SEALY CORPORATION

 

Sealy Corporation is a well-positioned and well-managed company that is the leader in the U.S. mattress industry with approximately 21% market share.  The company’s stock has languished since its IPO (priced at $16.00) in April 2006 due to a confluence of factors including general wariness regarding the strength of the consumer, high energy prices and rising interest rates.  The market also fears that a continued decline in the housing market, coupled with weakness in overall consumer demand and strong performance by Sealy’s competitors, will significantly adversely affect the company’s financial results over the short term.

 

As will be discussed in detail below, Sealy has several attractive investment characteristics.  First, Sealy has a strong competitive position. Sealy is the #1 player in the U.S. wholesale mattress industry and has held the leading market position for over 20 years. Sealy also maintains strong brand equity, substantial pricing power due to the infrequent nature of mattress purchases, and powerful leverage over its retail partners given the company’s scale and broad product portfolio. Second, Sealy competes in an attractive industry with consistent, predictable growth. Over the past 25 years, the U.S. mattress industry has grown at a 6.5% CAGR and has had only two years of declining revenues (1982 and 2001). Coupling domestic industry growth with Sealy’s opportunity to grow overseas, the company has ample avenues for continued strong growth. Third, Sealy’s business generates high returns on tangible capital (40%+), highlighting the company’s top tier franchise characteristics. Given Sealy’s entrenched competitive position and stable industry structure, returns on capital are likely to remain robust going forward. Fourth, Sealy has an outstanding management team with respect to operations, strategy and capital allocation.

 

Although Sealy is growing sales in the high single digits and earnings at rates in the mid-teens, its share price does not at all reflect such growth and does not account for the quality of the company’s management team or competitive position.  At 12.7X 2007E P/E and 8.0% 2007E free cash flow yield, an investment in Sealy at current prices represents an excellent risk/reward and is likely to generate annual returns in the high teens to mid-twenties over a 3–5 year time period with minimal risk of capital loss. 

 

 

Sealy is the leading bedding manufacturer in the U.S. The company manufactures and markets a line of bedding products, including mattresses and mattress foundations. Its conventional (innerspring) bedding products are manufactured and marketed under the Sealy, Sealy Posturepedic, Stearns & Foster and Bassett brand names. In addition, the company manufactures and markets specialty (non-innerspring) visco-elastic and latex bedding products under the TrueForm, SpringFree, Stearns & Foster, Reflexions, Carrington Chase, MirrorForm and Pirelli brand names. It serves domestically approximately 2,900 customers representing approximately 7,000 outlets, including furniture stores, specialty bedding stores, department stores and national mass merchandisers. Note that approximately 20% of the company’s revenue comes from overseas. KKR took Sealy public in April 2006 at $16.00 per share and currently owns approximately 51% of the company.

 

Sealy has the broadest product offering of any of its competitors, both by product type and price. Approximately 95% of its product portfolio consists of innerspring mattresses, while the remaining 5% are specialty products consisting of visco-elastic and latex products. (The company also has air products that are in the test phase.) The specialty market has been growing significantly faster than the overall market (30% in specialty, compared to the overall market of 12% in 2005) and Sealy expects to continue to penetrate this market. Segmenting Sealy’s product portfolio along price points, approximately 68% of Sealy’s 2005 sales consisted of mattresses that cost $750 or more. Sealy continues to focus on the high-end portion of the mattress market as it provides greater margins. Sealy’s share in the $1,000+ luxury segment is greater than its share in the overall market (which is 21%).

 

Sealy has been proactive at managing and growing its business and has been enhancing productivity through increased manufacturing efficiencies.  The bedding industry continues to be highly competitive, and Sealy recently has lost domestic market share while it has undergone its largest product-line upgrade in the company’s history. Typically, bedding manufacturers upgrade their product lines every few years.  During product upgrade cycles, sales typically slow because retailers are not able to advertise and market the new products in advance. To stunt the immediate adverse impact of upgrade cycles on overall sales, Sealy has historically staggered product-line upgrades. For example, the company would upgrade its Stearns & Foster line one year and its Sealy Posturepedic line the next year. However, because of the new flame retardant (FR) regulations (which all U.S. mattresses must meet by June 30, 2007), Sealy upgraded both its Stearns & Foster and Posturepedic lines in 2006 in order to meet the new FR standard. These product transitions impacted nearly 80% of Sealy’s domestic business over the past year, and Sealy’s recent sluggish domestic sales are largely attributable to these product upgrades. Furthermore, Sealy’s main competitors have yet to upgrade for the FR regulations, which bodes well for Sealy’s business in 2007.

 

Over the past several years, Sealy has dramatically improved its operating performance and working capital management.  Gross profit and EBITDA margins have improved from 41.6% to 44.3% and 11.2% to 15.7%, respectively, over the 2003 to 2005 period. These operational improvements have been driven by a combination of economies of scale, improved mix, improved ASPs and improved productivity, and the company expects further margin improvement going forward. On the working capital side, days receivable, inventory turns and days payable have each improved during the 2003 to 2005 period, as shown below:

 

 

These working capital improvements have been driven by increased efficiencies throughout the business, and management expects some further improvements in working capital going forward, albeit at a more modest pace. Obviously, KKR has been very helpful here.

 

Sealy has two significant growth areas: international and the specialty segment of the market. Sealy currently generates approximately 20% of its sales overseas and its international sales have been growing rapidly over the past several years. Sealy’s core markets outside of the U.S. are Canada (20%+ share), Mexico (leading brand supplier), Argentina (20%+ share) and Europe (developing opportunity going forward). The global mattress manufacturing industry is approximately $15+ billion, and the market outside of the U.S. is over $8.5 billion – a significant opportunity for Sealy. As mentioned above, Sealy has invested in its specialty product lines and is focused on gaining share within this $1.3 billion segment of the overall $6.5 billion domestic market (currently holds approximately 5% share). Coupling these two growth avenues with Sealy’s ability to gain market share domestically, Sealy is well positioned to grow its top-line at management’s guidance of high-single digits (though returns remain attractive in a much more conservative case).

 

The strong economics of Sealy’s business also allow it to earn superior returns on tangible capital of 40%+ and generate substantial free cash flow (8%+ FCF yield at the current price).  The company plans to use free cash flow to pay down debt until it reaches a 2.5–3.0X net debt / EBITDA ratio (currently at 3.3X) and pay a dividend (current yield of 2.2%). Once its target net debt / EBITDA ratio is achieved, the company may increase its dividend or buy back shares. Given substantial FCF generation and minimal capital requirements, Sealy is positioned to significantly increase value for shareholders over the next 3–5 years.

Management: 

Sealy’s management team is experienced, smart and focused. Dave McIlquham has been CEO since April 2002 and has been President since February 2001. He was elected Chairman of the Board in April 2004, had been Chief Operating Officer from February 2001 to April 2002 and has been with the company for approximately ten years and in the industry for twenty years.

 

Jim Hirshorn has been Senior Executive Vice President, Finance, Operations and Research and Development since July 2005. Prior to that, Jim had been Executive Vice President and CFO since November 2002. Prior to 2002, Jim was a Vice President with Bain Capital.

 

Jeff Ackerman has been Executive Vice President, CFO since joining in January 2006. From 1997 until joining Sealy, Jeff was Vice President, Finance with Dade Behring, Inc., a medical diagnostics company owned by Bain Capital.

 

Having spent time with senior management both at their headquarters in North Carolina and here in San Francisco, it is clear that management is very smart and focused on maximizing the value of this unique franchise. 

 

Sealy’s management team and board run the company as if it were a private company, which is attractive. They do not provide earnings guidance other than long-term goals (high single digit sales growth, 20–50bps gross margin improvement, 10% EBITDA growth and mid-teen EPS growth, annually). Furthermore, management’s lock-up lasts until the earlier of KKR selling (which is highly unlikely below the IPO price) or 2009, prior to which the management team is restricted from selling shares. This long-term lock-up is extremely attractive to shareholders, as management is entirely focused on long-term goals, as opposed to short-term results in hopes of pleasing Mr. Market. From discussions with management and conversations with several board members, I am wholly confident in management’s focus, direction and capabilities.

 

Sealy’s Board of Directors is terrific for a company of its size.  The board is comprised of the following individuals: 

 

It is worth noting that KKR is no longer taking management fees from the company as the management services agreement was terminated in conjunction with the IPO in April 2006.

Industry: 

The wholesale U.S. mattress industry was estimated to be approximately $6.5 billion in 2005, up 12% from 2004. Of the $6.5 billion U.S. market, approximately 80% is innerspring and 20% is specialty products. The U.S. mattress industry has proven to be stable and consistent over the past 25 years, with a CAGR of 6.5% and only two years of declining revenues (1982 and 2001). While the infrequent nature of mattress purchases can lead to temporary (i.e. monthly or quarterly) fluctuations in mattress sales, the industry has been quite stable on an annual basis.  Globally, the mattress market is estimated to be $15+ billion. North America and Europe are the largest components. 

 

The correlation between the mattress industry and the housing market is a source of great concern for Mr. Market. However, mattress sales are historically far more correlated to the overall economy (GDP growth) and consumer confidence, as opposed to the housing market. This observation makes sense when one considers that approximately 70% of mattress sales are replacement sales. The graph below shows U.S. mattress sales over the last 25 years:

 

 

Fluctuations in mattress volumes are in fact relatively mild compared with fluctuations in housing volumes, especially during downturns. The regression relationship illustrated below indicates that mattress volumes fluctuate only ~20% as much as housing demand. This 20% relationship is the average over a 20-year period, and it is important to note that the fluctuation was below average during the last major housing downturn in 1990-1991. During that period, housing transactions fell over 12%, while bedding volumes fell just over 1%. This more limited downside risk is driven by the large percentage (~70%) of mattress sales that are replacement in nature. Thus, even as housing transactions fall off, consumers are still prompted to replace old, worn-out mattresses, especially if they are a source of nightly discomfort.

 

 

 

The U.S. mattress industry consists of over 700 manufacturers, with the top ten manufacturers garnering approximately 80% market share. With 20% of the market highly fragmented, there is room for the larger players to improve market share.  Sealy has been the market share leader for the past 20 years, and the company is currently approximately 60% larger than its closest competitor. Below are the top five manufacturers in the U.S. market:

 

 

The mattress industry has experienced stable and consistent growth in the past and is expected to continue growing at a healthy rate in the future, driven by the following factors:

§         Rising average unit selling prices, helped by shift to high end mattresses

§         Growing unit demand due to:

–        Increasing size of homes; increasing number of bedrooms in homes

–        Increasing ownership of 2nd and 3rd homes

–        Rapid growth in the 39-57 year-old segment of the population, the largest and fastest growing segment of the population according to the U.S. Census Bureau

–        A general increase over time in consumers' willingness to "trade-up" and purchase higher quality, higher priced products

–        Faster customer turnover due to switch to one-sided mattresses

 

In addition to its consistent and stable growth characteristics, the industry’s competitive dynamics are particularly attractive. First, the industry is reasonably protected from the threat of Big Box retailers (e.g. Wal-Mart) and online sellers because customer service and floor space are critical to retailers’ success. From our fieldwork, we have found that mattress shoppers depend heavily on the advice and direction of their salesperson. Prior to a salesperson approaching a new shopper, the shopper often wanders through the store rather aimlessly. It seems natural that, with the infrequent nature of purchase, high price and the reality that people spend ~1/3 of their life sleeping, shoppers would look to a salesperson to help them feel comfortable with their purchase. Moreover, customers almost always want to lie down on a mattress and test it out for themselves, making floor space essential. Thus, the importance of customer service and floor space provide a nice buffer from Big Box retailers, which would likely drive down margins for manufacturers and retailers. In 2004, mattress sales by distribution channel were as follows:

 

 

Second, the industry is reasonably protected from low-cost imports. Imports from Asia currently account for less than 5% of U.S. sales. Factors inhibiting importer advantage include the fact that labor is typically a very small portion of total mattress manufacturing costs (less than 10%), just-in-time inventory management policy does not lend itself well to the long overseas shipping times, and transporting large items, such as mattresses, have high shipping costs.

 

Third, retailers lack pricing power over manufacturers.  Mattress manufacturers and retailers rely on a system of exclusives, which means each retailer gets their own version of a particular product line, with slightly different details such as the ticking (the fabric cover on the mattress). At the extreme, the system of exclusives means that the same mattress can be sold under a different name by literally every retailer that sells it.  The system of exclusives is critical in insulating mattress manufacturers from pricing pressures, because it effectively limits the ability of the consumer to price shop. If consumers are not able to price shop, retailers are not driven to put as much pricing pressure on mattress manufacturers.  Moreover, the retail distribution network is largely fragmented. The top five bedding retailers (excluding Select Comfort) each account for only about 2% of nationwide bedding sales, on average. The impact of the fragmented distribution system and consumers’ inability to price shop has been to effectively limit channel pricing pressures on mattress manufacturers.

 

Fourth, although retailers lack pricing power over manufacturers, manufacturers and retailers are able to drive strong ASP growth due to the infrequent nature of purchases. On average, customers purchase a new mattress every 7-10 years. The infrequent nature of purchases makes it difficult for customers to have reference points for prices, allowing manufacturers and retailers to enjoy price hikes without much push back from customers.  Mattress manufacturers’, and Sealy’s in particular, ability to increase prices is especially advantageous if the cost of inputs rise. Manufacturers are able to pass on a significant portion, if not all, of the higher cost of inputs to customers, rather than incurring margin erosion themselves. With the rising price of petroleum (a significant input cost to the foam in Sealy’s mattresses) over the last few years, Sealy has been successful at doing just that.

 

In sum, the dynamics of the bedding industry are very attractive.

 

 

Competitive Position: 

Sealy’s competitive position is excellent.  First, Sealy has been the largest player in its market for over 20 years. Sealy currently retains approximately 21% share in the U.S. market, making the company approximately 60% larger than its closest competitor, Simmons. In 2005, Sealy’s market share remained essentially flat while several of the other top mattress manufacturers lost more than 1% market share, including Simmons, Serta and Spring Air (according to Furniture Today). While Sealy has given back some of its market share in 2006 due to its product upgrades to FR standards, Sealy remains well-positioned to gain share domestically both over the next 15 months, while other top manufacturers are required to go through FR upgrades, and more importantly, over the next 3–5 years due to its broad product offering and value proposition to retailers.

 

As mentioned in detail in The Business section above, Sealy has the broadest product portfolio of any mattress manufacturer, both on a product type and product price point basis. By providing a number of products at different price points, Sealy is able to penetrate almost the entire market (absent the extremely high and low ends). This diverse revenue base is attractive, both on the risk and the reward side of the equation.

 

Sealy also has strong brand equity.  Our field studies show that brand is not a huge differentiator amongst the top players (especially Sealy vs. Simmons), while it is a significant differentiator when looking at all 700+ bedding manufacturers in the U.S.  During the purchase process, customers are much more comfortable buying a brand they know and recognize as opposed to a brand they have not heard of.

 

Additionally, Sealy provides a better value proposition than its competitors to retailers, incentivizing retailers to push Sealy’s products in stores. Sealy aims to provide greater net margin to the retailer at a price point that is slightly advantageous from a consumer’s perspective, thereby making sure that the retailer makes more profit. From our field studies, we found that sales associates at Mattress Discounters earned higher commissions on Sealy mattresses than any other mattress brand.  Being the low cost provider to retailers is a significant competitive advantage for Sealy.

 

Driven by its superior value proposition to retailers, Sealy is well aligned with top retailers.  Sealy is the leading supplier to the top 25 bedding retailers, which is growing faster than any other retail distribution channel.  The top 25 U.S. retailers currently control 40% of the market and are growing at about double the rate of retailers on the whole in the U.S. market.  This should help allow Sealy’s domestic growth to outpace the overall market.

 

It is worth noting that Sealy also has a diverse customer base, serving over 2,900 customers (which represents approximately 7,000 outlets).  Sealy’s top five customers made up 24% of 2005 sales, and no single customer accounted for over 10%.

 

In addition, Sealy manufactures most bedding to order and has adopted "just in time" production techniques in its manufacturing process to more efficiently serve its dealers' and customers' needs. Most bedding orders are scheduled, produced and shipped to retail warehouses within 72 hours of receipt. This rapid delivery capability allows Sealy to better satisfy customer demand for prompt shipments and improves inventory management.

 

Sealy also differentiates itself from its main competitors by internally sourcing the majority of its requirements for component parts through its component manufacturing facilities, which make parts exclusively for use by the company's manufacturing facilities. The component plants currently provide substantially all of the company's mattress innerspring unit requirements, and supply approximately 48% of the company's Sealy box spring parts requirements. Because none of its major competitors enjoy similar vertical integration, this component manufacturing capability provides the company with a significant competitive advantage. 

 

Overall, Sealy benefits significantly from its leading market position, scale, strong brand, value proposition to retailers, product breadth and operational efficiencies, including just-in-time production techniques. These characteristics are likely to support Sealy’s consistent and strong growth.

 

 

Price: 

Sealy’s shares currently trade at 12.7X 2007E P/E and 8.0% 2007E free cash flow yield, reflecting concerns around slower industry growth and competition.  Once Sealy fully completes the largest product transition in the company’s history (expected in the next month or soon thereafter), it will be in an excellent position to continue to grow domestically. Coupling this with its already robust international growth, Sealy will likely grow revenues in-line with management’s guidance of high-single digits, although modeling a far more conservative case still yields attractive returns.  In addition, the company’s targeted annual gross margin improvement of 20-50bps should be achievable through further manufacturing efficiency gains and Sealy’s proven ability to drive ASP growth for the foreseeable future. Combining this earning power with solid working capital management and low capital expenditures, the company will likely generate strong free cash flow.  Assuming management allocates capital efficiently, and I believe they will, the company will also likely drive shareholder gains through share buybacks and/or increased dividends. With what are likely conservative assumptions, an investment in Sealy should generate high-teens to mid-twenties compound annual returns at current share prices with minimal risk of capital loss.

 

Slowing Industry Volumes: 

Over the past several months, the U.S. mattress industry has experienced a slight decline in unit volumes. Many analysts and investors do not see this trend reversing over the coming months as the housing market continues to decline. First, this decline in volumes will likely prove to be temporary, as the mattress industry has been quite stable and resilient historically, even during housing downturns.  Second, the industry continues to drive strong ASP growth (approximately 9% in the June–August period), which is more than counteracting the effect of adverse volume trends.

 

Competition:

The bedding industry is highly competitive, and Sealy encounters competition from many manufacturers in both domestic and foreign markets. There are over 700 mattress manufacturers in the U.S.  Sealy faces competition from both the large players (especially Simmons, Serta and Spring Air) and small players. Because the industry has such high returns on capital, competition will likely continue to remain robust in the future. If Sealy’s product lines are not received well by customers, the company could experience market share loss, margin erosion, and difficulty in raising ASPs. Furthermore, Sealy does not have an extremely wide “moat” against its competition (other than its value proposition to retailers), making it subject to potential market share loss from effective competitors. However, given its strong competitive position, this is not a likely outcome.

 

Leverage:

At 3.3X net debt / EBITDA, Sealy has a reasonable, but not negligible, level of debt. Sealy has more debt than most of its competitors.  If the industry and/or the company experienced a catastrophic downturn, Sealy’s competitors could be better able to withstand adverse market changes and take market share from Sealy.

Brand Erosion: 

As with consumer products in general, brand erosion remains a risk for the mattress industry.  With over 700 manufacturers, there are numerous mattress brands from which customers can choose.  However, given customers’ comfort afforded by purchasing brand name mattresses and Sealy’s current brand strength, I believe this risk is acceptable.

 

Rise in Cost of Inputs:

Petroleum-based foam and steel represent approximately 60% of Sealy’s cost of goods and each product has the potential to be highly inflationary. Sealy may be able to counteract this increase with price increases, as there is not tight price sensitivity in the mattress market for units priced above $750. The company believes there is only a 4–6 week lag between rising prices of inputs and pushing those onto the retailers. Of course, this will affect the entire industry, and as the industry’s low cost provider, Sealy is best positioned to deal with this risk.

 

 

I believe an investment in Sealy is an excellent risk/reward.  Sealy has a strong competitive position in an extremely attractive industry, is run by a focused and smart management team, and is currently trading at a price that represents a significant discount to intrinsic value.

 

 

Although this investment is not at all “catalyst” based, and is more representative of a Buffett/Munger type purchase of buy and hold, there are a number of catalysts that may increase the stock price. Among them are:

 

1. Successful completion of product transitions to meet flame-retardant standards, which has taken the better part of 2006 and is close to being finished;

2. Main competitors having to undergo flame-retardant upgrades prior to June 30, 2007, allowing Sealy to gain market share over the coming months;

3. Achieving target net debt / EBITDA ratio, and therefore increasing dividends and initiating a stock repurchase plan;

4. Increased penetration in specialty and international markets;