Description

I'm submitting SCSS as a timely idea. I'll describe the biz below and why I think its a great company for the long-term, but the reason for submitting it now is that since the stock's high of $32 in late October, a large VC firm has been selling their stake. St. Paul Ventures, as reported in the media, has been selling part of its almost 13 million shares. On Nov 10th and 11th, almost 2.5 million shares were sold and there is speculation that the entire stake is being liquidated. Almost every analyst that covers SCSS values it at something north of $30/share and believes the current selling is unrelated to fundamentals. I believe that once the trading imbalance on SCSS shares is removed, the stock will return to late October levels. Its not trading at a huge current discount to appraisal, but I think that given the timeliness of the situation, the annualized potential returns could be more than satisfactory.

Select Comfort makes the Sleep Number bed. The bed is unique in that the mattress makes use of adjustable-pressure air chambers for support. The sleep number you choose corresponds with a particular air-pressure setting. The product allows anyone to set the bed to their desired Sleep Number for maximum comfort and improved sleep. The company is in the process of building national brand recognition and product differentiation. They sell through QVC, retail locations, and through direct marketing. They are different from traditional mattress retailers in that they use a make-to-order manufacturing process using just-in-time processes. They turn manufacturing inventory at 20x. Their air-chamber technology also allows them to ship efficiently direct to consumers via UPS or Fedex from their manufacturing plants without regional warehousing.

They are currently running net margins at about 7% and believe that they can trend these up to 10-12% within three years by leveraging their largely fixed manufacturing costs. The retail bedding market is a potential $7+ billion market where SCSS is doing over $300 million a year. There is plenty of room for SCSS to grow and a seasoned CEO from Pepsi Foods that came over in 2000 has put them on the right track to do just that.

Valuation: Most analysts who publish research on SCSS assign a value somewhere in the low 30s. I use a 5-yr discounted FCF using a 15% growth rate in sales - very conservative compared to company projections and street projections - (assuming 5-10% increase in stores with the remainder coming from direct and SSS growth) and assuming modest operating leverage on the SG&A line. I also assume an increase in media spend beyond the $50 million projected for 2003 for brand building. This gets me to a equity value of approximately $32/share.

I think the play here will probably be short term should my original premise prove correct (That SPV will finish their liquidation). However, the long-term economics of SCSS are attractive if management executes on their business plan and it could end up being a great core holding long-term. The bottom line is I see little downside at these levels.

Drawbacks:
1-One major competitor outside of traditional mattress firms - Nautilus Sleep Systems. They are much smaller but should definitely be monitored for price competitiveness.

2-That SPV is liquidating for an extended period keeping pressure on the stock too long.

3-That an extended retail slump eats into SCSS's biz. Mall based retail is not living up to expectations for the holiday season, and although SCSS is much less seasonal than most retailer, its not totally immune from a soft retail environment.

Catalyst

The St. Paul Ventures liquidation should end soon and remove recent selling pressure.