Description

EXECUTIVE SUMMARY

While Select Comfort is certainly not a “deep value” idea, the company is an excellent business with a small and growing market share in an industry with tailwinds.  The company’s differentiated product offering and integrated business model enable Select Comfort to outperform its competitors, take market share, and increase prices.  No competitor offers the high performance air technology based mattress that Select Comfort does and this is the company’s key point of differentiation.  Shares of Select Comfort are down over 22% since the company reported third quarter earnings as investors became concerned about the potential for slowing unit growth and weakness in mattress industry sales growth.  The short term decline should prove to be a buying opportunity as the long-term outlook for the company is bright.  Valuation is attractive with SCSS shares trading at just 13x NTM EPS and 6.1x EV/EBITDA.  I believe that shares can appreciate to $35 over the next 12 months, representing approximately 39% upside from the current price. 

BUSINESS DESCRIPTION

Select Comfort Corp. designs, manufactures, markets, and sells proprietary beds and other sleep-related accessory products.  It offers beds under the brand name Sleep Number.  The Sleep Number bed allows adjustable firmness on each side of the mattress using patented air technology.  Sleep Number beds are premium priced with an average price of a Sleep Number bed of $2,692 in Q3 2012.  Select Comfort also offers bedding accessories sheets, specialty pillows, headboards, frames, mattress pads, and related products.  Management has transformed the business by transitioning away from the wholesale channel and focusing on company controlled distribution.  88% of the company’s 2011 sales were through company owned stores, 9% of sales were through ecommerce channels and 3% of sales were through the wholesale and home shopping channels.  Select Comfort had 394 stores as of September 30, 2012 with non-mall stores accounting for ~20% of all stores.  The company was founded by Robert Walker and JoAnn walker in 1987 and is headquartered in Minneapolis, MN.

INVESTMENT THESIS

Mattress industry recovery continues to gain traction after the industry suffered during the recession.

Industry wide mattress sales have increased at a 5% CAGR from 1980-2011.  However, industry sales declined 19% from the 2007 peak to the 2009 bottom and are not expected to reach the prior 2007 high until 2013.  People have delayed the purchase of new mattresses, leading to ageing mattresses and pent up demand.  In addition, people tend to replace mattresses when they move and the industry is positioned to benefit as existing home and new home sales continue to recover from the recession.  The U.S. housing market continues to recover with recent strong growth in new home sales (up 17.2% YoY in October), existing home sales (up 14.5% YoY in November) and housing starts (up 21.6% YoY in November).  Growing new household formation should also support mattress industry growth.  Strong industry fundaments and pent up demand should drive industry growth above the 5% average annual industry growth for the next several years.  Recent mattress industry growth has been strong with 11% growth in November. 

Select Comfort currently has a low industry market share that has plenty of room to grow.

Despite robust recent market share gains, Select Comfort’s Sleep Number mattress has just a 4.7% market share (just 1.5% share of industry units) and I believe that it can move much higher over time especially considering that the premium segment (ASP over $1,000) that Select Comfort focuses on accounts for 54% of industry sales.  Just a 2% gain in market share for Select Comfort would imply a 41% increase in units sold.   In addition, Select Comfort’s growing store base and aggressive advertising ($120 mil. in 2012E vs. $61 mil. in 2009) should help to increase consumer awareness of the Select Comfort brand.  Sleep Number brand awareness, which is currently at just 20%, compared to a leading innerspring brand at 55%, leaving plenty of room for brand awareness increase.  Lastly, Select Comfort’s differentiated business model should enable the company to take share from its competitors (see below for full description of the business model). 

Differentiated product offering and vertically integrated business model have enabled Select Comfort to avoid the “foam wars” and take market share.

Select Comfort’s mattresses are differentiated from competitors in a few key ways.  Select Comfort’s revolutionary Sleep Number bed allows individuals to adjust the firmness and support of each side at the touch of a button through air technology. The use of air based technology is essentially unique to Select Comfort and differentiates the company from competitor products which are typically foam based.  Much of Select Comfort’s air technology is based on patents and proprietary technology and this helps to provide an economic moat for the company.  Select Comfort’s focus on health and wellness also helps the company to differentiate itself from the competition.  The company’s strong product offering and health benefits have enabled the company to price its Sleep Number beds at a premium price point in the industry.  These factors should enable the company to continue taking price increases.  In the third quarter, the company experienced an ASP increase of 19.5%. 

The majority of the wholesale mattress industry sells its products through mattress retailer stores such as Mattress Firm.  These retailers sell very similar mattresses (such as foam mattresses) and wholesalers are forced to compete for shelf space.  Due to the lack of differentiation at the retail level (mostly foam based mattresses), mattress wholesalers often compete on price and this can erode profitability.  In contrast, Select Comfort made the strategic decision to exit the wholesale channel and now generates about 95% of its revenue from direct to consumer sales which includes company owned retail and ecommerce sales.  In addition, company controlled distribution enables Select Comfort to control how its products are presented to and marketed to customers.  This has enabled the company to avoid the “foam wars” and pricing pressure that many of its competitors have succumbed to.  The company also transitioned all of its stores to Sleep Number from a mix of Select Comfort and Sleep Number stores in 2010 and this further enabled the company to focus its advertising message.  Select Comfort’s differentiated product offering and unique distribution distinguishes the company and enables it to achieve superior returns on invested capital. 

Just in time inventory system significantly limits Select Comfort’s inventory obsolescence risk.

Select Comfort is able to generate a negative cash conversion cycle in days primarily due to its limited working capital needs.  The modular design of the company’s Sleep Number bed allows the company to operate a just-in-time, build-to-order production process which requires minimal inventory.  Stores do not carry bed inventory and operate as showrooms, enabling the company to operate small mall based stores.  When a customer purchases a mattress, Select Comfort quickly manufactures and ships the mattress from its distribution center and customers typically receive their mattress by delivery in just a few weeks, avoiding the cumbersome process of taking the mattress home.  Competitors such as Tempur-Pedic must hold significant amounts of inventory in warehouses to supply retailers.  This significantly increases obsolescence risk for competitors as a mattress style or design could fall out of favor or industry demand could weaken.  In addition, some of company’s competitors typically have much larger off mall stores that hold sold amounts of inventory and take more inventory risk.   Select Comfort’s just-in-time inventory system reduces its inventory requirements and enables the company to quickly move away from poor selling mattress styles or designs.  The company held just 28 days of inventory at the end of the third quarter compared to Tempur-Pedic at 47 days.    

Since the company sells directly to consumers through company owned stores and television shopping shows, it quickly receives cash from customers, limiting the company’s accounts receivable balance.   Competitors such as Tempur-Pedic sell on credit to the retailers they supply and this can be a significant use of working capital and also adds the risk that a customer may not pay.  Select Comfort’s days sales outstanding in the third quarter were just 5 compared to Tempur-Pedic at 40.  This is especially a risk in the mattress industry given that there are so many small mattress retailers in the U.S. that may not be well capitalized.  Select Comfort also has done a superior job stretching out its accounts payable, significantly longer than most of its competitors.  These factors have contributed to Select Comfort’s cash conversion cycle of -27 days compared to Tempur-Pedic at 45 days.  The company’s cash conversion cycle is testament to the company’s differentiated business model.

Management continues to deliver operating margin improvement. 

2011 operating margin increased to 12.2% from 8.6% in 2010 and I expect it to reach 14.0% in 2012E and 14.8% in 2013E.  Operating margin expansion has been driven by gross margin improvement and leverage on SG&A expense due to growing sales that these factors should continue.  Management expects to reach $1.5 billion in revenue and 15%+ operating margin by 2015 and I believe that this guidance is achievable, especially given that Q3 2012 operating margin reached 16.3%.  Guidance assumes a 2012E-2015E revenue CAGR of 15% and management is targeting doubling its market share in many large and undeveloped markets.  The company’s guidance seems reasonable given that the industry should exceed annual growth of 5% over the next few years, management expects to increase the number of stores by approximately 5% to 8% annually over the next several years, Select Comfort has a small and growing market share, and the company has strong pricing power (ASP’s increased 19% in the most recent quarter).  Leverage on the company’s fixed cost base as well as increases in ASP should aid operating margin expansion and EPS growth over the several years.  

The company is still significantly underpenetrated in several U.S. states. 

While Select Comfort has had success penetrating many states including California and Texas, it still has significant growth opportunities with many large U.S. states (with significant populations) having just a few stores.  The company should be able to open well over 500 stores in the U.S. with 5% to 8%+ store growth over the next several years.  Management is focused on remodeling stores and half of all stores are expected to be remodeled by the end of 2012. 

Select Comfort is an exceptional business that generates impressive returns on invested capital and equity with a strong balance sheet.

Select Comfort generates exceptional returns on invested capital (ROIC) driven by its differentiated product offering and unique business model (low working capital needs).  The company’s ROIC reached 42.8% in 2011 (including capitalized operating leases), up from 20.0% in 2009 and I expect the company to maintain ROIC in the 40’s percent range as the company benefits from strong sales growth, margin expansion and limited growth in capital expenditures (see below).  In addition, Select Comfort also generated an impressive ROE of 65% in 2011 and 78% in 2010.  While the current ROIC may seem unsustainable, the company was able to consistently generate high ROIC in the mid 2000’s and the business model transformation also supports higher ROIC.  Select Comfort has an exceptional balance sheet with no debt, cash and marketable securities of $193.1 million ($3.38 per share) and clean inventory. 

Share repurchases could provide long-term support for shares. 

With a net cash and marketable securities balance of $193.1 million and $187 million in share repurchases authorized, Select Comfort has the ability to repurchase a meaningful amount of its stock.  Year to date, the company has repurchased $20 million of its shares.  While the company is focused on just repurchasing enough of its shares offsetting dilution from stock options in 2012, robust cash flow generation should enable the company to initiate a more aggressive repurchase program in coming years.  

The company has a strong management team led by CEO Shelly Ibach.

The company’s President and CEO Shelly R. Ibach has been with the company for over 5 years (CEO since June 2012) and is well qualified to lead the company.   While she may be new to the CEO position, her significant experience within the company has prepared her for the CEO position.  Furthermore, she was previously employed as Senior VP & Manager-General Merchandise for Macys.  Her experience with a direct to consumer retailer is especially valuable for Select Comfort.  She has enhanced Select Comfort’s strategy in a few key ways including a) supporting shifting away from the wholesale model to the company owned retail channel, b) focusing on a wider target demographic instead of a needs-based, back pain customer, and c) replacing Select Comfort’s previous direct marketing strategy that used 30-minute infomercials with broad reach marketing.

International markets present a long-term growth opportunity. 

The company currently has limited distribution in international markets with a distribution agreement in just Australia and New Zealand.  While the company does not have any plans to expand internationally in the near-term, longer-term the company should be able to expand into new regions as its differentiated product offering should enable the company to achieve success.  International expansion should also be supported by an emerging middle class in developing markets.   

VALUATION

Valuation is attractive and for a strong business with several tailwinds.

Select Comfort trades near its peers on a forward P/E and forward EV/EBITDA basis (see below) despite the company’s superior business model.  In addition, Select Comfort trades below its five year historical averages on a NTM P/E basis (13.0x vs. 19.8x) and an trailing EV/EBITDA basis (7.9x vs. 10.8x).  These discounts are unwarranted given the company’s differentiated business model, strong brand, small but growing market share, margin expansion potential and exceptional balance sheet.  In addition, improving housing market fundamentals should provide a tailwind for SCSS.  SCSS also has an attractive 2013E FCF/EV yield of over 7% driven by its business model that generates significant amounts of cash flow.  Furthermore, free cash flow should increase over time as the company completes remodels and reduces store openings.  The company has an exceptional balance sheet with a net cash of over $3 per share and this should provide some downside protection.  While the company has a cyclical component to its growth and a decline in the housing market could negatively impact the company, its differentiated business model and strong balance sheet should provide some downside protection.  Of note, the company’s business model is relatively flexible and management believes that it can still be profitable on a substantial 36% decline in sales.   I believe that as the company continues to deliver operating margin expansion and takes share from competitors, its trading multiples will move higher.  Therefore, I believe shares will trade at 15x (below the company’s 5 year historical average of 19.8x) my FY 2014E EPS of $2.33.  This seems reasonable for a company that should be able to grow EPS by 15% to 20% over the next several years.  Therefore, my one year price target is $35, or about 39% higher than the current price, providing a sufficient margin of safety for patient investors. 

INVESTMENT RISKS

Macroeconomic weakness. 

Mattresses are discretionary purchases and therefore, are sensitive to macro economic trends.  Furthermore, if the U.S. housing market were to weaken, it would likely have a negative impact on mattress companies such as Select Comfort.

Industry price wars. 

Competitors may decide to become more aggressive on price, therefore driving down industry profitability.  However, Select Comfort’s differentiated product offering should help to insulate the company from industry price wars.    

Margin expansion. 

While the company has been successful in expanding its margins, it could run into difficulties achieving further margin expansion.

Catalyst