Description

Thesis:
We are long shares of Select Comfort Corporation (SCSS). We believe that the market is underestimating the true earnings power of the business due to large, non-recurring revenue and earnings losses associated with the company’s botched rollout of its new ERP system late last year. Brokers are valuing the company on the low end of management’s 2016 EPS guidance, even though this guidance incorporates a sizeable, one-off earnings impact from the ERP disruption.

In our view, this combination has setup a very attractive risk-reward play. At 12.2x adjusted 2016 EPS, the company appears cheap in light of management’s mid to high teens growth target for EPS over the next three years. SCSS trades at a 8.0% 2016 levered free cash flow yield, even as it is projected to grow LFCF at a >30% CAGR over the next two years. Management has also been clear in its capital allocation priorities, dedicating a portion of free cash flow to share repurchases. Last year, the company opportunistically doubled its allocation to buybacks, retiring ~7.5% of shares outstanding ($100 million on a ~$960 million market cap). With no debt currently on the balance sheet, there are indications that the company could lever up for even more repurchases.

We see a clear path to ~$1.35 in EPS for 2016 – right between management’s target range of $1.25 to $1.45. From here, once the one-time earnings impact from the ERP implementation rolls off, we believe there will be visibility to >$1.80 in earnings power for 2017. At 15.0x – a ~10% discount to the 5-year average NTM P/E of 16.4x – SCSS would trade at $27.00, a ~40% increase from today’s price.

Trading Multiples:

Company / Industry Overview:
Select Comfort Corporation (SCSS) is a vertically integrated manufacturer and retailer of mattresses and bedding accessories, selling a full line of beds under the Sleep Number brand. As of year-end 2015, the company operated 488 Sleep Number stores across the country. At nearly $1,000 in sales-per-square-foot, SCSS’s productivity ranks in the top 10 of U.S. specialty retailers.

The company sells specialty mattresses (i.e. without traditional innerspring) with adjustable air chambers into the premium segment of the market – its mattresses are largely in the $1,000 - $3,000 range. SCSS also sells attachments with its mattress sales, such as the FlexFit adjustable base (adjust head and foot of bed, massage feature, etc.) and SleepIQ technology (sensors inside the bed tracks the quality of your sleep, which you can view with the SleepIQ app).

After the Great Recession, the company underwent a broad strategic shift:

1. Largely ended its wholesale distribution;

2. Shifted marketing and branding strategy from mattresses relieving back pain for older consumers (with associated infomercials) to a premium bedding solution provider targeting affluent, health-conscious consumers (with heightened, broader-reaching brand advertising);

3. Rebranded all stores to Sleep Number (some had been Select Comfort) as well as renovating, remodeling and relocating many stores (historically the company’s retail footprint had been exclusively in malls; SCSS began operating in off-mall locations in 2010; approximately 44% of the 488 stores today are in off-mall locations);

4. Heightened focus on innovation, with more frequent product introductions

While this shift has been underway for several years now, the company has still been in investment mode for the past couple of years, which in large part explains why the full effects of the operating leverage in the business have yet to bear out (we will touch upon this in greater detail later).

The company is the second largest retailer of mattresses and bedding accessories in the U.S., with an estimated ~8% share of total 2014 retail sales:

The company is the fifth largest wholesaler of mattresses and bedding accessories in the U.S., with an estimated ~5% of total 2014 wholesales:

Competitive Positioning:
Mattress manufacturers and retailers primarily compete on price, quality, and convenience. We believe that SCSS is well positioned on quality and price. Its proprietary technology keeps it in the premium segment of the market and appears to justify the premium pricing. As an example, its average revenue per mattress unit has increased from $2,694 in 2011 to $4,028 in 2015. Increasing attach rates has driven much of this increase, which shows that there is real demand for these innovative add-ons and consumers are willing to pay up for them. The Company is also focused on maintaining its technological leadership – last September, it acquired BAM Labs, the Silicon Valley-based company that partnered with the company to develop the SleepIQ technology (SCSS previously held an equity investment in BAM of ~18%).

On convenience, there has been much discussion surrounding the rise of the online “bed-in-a-box” players. Our view, like that of many others, is that consumers will still want to go to a mattress retailer to try out various mattresses. SCSS has been responsive to this threat, however, and is introducing the ‘it’ bed this summer, targeted at millennials (25- to 34-year olds with average income of $50,000). The bed will be available with a simple online purchase, features dual adjustability, the SleepIQ technology, and is priced around $1,000. While there could be some pricing pressure here, we feel that the proprietary nature of the Sleep Number product would still justify the premium pricing.

We actually feel that the company-controlled retail footprint serves as a competitive advantage for SCSS. Compared to other manufacturers, the company does not have to compete for floor placement. It also allows the company to provide a more targeted and effective sales pitch and product promotion to customers, which can be especially important for the various attachments. Compared to other retailers, SCSS has an advantage in its working capital efficiency – it manufactures its products by the order, so it is able to operate with very low inventory levels. The company actually has historically operated with negative working capital (we would mention, however, that the company is beginning to manufacture some mattresses ‘ready-to-order’ to reduce lead times).

Why the Opportunity Exists:
In the process of transitioning its legacy systems and manual processes to a fully integrated ERP platform, the company experienced extreme difficulty in the last quarter of 2015. The supply chain and order handling essentially broke down, causing missed and delayed deliveries and requiring manual intervention. Net sales were down 33% over the prior year’s Q4, the company incurred an operating loss of ~$30 million and a loss per share of $0.42.

The botched rollout is also expected to impact the first half (primarily first quarter) of 2016. This is where we find the investment opportunity – the sell side is valuing the company on management’s guidance for 2016 earnings, even though this guidance includes a sizeable impact from the ERP disruption. We believe that this approach dramatically underestimates the true earnings power of the business.

Management has guided to $1.25 to $1.45 in EPS for 2016. This assumes $0.25 to $0.30 of ERP implementation pressure on sales and costs (primarily in Q1). Most brokers are valuing the company at the low end of this guidance and apply a discounted multiple to the company’s historical average. We have included several sell side quotes on valuation below:

“We estimate 2016 EPS of $1.30. We believe SCSS should trade at a forward PE multiple of ~16x, toward the mid-point of its five year historical valuation range, still below the five year historical average 16.8x, given economic uncertainty despite prospects for longer-term EPS growth in the mid-high teens. Our $21 target price is 16x our 2016 EPS estimate.” – Wedbush, March 21, 2016

“We are maintaining our Neutral rating and lowering our PT to $18 (from $22) following Q4 results that were far worse than feared…Management reiterated its long-term guidance for 2019 EPS guidance of $2.75; this could represent a good time to get involved with the stock, but this goal now looks to us like more of a stretch and the current outlook is murky. Our $18 PT is based on 14x our revised 2016E EPS of $1.30 and we have lowered our multiple to 14x (from 15x) due to a slower than expected rebound from the implementation.” – Piper Jaffray, February 12, 2016

“We remain cautiously optimistic about SCSS’s underlying trajectory, as lost sales due to ERP-related disruptions are normalized in the next several quarters. Despite these headwinds, management expects to generate 29%-49% EPS growth in 2016. Valuation appears attractive relative to our coverage, and we would likely look to get more positive on shares once the Company gets past the current ERP issues and margin headwinds in the 1H.” – KeyBanc, February 11, 2016

In our view, uncertainty surrounding future operational execution has led to excessive conservatism in valuation and has provided a highly attractive risk-reward opportunity. Based on management guidance, we see a low hurdle to $1.60 in 2017 EPS – at a depressed 13x forward multiple, this would put the future share price slightly higher than present levels (or roughly fairly valued using a 10% discount rate). Our base case, however, projects visibility to >$1.80 in earnings power in 2017. We believe much of the downside risk is already priced into the stock because of the Street’s conservative valuation approach; our downside of a (35%) return is more than compensated by ~75% appreciation in our upside scenario.

Valuation:
SCSS appears to trade on P/E. We therefore approached valuation by assessing what the company’s earnings power for 2017 could be one year from now i.e. where the company will guide for 2017 EPS or what the market will be able to project based on 2016 actual results. We estimated the 2017 earnings power two ways. First, we use management guidance to (simplistically) bridge to a 2017 EPS that we feel is conservative (conservative given management guidance, however). Second, we break down management guidance to fully understand the $1.25 to $1.45 EPS target for 2016 and, flexing the underlying assumptions as a base, bridge to a 2017 EPS.

Approach 1:

Management has guided to $1.25 to $1.45 in EPS for 2016. This assumes $0.25 to $0.30 of ERP implementation pressure on sales and costs (primarily in Q1). If you assume that this earnings impact laps in 2017 and there is no further growth in earnings, we can get to $1.575 of EPS in 2017 (assuming the midpoint of the above ranges). Importantly, there is another one-time ‘charge’ embedded in management’s earning guidance that we think has been overshadowed by the ERP disruption. The company acquired BAM Labs in Q3 2015. It guided to $0.10 to $0.12 in dilution relating to the acquisition for 2016, before turning accretive in 2017. This detail was only mentioned in the Q3 transcript and was not reiterated in the Q4 transcript when management first released its 2016 EPS guidance (only the margin expansion opportunity associated with the acquisition was briefly mentioned). Assuming the acquisition can get to breakeven in 2017, we arrive at $1.69 of EPS in 2017 which, again, assumes no further earnings growth ($1.60 using the low end of all ranges above, which is the number we cited in the section above). The current median consensus estimate for 2017 EPS is $1.75. We view this as a very low hurdle. If this earnings potential comes into clearer view as we move toward the end of 2016, we think a 15.0x multiple could be warranted (~10% discount to 5-year average NTM P/E of 16.4x and right around where brokers are currently valuing the company). This would put the stock at $26.25, ~36% above the current price.

Approach 2:

We further dug in to management guidance to assess the projections. This would allow us to triangulate exactly how aggressive management was being (i.e. by looking at implied share buybacks) and to see if the guidance was reasonable when compared to historical results as well as where the business was trending in Q3 2015 (before the ERP debacle). The ultimate goal here is to see whether or not the assumptions are an appropriate base to go off of to assess the company’s 2017 earnings power.

Below is the bridge to the company’s $1.35 midpoint for 2016 EPS:

We believe that all of the estimates are reasonable (illustrated below when compared to historical results), however, we think two items deserve discussion. First, the 47 net increase in store count appears somewhat aggressive in our view, in light of the historical growth of 20 – 30 net stores per year and management’s stated goal of growing the net store portfolio 5% to 7% annually. (One might also question this number when compared against the decrease in capex from the prior year. This is because ~30% of last year’s capex was related to the ERP implementation. Most of the capital expenditures for the ERP system should already have been incurred, therefore this next year’s capex figure is actually a like-for-like increase). We would point out that management has targeted a retail footprint of >550 stores, so the resulting absolute number does not appear to be a stretch. We are aware, however, of the risk that management is overly aggressive with store openings to compensate for a slowing increase in average revenues per mattress unit and average revenues per store.

Second, the implied cash spent on buybacks was more aggressive than we expected to see. While it is around last year’s figure, it is important to recognize that the company benefited from the release of $130 million of required cash last year through marketable securities sales. SCSS had historically kept a cash / marketable securities balance of $100 million for operating purposes (likely overly conservative, as one investor brought up in the Q1 2014 earnings call); however, this past September they increased their revolver to $100 million from $20 million, and in February 2016 increased it further to $150 million (while maintaining $50 million accordion feature). This allowed the company to reduce its required cash balance ($130 million released) to supplement cash flow from operations (~$110 million) in its funding of capex (~$85 million), acquisitions (~$70 million) and share repurchases (~$100 million).

Next year, it is unlikely that the company will make another large acquisition like that of BAM Labs. Equally unlikely is the sizeable increase in inventory (~$33 million), which is a combination of the order delays from the ERP situation and the partial shift to ‘ready-to-order’ manufacturing to reduce lead times. However, it is important to recognize that the median estimate for levered free cash flow for 2016 is $77 million ($147 million in CFO less $70 million of capex); the remaining $36 million in cash and equivalents / a revolver draw may be necessary to reach $100 million of repurchases.

With these considerations in mind, we move to flexing management’s guidance and comparing it to historical results. We created three cases:

1. Base case: flexed management’s guidance to arrive at low end of 2016 EPS guidance ($1.25) and use this as a base to project 2017 EPS

2. Upside case: flexed management’s guidance to arrive at upper end of 2016 EPS guidance ($1.45) and use this as a base to project 2017 EPS

3. Downside case: severely flexed assumptions lower to arrive at a ‘worst case’ 2016 EPS figure and use this as a base to project 2017 EPS

Below is our base case output, along with a summary of the cases. The upside and downside case output can be found in the appendix section at the end.

For our base case, we targeted high single digit revenue growth for 2016 – this puts us at a 2016 revenue figure right around where the company was at for LTM Q3 2015. For 2017, we assume the company can get to the 550 store target, and that there is continued growth in the average revenue per store (we would note that management has targeted $3 million average revenue per store – at Q3 2015, already 25% of stores were at this level). For gross margin expansion and sales and marketing as a percentage of sales, we took the midpoint of management guidance for 2016, with additional expansion in 2017. For G&A and R&D, we take management’s guidance for the dollar value increase. We feel that the resulting EBIT margin is reasonable at 6.9% for 2016, especially considering that the company was at ~10% before the ERP implementation trouble. For 2017, the 8.8% margin is where the company was at in 2014. We assumed only $50 million in buybacks. Looking at net income plus D&A less capex as a proxy for LFCF, we get to $50 million (this is understating LFCF, however, as the company is starting to have significant deferred revenue in connection with its SleepIQ sales, which are recognized over a 5 year period).

For the upside case, we were slightly more optimistic on growth and margins (taking management’s sales growth guidance of low double digits, using upper end of margin expansion guidance, etc.). We still feel that the resulting EBIT margins for 2016 and 2017 of 8.0% and 10.1% are defensible when compared to historical levels. We were also a bit more aggressive on buyback assumptions, using $75 million.

For the downside case, we attempted to project a ‘worst-case’ scenario for the company. We forecast an EBIT margin of 4.3% for 2016 and $0.71 in EPS. For 2017, EPS is $0.96.

We feel that there is an asymmetric risk-reward here.

Catalysts / Event Path:
The event path for this investment is centered on moving through 2016 and the associated operational hurdles so that the market values the company on projected 2017 EPS, which we feel will be a much more accurate estimate of the company’s true earnings power. However, there are a couple important interim ‘steps’ to be aware of:

1. Q1 2016 results will be particularly important, as management will provide an update on the company’s handling of the ERP operational issues. Positive results may encourage some brokers to increase their price targets, as this uncertainty around execution begins to pass. On March 23^rd, the company issued a press release saying that it continued to meet weekly milestones with the ERP system implementation and returned to normal home delivery lead times.

2. We believe that there is a high likelihood that the company announces an expanded share repurchase program soon. Indications are that the company will draw on the expanded revolver to fund buybacks. From the Q4 2015 earnings call:

   Question: “Just on the buyback and looking at your balance sheet, I mean, for the fourth quarter, if you look at kind of the cash marketable securities and then net that against the prepayments, which are actually high for obvious reasons. As we look into 2016 now, I know last year, you said you wanted to maintain like a $100 million number based on those variables. Given that in Q4, I think if you net all those numbers together, it's actually a negative. Should we be expecting you guys, given you said you were going to be assertive on the share buyback to be taking on debt to buy back stock down here?”

   Answer: “Yes, it's an important question, Jon. We talked about last, in the third quarter, that we once we get to the other side of the ERP implementation, that need for the substantial cash reserves wasn't there anymore. So we intended to lean into our share repurchases. We intend to continue to be opportunistic in our share repurchases. We've got an unused revolver of $100 million today that we're planning in this quarter to increase to $150 million. But we haven't given an indication of the pace at which we would buy back shares.”

   To be clear, this reiterates our point earlier that, in order for management to hit the $100 million buyback target, they will likely need to draw on the revolver. A draw on the revolver to target this level therefore would not be as important, since it is already embedded in the guidance. But, we think it still represents a critical step, as it will help get the company closer to $1.80+ in 2017 EPS potential.

   However, we think there is a possibility that the company is even more aggressive with the buyback, aiming above the $100 million target. Management has indicated that they see value in the shares at current levels – they opportunistically doubled the amount of buybacks last year to ~$100 million as the share price declined, retiring ~7.5% of outstanding shares in the process. If we assume ~$50 million in LFCF for 2016, with ~$36 million in cash / marketable securities, and ~100 million in revolver capacity to fund buybacks ($200 million total availability with accordion less ~$100 million required to maintain adequate liquidity for operating the business), there is ~$185 million in ‘dry powder’ to fund repurchases. We also point out that the company just brought on Barbara Matas, the ex-head of Citi’s leveraged finance group, to the Board; to us, this is another indication that the company is seriously considering a shift in their capital structure.

Finally, looking beyond the next year, we think that there is nice optionality for this investment. Despite our downside case of $0.96 in 2017 EPS, we believe the more likely downside scenario is that this is dead money for the next year. If that ends up being the path, you can reassess the company’s prospects in a year. We like this, as we believe that SCSS is a solid business. Yes, the company does operate in a highly competitive industry. But it has earned good returns on capital above its stated 10% cost of capital. It has attractive growth prospects in an industry that has exhibited stable growth for multiple decades. And, finally, there is solid cash generation, some of which has yet to be realized; we alluded to this earlier – the company has been in ‘investment mode’ for the last several years. It has been spending aggressively on advertising to push brand awareness (has been spending more than double normal levels in early years for 15 targeted ‘aggressive growth markets’). This will eventually level out (the company is on the 11^th growth market for 2016). The company has also been spending aggressively on capex – renovating stores, opening new stores, revamping the company’s digital offering, and implementing the new ERP platform. Once the pace of investment slows and the company begins to realize the operating leverage in this business, we think that the free cash flow could be materially higher than today’s levels.

Risks:
The main risk for this investment is that the company materially misses its 2016 EPS guidance and, as a result, 2017 EPS projections come down. The three main, broad risks to the company missing 2016 EPS are (i) an industry-wide slowdown, induced by either a recession or online competition taking share at an accelerated pace, (ii) operational mistakes by the company, or (iii) inadequate guidance. For (i), we admit that we do not have a view on where we are in the mattress cycle. The fears of an economic slowdown seemed to have taken a toll on the mattress players this past year though, so there does appear to be concern for where we are at in the cycle. We would just point out that mattress sales have been tremendously steady for the past several decades: the 30-year average annual growth rate has been ~5%. And while 2008-09 saw sharp declines in sales, there have only been four declines (on dollar basis) over the last 30 years. SCSS is also in the specialty mattress sub segment, which has been gaining in popularity compared to traditional innerspring. Finally, SCSS is arguably in a better position to take market share as it increases brand awareness. We also admit that we do not have any special insight into the online competition threat. We believe, however, that this risk, along with the economic slowdown risk, can be hedged by shorting / buying puts on the other mattress players (relative valuation appears attractive; gs0709 also just wrote-up a short on Mattress Firm, which we would encourage everyone to read).

For company-specific operational risk, we think that we are being handsomely compensated for this with the asymmetric return profile of the investment. You have to be comfortable with this if you make this investment.

For (iii), ‘guidance risk’, obviously taking management’s word for projected results is risky. At the company’s May 2012 Investor Day, Shelly Ibach, the Company's then COO, and incoming President and CEO, targeted doubling the company’s 2011 sales and achieving 15% operating margins by 2015. Both of these have not been achieved. During Ms. Ibach's first quarterly conference call as CEO on July 18, 2012, the Company predicted future earnings growth of at least 20% per year over the next three years. This has not been achieved. The company also had a string of guidance misses / reductions in 2013. One might therefore push back and ask how we can rely on management’s 2016 EPS guidance. One, this is near term guidance, which should be easier to forecast; note that we are not relying on management’s long term 2019 EPS target of $2.75 for this investment. Two, we went through the whole exercise of breaking down the guidance to check for reasonability. Three, an activist investor – Blue Clay Capital Management – has been involved with the company (sending letter to management in April 2015, recommending Board nominees); importantly, the investor highlighted the guidance misses of the past. We think this would encourage the company to be a bit more conservative in giving guidance moving forward. Fourth and finally, the CFO at the time of these overly aggressive guidance projections and misses was Wendy Schoppert; prior to assuming the CFO position in June 2011, she held positions as Chief Information Officer and Chief Marketing Officer of SCSS (and previously led US Bank's Private Asset Management team and served as Head of Product, Marketing & Corporate Development for the bank's asset management division). The company has since brought in David Callen (April 2014), who has actually held significant financial positions in the past – he served as the Principal Financial Officer, Vice President, Finance and Treasurer for Ethan Allen Interiors, from 2007 to 2014; was Vice President of Global Finance of Phototronics, and was Corporate Controller of Johnson Outdoors. We think this appointment would bring a more disciplined approach to investor guidance.

Appendix:

Catalyst

Move through 2016 so that company is valued on 2017 earnings

Q1 2016 results, with update on handling of ERP operational issues

Expanded / accelerated share buyback