Description

In light of MHTD’s SNBR long idea posted yesterday, we are publishing our opposite view. We do not think SNBR’s current issues are temporary as described in the write-up. Rather, we think SNBR is facing long-term structural pressures and also see a high risk that the company will miss expectations for the second half of the year.

-          Structurally, the company appears to be stuck in a rut as growth over the last few years has been essentially profitless. While sales expanded by nearly $500m over the period FY13-17, operating and net income remained essentially flat over the period as operating and net income margins declined by 3% and 2% respectively over the period.

-          This in turn appears to be a function of the company’s vertically integrated model which allows the company to drive sales by simply increasing the store count but does not allow for any operating leverage as contribution from the marginal sales dollar appears to be subsumed by the marginal cost of operating new stores.

-          Underlying growth also appears to have petered out with SSS averaging a CAGR of approx. 3% over the last five years. Further, all of this SSS growth appears to have been driven by price increases rather than by the company selling more mattresses on a SSS basis. Volume growth on a SSS basis has been negative in each of the last four years.

-          The decline in volume in turn appears to be a function of a significant decline in store productivity. In particular, mattress units sold per store have declined steadily over the last few years. This is even though stores have actually been growing larger over the same period. Thus, while average store size increased from approx. 1800 sq. ft. to 2,600 sq. ft. over the period FY13-17, mattress units sold per store annually declined from approx. 600 to 560 over the same period.

-          The trend in units sold seems to suggest clearly that demand for the company’s sleep number beds is on a decline. This in turn appears to be a combination of various factors including the significant rise of ‘bed in a box’ retailers over the last few years as well as the sharp and sustained rise in the price of the beds (7% CAGR over the period FY13-18) which in turn has likely shrunk the addressable population and driven potential customers to cheaper offerings.

-          The advent of ‘bed in a box’ retailers is particularly problematic as apart from taking customers away, they have enabled price discovery / transparency in the market and thus helped customers understand the actual cost of the bed they are buying, and the sizeable mark-up applied by established companies.

-          In terms of the near-term risk of missing expectations / guidance for the full year, as price growth is expected to flatten out post the completion of the rollout of the company’s new line of beds in Q2, SSS growth in periods post Q2 could decelerate fairly sharply. This appears to be somewhat at odds with consensus expectations of SSS growth of around 1.5% for the second half.

-          Overall growth expectations for the full year and by implication for the second half also appear very optimistic. The company has already reduced guidance from MSD-HSD for the full year  to just MSD sales growth for H2 2018 following growth of 10% last year. With sales growth for H1 at just 3.9% this implies that sales growth will need to improve to 4.5% for the rest of the year in order to hit growth expectations of 4.2% for the full year.

-          However, there are several indicators that suggest that this could prove optimistic:

·         As per earlier, most of the growth last year was driven by price increases rather than volume growth (on a SSS basis). As almost all of price increases are now in place, this is unlikely to be a source of growth past Q2. Price could in fact potentially be a negative impact post Q2 given how strong price increases have been since Q3 last year.

·         While volume growth could make up for the lack of price growth, SSS volume growth has been negative for the last four years and was a negative 13% in Q1 (although this rebounded somewhat in Q2 as they closed out some old stock to fully transition to the new 360 bed product). The build-up in inventory as discussed below also does not suggest that volume growth is likely to pick up near term.

·         Inventory jumped quite sharply by 27% on a DSI basis YOY in Q1, up 11days, and in Q2 inventories we up again by 6 days YOY.  Viewed in conjunction with negative volume growth, this suggests that demand for the company’s latest sleep number beds has been much less than anticipated.

·         Store count growth could potentially have helped fill the gap. However, the company’s CAPEX guidance of lower than last year suggests that store count growth is likely lower than the 3% achieved last year. Store count growth of c.2.9% in H1 also appears to corroborate this trend.

·         In summary, overall growth for the next 6 months appears likely to be around 2-3% (flat pricing + flat or negative volume + 3% or less store count growth) compared to the 4.5% required to meet current consensus expectations.

-          Stock is trading at 18x forward earnings which is in line with its long-term average but seems high for a company facing structural growth challenges and a poor underlying growth profile.

Regarding the Q2 improvement and some of the positive developments mentioned in MTHD’s write-up specifically we highlight a number of things:

-          Re-TTM average sales per store being +4%: they changed the definition of ‘average sales per store’ and ‘average sales per square foot’ adding the words “company-controlled comparable” likely inflating this metric compared to previous disclosures.

-          Comp sales of 9% included a 7% benefit from ‘value customers responding to close out deals’ as the company cleared out old stock and fully transitioned to the new 360 bed product. As such, this is a lower margin, one-off benefit to comps. Adjusted for this, comps for the new 360 beds seem to be flattish (and likely all from price rather than volume) which is not a good sign given that the new beds were in 75% of the stores at the start of the quarter.

-          There was quite a bit of back and forth on this on the call with the company claiming that sales growth is MSD-HSD for Q3 and HSD for Q4 once adjusted for the inventory issue last year (which shifted $25 million of sales from Q2 to Q3). However, if we indeed adjust for this and then look at H1, then sales growth is flat in H1 and MSD for the full year (i.e. an implicit lowering of the full year guidance).

-          Re-margins improving going forward: Gross margin fell quite sharply by 230 bps YOY in Q2 which was partly due to closeouts. While gross margin is expected to improve sequentially by 50 bps (i.e. to 61%) in 2H, it will still be lower than the 2H gross margin last year of 61.9%.

-          On the other hands, operating expenses came in much better by 400 bps YOY. Part of this was due to the company holding back media spend which seems like they will start doing again in 2H.

-          The CEO mentioned several times on the call that the marketplace is getting more intense with a lot of commoditised product coming into the market. This in turn is driving up search costs as lots more players enter the marketplace. An analyst called out the CEO on this that she was mentioning the commoditised marketplace a lot more than in the past. The CEO concurred by saying that that's what she is seeing in the market and what analysts are writing about.  Further, the company’s strategy is to counter this by offering their value product at $999 (compared to their AUR of $4,300). The CEO further commented on this by saying that more the customers buy their value brand, more they are not buying some other [non SNBR] brand.  However, if a lot more customers start going for the value brand, then their AUR will take a sharp drop and this will be inconsistent with their positioning as a premium brand in the marketplace.

-          Net debt is now up to $180 million from $73 million last quarter as the company is aggressively levering up the balance sheet and using it mostly for share buybacks. The liquidity cushion requirement also seems to have been lowered from $100-150 million earlier to $100 million now. 

Overall, Sleep Number shares are very expensive for a low-quality business facing structural challenges.  We believe that disappointing results in the second half of the year will lead to expectation being reset for 2019 and beyond leading to earnings downgrades and a significant derating.

Catalyst

Disappointing H2 results and reset of 2019 expectations