EXECUTIVE SUMMARY: I recommend a SHORT position in Select Comfort (SCSS), with a 12-18 month price target of $16/share (-30% expected return as of my initial recommendation). SCSS is the exclusive manufacturer, retailer, and servicer of the Sleep Number bed, a fully-adjustable air mattress that offers the ability for users to customize the firmness and support on each side of the bed at the touch of a button. Sleep Number mattress prices range from $999 to $4,999. About 90% of Sleep Number mattresses are sold through SCSS’s 410 retail stores; the rest are sold mostly via phone or SleepNumber.com. The Street is positively biased on SCSS: of the 10 sell-side analysts covering the name, there are four “Buy” ratings and six “Hold” ratings with an average price target of $22. Short interest ratio is 3.0 and there are no “Sell” or “Underweight” ratings; that’s where I come in.

MY BEARISH INVESTMENT THESIS: My differentiated bearish thesis is that SCSS will lose market share as consensus significantly underestimates the competition that SCSS is facing, both as a manufacturer and as a retailer of mattresses. [1] The two biggest mattress makers, Serta Simmons Holdings and the recently merged Tempur-Pedic (TPX) and Sealy (ZZ), hold ~65% market share today. Bulls underestimate the market share these competitors can take from SCSS via strong promotions and positively reviewed new products such as Tempur-Choice that could compete directly with Sleep Number. In contrast, SCSS has not announced any major new mattresses this year. [2] The two largest retailers, Mattress Firm (MFRM; ~1,100 stores) and Sleepy’s (~800 stores), have been consolidating and are growing their store base faster than SCSS. They do not carry Sleep Number mattresses, which are sold only through SCSS’s own “Sleep Number” stores or distribution channels. Competition on two fronts, along with SCSS’s recent marketing missteps, has led to SCSS’s operating de-leverage and deceleration in Y/Y company-controlled comp sales growth to 10.6% in 4Q12 and -8.8% in 1Q13, which I do not expect to recover to its 2011-2012 levels of ~20%+ Y/Y anytime soon.

Despite the aforementioned challenges, consensus expects SCSS to experience comp growth of 6-8% for each quarter from 3Q13 and beyond. This rate is greater than that of MFRM, TPX, and ZZ, implying that consensus believes SCSS is not only growing faster than the overall mattress industry but is also taking share from competitors. Based on my assessment of the competitive dynamics, I believe consensus expectations for sales growth and operating margins are too optimistic. SCSS holds less than 5% global market share in dollars and less than 2% in units today, and I disagree with the consensus view that SCSS will gain incremental share. I believe now is the time to bet against SCSS, since SCSS is coming up on tough Y/Y comps of 25.4% and 21.0% for 2Q and 3Q respectively.

CONSENSUS BULLISH VIEW: The bull thesis on SCSS is typically based on the perception that its Sleep Number mattresses offer differentiated comfort and customization over other mattresses (my channel checks suggest that this perception may be tenuous), its vertically integrated business model leads to more effective process control, branding and store-level execution, and its balance sheet remains debt-free (in fact, there is “hidden debt” in the form of operating leases, which include minimum rental payments of $37mm in 2013 and $31mm in 2014). However, none of these factors actually gives SCSS a sustainable competitive advantage in my view.

UPSIDE RISKS: My main caveat is that SCSS shares are somewhat volatile. Historically, shares have seen several quarters with 10%+ swings in either direction, depending on whether earnings calls are positive or negative. Since shorts get bigger as they move against you, investors must be cognizant of SCSS’s trading history. Thus, I recommend this short only to investors that can embrace a longer-term view as opposed to making quarterly bets, or who would consider a pair trade by going short SCSS and long TPX. I believe TPX is a superior investment that similarly trades at ~7x 2014 EV/EBITDA. (My TPX price target is $60; please feel free to contact me privately for my TPX bullish thesis.) Other upside risks may be that the housing market improves faster than expected and new competing products fail to gain traction. However, my primary research, which has entailed numerous conversations with mattress professionals and visits to mattress stores, suggests that mattress competition is likely to intensify and housing recovery could be protracted.

VALUATION: At ~$22.40/share, SCSS currently trades at 16.5x 2013 consensus EPS of $1.36 and 13.6x 2014 consensus EPS of $1.65. These valuation multiples are near their 52-week average, so shares do not seem expensive at first blush. However, I believe consensus estimates are too high given the increased competition from both suppliers and retailers. Over the next four to six quarters, I can see same store sales growth in the low-single digits (versus consensus of 6-8%) and aggregate EPS that is at least 10% below consensus. Based on my 2014 EPS of $1.45 and modest multiple contraction to 11x, I believe SCSS is worth about $16/share.

The text above summarizes my pitch. Please read on for additional details on historical context, industry overview, and why an investment opportunity exists today.

HISTORICAL CONTEXT: SCSS shares are down 20% YTD due to several key events. First, on January 30, the company reported 4Q12 sales and EPS far below consensus, and issued 2013 EPS guidance of $1.65-1.80 that was also sharply below consensus of $1.92. Management attributed this shortfall primarily to a two-week sales slowdown in December, which they noted was “unexpected and abrupt.” After seven consecutive quarters of over 20% Y/Y company-controlled comp growth, their reported growth for 4Q12 was just 10.6%. SCSS shares traded down from $28.20 to $23.16 the day after (-$5.04, -17.9%), but remained range-bound between $20-23 for the next five weeks as consensus seemed to accept that this shortfall was an exceptional issue. Then, on March 4, SCSS pre-announced that their 1Q13 sales would miss their internal goals due to “accelerated changes in its media buying strategy,” without actually quantifying how large the “miss” would be. SCSS shares traded down from $20.51 to $17.28 (-$3.23, -17.9%).

When SCSS reported full 1Q13 results on April 18, management revealed several unimpressive metrics including declining comp growth (-9% Y/Y) and store traffic (-15% Y/Y), EPS of $0.41 (vs. consensus $0.44), and reduced 2013 EPS guidance of $1.30-1.50 (from $1.65-1.80 as of 4Q12). Yet curiously, share price has since rebounded to over $22 as investors seemed to have accepted management’s explanation that their marketing miscues were due to a one-time consolidation of media buying from multiple agencies into one, and that these issues were largely behind them. Evidently, some growth investors still believe in the SCSS story and are hanging onto fond memories of pre-4Q12 comp growth of 20%+. However, I think it is just a matter of time before the shareholder base turns over, given my view that the competitive dynamics are much more challenging today.

INDUSTRY OVERVIEW: Before delving into the specifics of why I think SCSS is overvalued, it is worth discussing what the mattress industry looks like. According to the ISPA and company estimates, the global mattress market represents a $20 billion opportunity. In the $7.5 billion wholesale U.S. market, the dominant players are Serta-Simmons (34% market share) and the recently merged Tempur-Sealy (30% market share). SCSS reports that it holds less than 5% market share in dollars and about 2% in units. The U.S. market has grown at a 5% CAGR since the 1980’s, but the sub-$2,000 segment has grown at just 1-2% CAGR over the last decade. In contrast, the fastest growing specialty (non-innerspring) segment has grown at a CAGR of ~10% over the past few years.

Within the specialty bedding market, Tempur-Sealy is the leader with about 35% market share, followed by Serta-Simmons (~25% share) and Select Comfort (~16% share). The major wholesalers and manufacturers, namely Serta-Simmons and Tempur-Sealy, sell most of their mattresses through retailers such as Mattress Firm, Sleepy’s, and other bedding stores. In comparison, SCSS generates virtually all its sales through its own retail stores, phone or web.

WHY AN INVESTMENT OPPORTUNITY EXISTS TODAY: The consensus bullish view is that SCSS’s relatively small market share today provides a sizable runway to grow its business. Bullish investors might also say that SCSS’s air-based technology is a key differentiator of its Sleep Number mattresses, or that SCSS’s vertically integrated model offers a competitive advantage in optimizing control of its supply chain, marketing, and store-level execution. While SCSS has an undeniably strong cash conversion cycle of negative 33 days and a clean balance sheet, I believe consensus is underestimating competition from both retailers and manufacturers, the latter of which have far broader distribution channels and are launching mattresses that could compete directly with Sleep Number. I believe the net result will be lower sales growth, operating margins, and EPS for SCSS relative to consensus expectations.

Moreover, I do not see this competition abating unless SCSS can innovate new beds that will rival the compelling launches that are being offered by competitors, rectify its marketing execution, and grow its store base meaningfully without cannibalizing its own sales. The housing market recovery also appears to be progressing slower than what was anticipated at the beginning of the year. This trend is important to note, since housing demand is often cited as a primary leading indicator for mattress sales.

On the product side, SCSS’s market share is more at risk now than ever due to several compelling mattresses by competitors that were introduced at the Las Vegas Market Furniture Show in January. These mattresses will start rolling out to stores in mid-May. Several mattress professionals have noted that the most potentially disruptive innovation is the Tempur-Choice mattress by Tempur-Pedic (TPX). Tempur-Choice uses air-based technology that compares favorably to Sleep Number and appears positioned to take share from SCSS. (Please message me for my bullish thesis on TPX.)

TPX will start shipping Tempur-Choice to retailers in mid-May, and I expect it to be available in all stores carrying the TPX brand by Labor Day. Tempur-Choice combines Tempur-Pedic’s legacy memory foam technology with three air-filled chambers on each side of the bed. The hybrid air/memory foam technology enables the user to adjust the mattress firmness to his or her unique preferences. In speaking with numerous mattress retailers, I have learned that they expect Tempur-Choice to compete formidably with SCSS’s Sleep Number and could be a superior product. Although Sleep Number has a strong brand, the general sense I have gotten from mattress retailers (admittedly not SCSS stores) and consumers is that Sleep Number beds are “OK” or “good” but not necessarily “great.”

TPX is already the market leader in specialty mattresses and could widen the competitive gap, since the company has become more “retailer-friendly” and will likely aggressively market Tempur-Choice. Of the total U.S. consumer advertising for mattresses since the mid-2000’s, TPX’s marketing spend has represented over 90% of that pie versus low-single digits for all other competitors. I have spoken with several managers and executives at mattress stores in various metropolitan statistical areas (MSA’s), who have forecasted that Tempur-Choice could take up to 10% share from SCSS in their local markets within the first year of nationwide rollout.

Investors that are bullish on SCSS might say that Tempur-Choice, at $3,499-3,999 for a queen set, will be meaningfully pricier than the average Sleep Number unit at ~$3,000. However, I believe that the more relevant comparable would be those Sleep Number mattresses that actually contain memory foam, which retail for $3,299-$4,699 according to the company’s website. Moreover, TPX products are sold in 8,700 stores in North America, a number that is 20x larger than SCSS’s store base.

Sealy, Serta, and Simmons also showcased new higher-end mattresses and non-innerspring hybrid models at Las Vegas in January. In contrast, SCSS did not unveil any new products there. SCSS did announce in April that it would be launching DualTemp, a bedding layer that enables the sleeper to electronically control the temperature setting. DualTemp will be nationally marketed starting in June and should lead to higher ASP’s, but it is not an actual mattress. This leaves one to question whether SCSS has notable new mattresses in its pipeline, or if it is simply falling behind on innovation. To understand the effect that new competition can have, look at what happened to TPX (and its stock price) in 2012 when the company turned somewhat of a blind eye to Serta’s iComfort and other new memory foam entrants: TPX’s specialty market share declined from 55% to around 30-35% before stabilizing just recently.

To reinforce my view that SCSS’s market share is at risk, it is worth reviewing SCSS’s 2012 annual report (filed on 2/21/13). Compared to its 2011 10-K, virtually all risk factors remained the same except for one conspicuous new addition, as follows: “A number of mattress manufacturers, including several of these larger competitors, have offered adjustable firmness air beds in the past, and the largest manufacturer of viscoelastic foam mattresses recently announced plans to offer adjustable firmness air beds that will compete directly with our products.” The competitor that SCSS is referring to is obviously TPX, and I believe this is the first time in any SEC filing that SCSS has made such an acknowledgement. The inclusion of this new risk factor is definitely not an accident and seems too uncanny to be coincidental: it appears that SCSS management, like many others, has been impressed with Tempur-Choice.

On the retailing side, the industry continues to consolidate as Mattress Firm (MFRM) and Sleepy’s, the #1 and #2 largest mattress retailers respectively, have been rolling up smaller mattress chains and are expanding their store base more rapidly than SCSS. MFRM already operates over 1,000 stores and has an additional 158 franchise locations, and management has guided a net increase of 90-95 stores in 2013. Sleepy’s has over 800 showrooms. In contrast, SCSS ended 2012 with 410 retail stores and expects to add just 25-35 net units in 2013. About 20% of SCSS stores are in non-mall locations, which offer higher ROI than SCSS’s mall-based units have been averaging about $2 million in revenues during their first full year. Nonetheless, I believe Mattress Firm and Sleepy’s will become more advantaged due to the widening gap vis-à-vis SCSS in terms of both geographical footprint and economies of scale.

In addition, other prominent mattress brands such as the Three S’s (i.e. Serta, Simmons, and Sealy) and TPX have nearly 10,000 retail distribution points in North America, compared to SCSS’s significantly smaller store base. When one couples SCSS’s comparative disadvantage in distribution points with its recent marketing missteps, I believe there is reason to be concerned about SCSS’s ability to sustain market share. To further complicate matters for SCSS, the North American mattress store count has been approaching saturation, and an argument can be made that the number of mattress stores is already at over-capacity. According to TPX’s 2012 annual report, management sees a total of about “11,500 stores we have identified as appropriate targets” for retail and distribution. This means that the “Three S’s” and TPX have already penetrated nearly 90% of the addressable store base on the continent.

The abundance of mattress stores could limit the ability of any retailer, including SCSS, to launch new stores without cannibalizing its own business or hurting store-level productivity metrics. Although there is a consensus view that SCSS’s selling of its Sleep Number mattresses through its own stores somehow protects the company from price competition, my channel checks suggest that the protection is not as strong as consensus believes. This is most evident in the sharp decline in company controlled comp growth in the past two quarters, as well as the fact that in most MSA’s, mattress stores are within a few minutes’ drive from one another. It is simply not that difficult for consumers to travel from one store to another and compare products across different brands.

Much of my analysis thus far has centered around the competitive landscape and industrial structure, though it is also worth evaluating SCSS on its own operational merits. For example, marketing has historically been viewed as one of SCSS’s key strengths. SCSS had previously acknowledged its “dependence on the effectiveness of our marketing messages and the efficiency of our advertising expenditures in generating consumer awareness” in the risk factors of its SEC filings, which seems pretty innocuous on its surface. However, in its 2012 annual report, management added the following lines: “We have experienced a significant degree of variability in the effectiveness and efficiency of our marketing messages and advertising expenditures in recent years and may continue to experience such variability in the future.” Although I appreciate management’s candor, I am concerned by this new disclaimer.

Finally, although I personally do not try to time market cycles, mattress professionals with whom I have spoken have noted that the housing recovery has been modest thus far. This is a concern since housing demand is typically cited as the primary driver for mattress sales. I am reticent about betting on an acceleration in housing recovery in the wake of high unemployment, strict consumer lending standards, fiscal stalemate, and national debt levels that continue to hinder real economic growth (as Seth Klarman, founder of The Baupost Group, alluded to in a recent investor letter).

In conclusion, I believe that against a challenging macroeconomic backdrop and rising competition on multiple fronts, SCSS is the publicly traded mattress company whose underlying business appears to be at greatest risk. Therefore, I recommend selling SCSS or executing a pair trade by going long TPX (my price target is $60) and short SCSS with a 12-18 month investment horizon.

I believe that multiple downside catalysts could lead to a decline in SCSS’s share price, as follows:

(1)     Market share loss to competing air-based mattress innovations such as Tempur-Choice (expected rollout beginning in mid-May, and could begin tangibly impacting SCSS’s market share in 3Q13 and beyond)

(2)     Declines in operating margins, productivity, or store unit growth (management expects to end 2013 with 435-445 retail stores)

(3)     Continued execution difficulties with marketing (marketing was once considered a core competency for SCSS, but was cited as a key factor for the company’s shortcomings during their 4Q12 and 1Q13 earnings calls)

(4)     Slower than expected recovery in the housing market, consumer sentiment, and overall economic growth