the 3rd Liens (like limitations on incremental indebtedness ahead of you, asset sale restrictions, merger restrictions) - but nothing along the lines of quarterly financial tests (part of the reason for taking out the banks was to remove these).  It is worth noting that the equity sponsor's interest is aligned with those of the convert holders (as they are the largest convert holder) - so the risk of getting massively primed in some creative way not covered in the covenant for the 3rd Liens (or some other disaster-like outcome) is very unlikely as the sponsor is probably not going to take action harmful to them.

TERMS / CONVERSION RIGHTS:

$25 par value with $2.00 per note coupon (8% PIK at par), each note is convertible into 25 shares with a $1.00/share conversion price (currently in the money).  The parent retains the right to terminate holders' conversion rights on or after 7/15/12 if: the 30 day average price exceeds 250% of the conversion price ($2.50/shr) or net debt to EBITDA on a trailing basis is less than 3.4x.  There is more than enough time for this to play out before you have any risk of rights termination.

INSTITUTIONAL OWNERSHIP OF SEALY COMMON EQUITY:

Not exactly a crowded or fast money list, which is not a bad thing - always good to know who is in a name with you...

 MANAGEMENT OWNERSHIP:

Management has a decent level of ownership - and should be aligned with shareholders (I'm sure KKR makes certain of that...). It is worth noting that most of their options are struck at decent enough premium to where the stock is to really incentivize them get the price up - though not so high it is unattainable (~$6/shr is the approximate weighted average of the strike prices).

 Management compensation is EBITDA based - so they are definitely incentivized to get EBITDA higher.

Catalyst

-       Operational turnaround

-       Free cash flow generation used in accretive manner for common equity (benefiting converts)

-       Eventual monetization by KKR of their position in Sealy is likely to lead to an acquisition premium (significant interest in the space remains as evidenced by the recent Simmons deal).