Sleep Number Corporation (together with its subsidiaries, “SNBR” or the “Company”) designs, manufactures and sells mattresses and other bedding products in the United States.  Among mattress manufacturers, SNBR is unique insofar as it sells the vast majority of its mattresses through its own stores, which make it the second largest bedding retailer in the United States (behind Mattress Firm).  

I recommend purchasing SNBR’s stock, which is down more than 50% over the past year.  Like its peer Tempur Sealy International, Inc. (“TPX”)—which I also recommend for reasons discussed herein and in burlap’s 02/10/22 write-up—SNBR delivered record performance in fiscal year 2021 yet has been punished by a variety of concerns that, in my view, are overblown.  Specifically, investors appear to believe that (i) SNBR and the U.S. mattress industry more generally have over-earned during the pandemic; (ii) recent supply chain problems will persist; (iii) cost inflation cannot be passed through and/or (iv) consumer demand will crater.    

In contrast, I believe that (i) fiscal year 2021 will not prove to be the near-term peak of the industry as demand will continue to be robust, particularly outside of the lower end (where SNBR has very little exposure); (ii) supply chain problems will ultimately be resolved and in the interim, should not impair the long-term value of SNBR; (iii) SNBR has pricing power and (iv) even if there is a downturn in demand owing to a recession or otherwise, history suggests that it will come back within a few years.  Given the preceding views, I think that SNBR can plausibly grow its earnings per share at a 15% to 25% CAGR in the medium term.  Accordingly, at 9x fiscal year 2022 EPS at the mid-point of Company guidance, SNBR strikes me as far too cheap and could easily be a double from current levels (which would be more in line with its pre-pandemic P/E ratio).  And if I am wrong, I think that the Company’s un-demanding valuation (~23x pre-pandemic EPS) and conservative balance sheet should provide substantial cushion against a blow-up. 

Capital Structure

Below is SNBR’s capital structure.  With 1.4x net leverage or 2.6x under its lease-adjusted definition, the Company carries very little debt and has ample liquidity.  Further, with the ability to make restricted payments at or below 3.75x lease-adjusted net leverage, SNBR has substantial cushion under its credit facility for dividends and share buybacks.  Regarding the latter, the Company has over $400 million remaining under its existing share repurchase authorization and based on its expected free cash flow, should be able to buy back a significant percentage of its shares in the years to come.

Business Overview

SNBR sells mattresses and other bedding products.  Its mattresses are foam mattresses with air chambers that provide for DualAir adjustability, allowing sleepers on each side of the bed to adjust firmness to their desired Sleep Number score.  In addition, the Company’s mattresses have sensors that employ SleepIQ technology to track breathing, heart rate and movement, delivering a SleepIQ score each morning that shows how the sleeper slept so he or she can learn and adjust.  SNBR’s primary product is its Sleep Number 360 Smart Bed, which includes four series with multiple models as listed below (estimated prices are for a queen).

SNBR still sells primarily through its own retail channel, which consists of 648 stores located across the United States.  Over the past decade, SNBR has steadily grown store count while also growing productivity per store, a trend that I expect to persist.

Industry

SNBR operates within the U.S. mattress and foundation industry.  At wholesale, this is an ~$11 billion market that has steadily grown over time, with demand correlated to the replacement cycle, GDP and housing.  Notably, over the past five decades, the only period during which the market meaningfully contracted was the Great Recession of 2008, and even then, the peak-to-trough decline was less than 20%. 

Not only has the mattress industry enjoyed prolonged growth, but it remains concentrated.  By my estimates, TPX, Serta Simmons Bedding, LLC (“SSB”) and SNBR account for ~2/3 of the U.S. market (excluding imports).  Although SNBR remains a distant third behind TPX and SSB, it has steadily grown share while SSB has ceded it.  

SNBR’s gains have come notwithstanding the proliferation of direct-to-consumer companies such as Casper Sleep Inc. (“CSPR”) and Purple Innovation, Inc. (“PRPL”).  And to the extent that direct-to-consumer growth ever was a threat to SNBR or other traditional industry players, I believe that threat is fading as companies like CSPR and PRPL have struggled of late, at least in part because many of them (with the possible exception of PRPL) are glorified marketing companies without differentiated products.

In addition to direct-to-consumer upstarts, the industry has also grappled with imports.  But as with the direct-to-consumer threat, the threat of cheap imports has recently faded, in the latter case owing to anti-dumping actions.  Moreover, even if cheap imports remained a problem for the industry, SNBR would be less exposed than competitors as, unlike TPX’s Sealy or SSB’s Serta, it does not really compete under the $1,000 price point.

Valuation

Below is a simple operating model that illustrates the potential earnings power of SNBR over the medium term.  While this is somewhat conservative to the Company’s latest guidance, it shows that through a combination of operating improvement and buybacks, SNBR can generate over $15 per share of earnings within five years, implying a ~4x forward earnings multiple.

One might scoff at the above by noting that, even if all of the numbers prove accurate, SNBR is not necessarily cheap on a relative basis given that various retailers (e.g., certain department store and sporting goods chains) now trade at 4x or less next year’s earnings.  However, unlike many of these companies, SNBR operates in an industry that is not in structural decline and it has a differentiated product offering that, I believe, provides it with a moat.  Moreover, while the above math is somewhat similar for TPX (which I also like), I think that SNBR is superior in this environment because it is less exposed to lower-end mattresses, which I expect, and have already proven, to be more sensitive to the health of the consumer.  I therefore believe that within the coming years, SNBR could easily double from here.

Risks

There are several risks to the above thesis.  First, near-term supply chain challenges may not be quickly resolved.  SNBR is particularly exposed to semiconductors and has already suggested that the first quarter of 2022 will be challenging.  Second, consumer demand may roll over due to a recession or a pullback in the mattress space specifically.  Finally, SNBR, which has been criticized before for sub-par execution, may poorly execute on its value creation plan.