Description
Sleep Country is a category-killing specialty retailer available at 10.6x FCF, a 7.5% yield, and growing 5-10% per year. This is Canada’s leading mattress retailer, with 19% national market share and 40% regional market share. I expect this idea to appeal to those of you who like good businesses, run by good people, trading at a reasonable price, and also paying a very good yield.
Once you get past the inherent dullness of mattress retailing, you find that Sleep Country represents a surprisingly good business. The company’s dominant market share allows for advantages of scale and brand awareness that together create a formidable competitive moat. Also, unlike most growth retailers, Sleep Country enjoys negative working capital, low capex requirements (even including growth capex), limited seasonality, and therefore positive free cash flow throughout the year.
These favorable business characteristics explain why Sleep Country is well-suited to be structured as an income trust. This structure shields Sleep Country from all income taxes, allowing it to pay out the majority of its net income as a monthly distribution. Currently, Sleep Country’s distribution rate is 10.83 cents per month, which equates to a 7.5% annualized yield.
Sleep Country’s current value is a result of the stock being 30% off its highs of nine months ago (C$25) due to fears of a slowdown in consumer spending. Those fears have recently taken precedence over Sleep Country’s strong operating results right up through the most recent quarter (including comp sales up 7.3%), as well as good prospects for growth over the years ahead. My thesis here is that the consumer spending fears are now fully baked into Sleep Country’s stock, providing a good reward/risk entry to investors with a 2-3 year horizon.
Let me now give credit where credit is due. This report is a follow-up to Dylex844’s superb VIC write-up on Sleep Country in September 2003. Since that original write-up, Sleep Country has provided capital appreciation of 44%, while also increasing its distribution three times (+5.1% in Apr 2004; +10.6% in Sep 2004; and, +4.0% in May 2005), such that the total return has been 63%. I encourage anyone interested in Sleep Country to carefully read Dylex844’s report, as well as the excellent Q&A that accompanied it.
BUSINESS GROWTH HAS EXCEEDED STOCK’S GROWTH
Now, you might be thinking that with Sleep Country’s stock up so much over the past two years that it couldn’t possibly be a bargain now. But in fact, the stock has not even kept pace with the underlying business growth. Over the past three years (Q3 ’02 thru Q2 ’05), Sleep Country’s EBITDA has grown at a 21.7% CAGR, which surpasses the stock’s capital appreciation of about 20% CAGR. Or to look at this dynamic from another angle, consider that at Dylex844’s recommendation price of C$12.00 per share, Sleep Country was priced at 8.4x TTM EBITDA. Today, at C$17.35, Sleep Country trades at a somewhat lower multiple of 8.2x TTM EBITDA. Hence my rationale for re-recommending this excellent and underappreciated company.
Here’s a run-down of Sleep Country’s valuation based on TTM statistics thru Q2 ’05 (unless noted otherwise, all figures in this report are in Canadian $):
Stock Price $17.35
Diluted S/O 14.046M
Market Cap $243.7M
EV $261.3M
Sales $205.3M
EBITDA $ 29.7M
Net Income $ 19.4M
OCF $ 26.2M
Capex $ 3.2M
FCF (OCF–Capex) $ 23.0M
Annual Dividend $ 18.3M
P/FCF 10.6x
Yield 7.5%
SUMMARY BUSINESS OVERVIEW
Founded in 1994, Sleep Country (Toronto: Z.UN; US Ticker: SLPCF) has grown organically to be the #1 retailer of mattresses in Canada with 19% national market share versus an estimated 31% market share for the next four largest competitors combined. The company has 101 stores and eight distribution centers in seven regional markets: Vancouver, B.C. Interior, Calgary, Edmonton, Toronto, southwestern Ontario, and Ottawa. Within each of these regions, Sleep Country commands a leading market share position that averages 40%. Also impressive is that Sleep Country has achieved positive same store sales each of the past nine years, as well as each of the past eight quarters.
Sleep Country’s dominant regional market share creates two important competitive advantages:
1) Advantageous Operating Scale. The retail mattress industry is characterized by the existence of substantial regional fixed costs (advertising, management and distribution) that are independent of the number of stores in a particular region. Sleep Country’s strategy is to become a leader in each of its regions so that these regional costs are spread across a wide base of stores, allowing Sleep Country to devote a greater overall investment to brand advertising and customer service than the competition while still allowing for high store-level profitability.
2) Preferred Customer Status. Sleep Country’s dominant market share makes it the #1 or #2 customer to each of its key suppliers (#1 for Sealy and Serta; #2 for Simmons). These manufacturers produce mattress sets at local plants, whose sales are typically focused on a limited number of regional markets. As such, Sleep Country typically represents one of the most important customers for any given mattress manufacturing plant in the regions it serves. This often results in product cost advantages, differentiated product features, and just-in-time delivery terms.
Together, these two advantages have allowed Sleep Country to achieve strong growth and solid profitability, as can be seen in the following table ($ millions):
2003 2004 H1 ‘05
Sales $165.5 $195.4 $ 98.0
Sales Growth YOY 13.5% 18.1% 11.2%
Comp Store Growth 2.6% 12.3% 4.3%
EBITDA $ 22.5 $ 28.4 $ 13.1
EBITDA Margin 13.6% 14.5% 13.4%
Ending Stores 87 95 101
MATTRESS INDUSTRY RESILIENCY
Sleep Country’s recent stock price weakness seems to be the result of worries that rising oil prices and a toppy housing market might spell trouble for consumer spending on durable goods, including mattresses. Sure, a mattress purchase can be postponed during tough times, but I don’t foresee (not anytime soon, at least) such a severe consumer retrenchment as to cause a material reduction in Sleep Country’s results.
Obviously it’s open to debate what the near-term fate will be of consumer spending, but I take some comfort in the historical resiliency of the mattress industry. As was pointed out in Dylex844’s original report, the Canadian mattress industry has not had a negative year of growth in the last 10 years. Dylex844 also noted that within the U.S., the lowest growth within the last 40 years was negative 1.9% in 1982, and there has only been one other negative growth year in the U.S. since 1980 (negative 0.3% in 2001).
Sleep Country estimates that the Canadian mattress market has grown at a CAGR of 5.6% since 1993. Mattress demand is being driven by general population growth, a trend towards larger houses with more bedrooms, and growth in demand for second homes.
FREE CASH FLOW & DISTRIBUTIONS
Sleep Country is structured as an income trust, and thus pays out the majority of its net income as a monthly dividend. Sleep Country’s policy is to make equal monthly distributions, so it generally sets its payout at level that equates to 90% of conservatively sustainable net income.
You may wonder how a growing retailer can possibly afford to pay out nearly all of its profits, and yet still have the necessary capital for growth. Ah, that’s one of the great features of this business – Sleep Country has an exceptionally capital-light business model, thanks to negative working capital and super-low capex requirements. It costs Sleep Country only about $50-100K to open a new store, which at 8-12 new stores per year keeps total capex at very reasonable levels. Also, unlike many retailers, Sleep Country doesn’t face much seasonality (although Q2 and Q3 tend to be a bit stronger), so FCF remains positive through all four quarters of the year. These features make Sleep Country well suited as an income vehicle.
To give you a sense for Sleep Country’s quarterly profitability and how FCF varies through the year, the table below shows the past eight quarters of net income, cash flow, distributions, and end-of-quarter net debt ($ millions). Notice that because cash flow has exceeded distributions, net debt has been steadily reduced:
Q3 ’03 Q4 ’03 Q1 ’04 Q2 ‘04
Net Income $ 5.2 $ 2.6 $ 3.3 $ 4.6
OCF 13.3 3.1 1.1 6.8
Capex 0.8 0.3 0.4 0.0
FCF (OCF-Capex) 12.5 2.8 0.7 6.8
Total Distribution 3.8 3.8 3.8 3.9
Net Debt 21.6 22.6 25.6 22.7
Q3 ’04 Q4 ’04 Q1 ’05 Q2 ‘05
Net Income $ 6.8 $ 4.3 $ 3.5 $ 4.7
OCF 15.5 1.2 1.2 8.4
Capex 1.2 0.9 0.4 0.6
FCF (OCF-Capex) 14.3 0.3 0.7 7.7
Total Distribution 4.1 4.4 4.4 4.5
Net Debt 12.4 16.6 20.2 17.6
BALANCE SHEET
Unlike some Canadian income trusts that carry heavy debt loads and precariously pay out all their cash flow, Sleep Country has very modest debt. As of June 30, 2005, Sleep Country had cash of $22.8 million and debt of $40.3 million (five-year paper at 5.19%), or net debt of only $17.6 million. That compares to Sleep Country’s equity of $135.1 million, so net debt is only 13% of equity. Thus, Sleep Country has a balance sheet that’s plenty strong to support the income trust model of paying out nearly all distributable cash flow.
GROWTH PROSPECTS
Sleep Country added eight new stores in each of 2003 and 2004. Through the first half of 2005, Sleep Country added six new stores within existing markets, and one more in-fill store is expected before year-end. In addition, Sleep Country recently began its next wave of regional expansion, this time into Winnipeg. Two of these new Winnipeg stores were opened in early August, and another four are already in the works.
The one near-term drawback to this regional expansion is that management doesn’t expect the new Winnipeg stores to break even for 12 to 24 months (based on its experience with past regional expansions). This will have a moderating effect on margins over the next year or so, but all while setting the stage for stronger growth in 2007 and beyond. Also, management has emphasized that it will continue to perform at a level required to meet current distribution targets.
Looking out further ahead, Sleep Country continues to have several untapped regional growth opportunities, including Halifax, Dartmouth, and Quebec. It’s been estimated that Quebec alone could handle 30-40 stores. Overall, I’m expecting the combination of in-fill stores in existing markets plus new regional expansion to provide room for an additional 5-10 new stores per year over the next decade.
In terms of quantifying this growth, I’m generally expecting FCF growth to be in the low single digits over the next 12 months, but then rising to mid-to-high single digits over the years ahead. I’m roughly estimating that Sleep Country will reach maturity by 2015, after which I expected comp store growth plus an occasional new store might allow for low-single digit terminal growth.
MANAGEMENT
Sleep Country was founded in 1994 by current executives Stephen Gunn (Chairman and CEO) and Christine Magee (President). Each owns a combination of units and shares (economically equivalent to units on a one-for-one basis) that amount to a 3.2% equity stake for Gunn (244,531 units; 202,678 Class A shares) and a 1.8% equity stake for Magee (122,426 units; 137,088 Class A shares). Cash compensation is reasonable ($500K for Gunn; $400K for Magee), and bonuses are based on the degree to which the company exceeds an EBITDA target set by the board at the beginning of each year. In 2004, both Gunn and Magee received a bonus of $600K.
I like Sleep Country’s incentive structure. Thankfully, the company does not make use of stock options. Instead, both Gunn and Magee are eligible for compensation under a long-term incentive plan (LTIP), whereby the company sets aside a pool of funds based upon the amount by which the Fund’s per-unit cash distributions exceed certain minimum thresholds. With this pool of funds, the company will then purchase units of the Fund on the open market and will hold these units until ownership vests to each participant.
VALUATION
At the current price around C$17.35, Sleep Country carries a Canadian market cap of $243.7 million and EV of $261.3 million. FCF over the last 12 months is $23.0 million. So the P/FCF here is 10.6x. With net income of $19.4 million, the P/E is 12.6x.
From a “what’s the downside?” perspective, here’s how I view things. Even if you think a consumer spending slowdown might cause Sleep Country’s profits to flat-line or fall a bit over the next few years, I still believe the current valuation is still reasonable enough to afford 8-10% annual returns over time. I also expect the stock to be resistant to further downward pressure given the already beefy 7.5% yield.
In terms of upside, if Sleep Country is able to successfully achieve profitability in the Winnipeg market over the next 12-24 months, I think we could see Sleep Country justify a P/FCF multiple in the mid-to-upper teens, which I believe is commensurate with a strongly cash-generative model that can grow 5-10% annually. At a 15x FCF multiple, Sleep Country’s share price would be C$24.50. At that price and based on the current distribution rate, Sleep Country’s yield would still be a healthy 5.3%.
In conclusion on Sleep Country, I see negligible downside, and upside of 40%+ over the next few years. It's a good business with a sustainable competitive advantage, management that's incentivized properly, and with a structure that provides for excellent income to investors.
Catalyst
--Continuation of positive fundamental results.
--Attraction of high dividend yield, currently 7.5%.
--Execution on Winnipeg growth strategy, and getting that region up to profitability by late 2006, early 2007.