Sleep Country Z-U CN W
September 19, 2003 - 11:39am EST by
2003 2004
Price: 12.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 169 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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If I told you this write-up was about a Canadian mattress retailer you probably wouldn’t bother getting out of bed. On the other hand, you may get out from under the covers if I opened with a description of a specialty retailer with 40% market share, double digit EBITDA margins, negative working capital, double digit ROIC, 8% management ownership, and a market cap that equates to double digit FCF yield. Oh yeah, FCF is growing and the business requires a de minimis amount of capex.

Valuation - All figures in this write-up are in Canadian dollars
Let’s run through this section first, because if you do not believe the stock offers value, there is little reason for you to finish reading this epic.

To begin with, this is a Canadian income trust. The Company pays no income tax on the first $15.2m of net income generated each year, but will pay income tax annually on any income in excess of $15.2m. Given that the company is not highly geared (debt is equal to 1.5x EBITDA) we are going to talk about Free Cash Flow (FCF) to equity holders. We define FCF as EBITDA less interest expense, less tax, less working capital requirements, less maintenance capex, less growth capex. This is what we view to be true FCF, or what someone could put in their pocket if they owned 100% of the equity.

Based on our forecast for 2003 and 2004, the company will generate fully diluted FCF per share of $1.12-1.18 and $1.32-1.47, respectively. Based on the current share price of ~$12.00, this values the equity at 10.7x ’03 FCF and 9.1x ’04 FCF if you take the low end of our range. While we won’t get into all the details of our model, we are happy to discuss our assumptions in follow-up posts if anyone would like a detailed description. However, we would like to note that we think we are being relatively conservative in our assumptions and remind everyone that we are deducting both maintenance and growth capex from our FCF figure. As such, our investment thesis is predicated upon the argument that you agree that a 2004 FCF yield of 11.0% is an attractive return for a nice low-risk growing business.

As an aside, the company pays out the majority of its FCF in an annual dividend. The current yield is 9.0 %. Going forward our FCF figure may differ from distributable cash depending on whether the company decides to build a small cash balance, paydown debt, pay a special dividend, etc… Nonetheless, as US investors the dividend will be taxed at 15%, providing an attractive after-tax return.

To give you an alternative VIC metric, the company is trading at a total enterprise value of 9.5x ‘03 EBITDA, and 8.5x ‘04 EBITDA – our EBITDA forecast is for $20.7-$21.2m in 2003, and $23.4-25.4m in 2004 (we use the low end of our range for the multiples). While these EBITDA multiples look high and suggest this is an overpriced retailer rather than a VIC special, we remind you that we believe our definition of FCF is preferable because Sleep Country 1) has a perpetual tax shield on the first $15.2m in net income generated each year, 2) requires less than $2m per year in maintenance capex ($17k per store, $37k per distribution centre), 3) has negative working capital. As an indication of the conservativeness of our EBITDA estimates, management stated in an April presentation that the company could generate mid-twenties EBITDA within three years if it never opens another store after the end of this year. In contrast, our 2006 EBITDA forecast is only $25.7m despite our assumption that the store base expands by 16-26% between 2004-06.

As a footnote, the negative working capital dynamic arises because the company receives payment from the customer on day 1, delivers the mattress on day 4, and makes payment to the vendor on day 30-45.

Company Background
The Company was founded in 1994 with seed capital of $1.8 million (and it should be noted has never needed another dime to expand). Started in Vancouver in late 1994 with four stores, the Company has grown to 85 stores in seven regional markets. Over the past six years sales have grown at a CAGR of 33% and EBITDA at a CAGR of 39%. The Company was IPO’d earlier this year to monetize a private equity investment made by Bain Capital. Although Bain no longer has a holding in the Company, management retained a 7.8% interest in the IPO.

Sleep Country ( is one of Canada’s leading mattresses retailers and is the number one retailer of mattresses in the three provinces in which it operates. Although the Company only has 16% national share, it has an average regional market share of 41% across the seven regional markets it serves. Regional market share ranges from a minimum of 27% in Ottawa (only entered in 2001) to 56% in Calgary. To sum it up, the Company is the number one retailer of mattresses in every regional market in which it competes.

For those of you who have read the book “Discipline of Market Leaders”, we believe Sleep Country has “Operational Excellence” down to a tee. The Company offers a sustainable business model that provides consumers with a compelling value proposition - the low cost provider with the highest level of service. The following strategy discussion will provide examples to support our thesis.

Sustainable Business Model
There are several reasons why regional market share is particularly critical to operating successfully in the mattress retailing industry. 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 believes that its strategy of becoming a leader in each region with multiple stores brings regional fixed costs to an effective level on a per-store basis. In addition, manufacturers produce mattress sets at local plants, whose sales are typically focused on a limited number of regional markets. Given its leading regional market shares, Sleep
Country believes that it 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 and differentiated product features, which collectively create a significant competitive advantage.

The Company has built its regional market leadership by focusing on one regional market at a time before expanding into the next regional market. Sleep Country implements a significant sustained advertising program in order to build brand awareness in each market it enters. Typically, within the first year of entering a new regional market,
Sleep Country opens 50% to 75% of the stores it ultimately projects to have within that market. Stores and distribution centers are initially staffed with a combination of new local hires and experienced Sleep Country managers, salespeople and delivery people to ensure that the Company’s in-store and home delivery service is as strong in the new market as in its existing markets.

The Company invests significantly in advertising and brand development to create ‘‘top of mind’’ brand awareness so that it is the first mattress retailer chosen by customers. Through a combination of radio and television advertising, Sleep Country strives to convey that it is a trustworthy, enjoyable place to purchase a mattress. Messages are repeated frequently, consistently focus on the brand name, Sleep Country Canada, use a catchy jingle, and incorporate the Company’s trade-mark ‘‘Why Buy a Mattress Anywhere Else?’’. The Company’s advertising features Sleep Country’s President, Christine Magee, as spokesperson, to appeal particularly to women ages 25 to 54, the largest target market influencing the purchase decision. Sleep Country prominently positions the Sealy, Serta and Simmons brands in its advertising to build on the strength and popularity of these brands, and to take advantage of supplier advertising arrangements. In addition, Sleep Country has earned a reputation with customers for competitive prices (lowest price guarantee) as well as outstanding service and quality products, all of which represent a substantial competitive advantage. This success is due not only to its advertising strategy, but also to its superior in-store and home delivery execution, which contribute directly to word-of-mouth advertising.

Because a mattress is a big ticket purchase for the mass market, Sleep Country prides itself on serving customers with a professionally trained sales force. As opposed to department store, where the same guy that sells you a vacuum is selling you a mattress, Sleep Country sales staff are mattress specialists. While all this sounds nice in theory you probably want some examples of how a company can truly differentiate itself in the mundane world of mattress retailing. While we can not put our finger on any one element, we believe it is a true devil in the details approach that has led to the company’s success. Whether it is the soft sales pitch, lowest price guarantee, thank you card sent to each customer, free old mattress removal, three hour delivery window, or the 60 day no-questions-asked return policy, the Company is doing something right. To support this statement, we can report that 98% of Sleep Country customers state that they would recommend the store to friends and family.

Sleep Country has 16% national market share, which places the Company in a tie for first place with Sears Canada. However, as we noted previously, the Company’s regional market share is much higher, such that Sleep Country is number one in every market in which it operates.

After Sleep Country/Sears, you have the Brick with 8%, and Leon’s with 5%. Both the Brick and Leon’s are large furniture retailers who probably sell their fair share of mattresses each time they sell a bed. Approximately half of the market is then held by smaller family chains or one of mom-and-pop stores. When Sleep Country enters a new area it pinches a bit of market share from everyone, although the smaller independents are likely to feel the most pain.

Why We Surprisingly Like the Mattress Industry
We like the mattress industry because it is stable and has favorable growth characteristics. Sleep Country estimates that the Canadian mattress market has grown at a CAGR of 5.6% since 1993. According to the International Sleep Products Association, the US wholesale mattress market has experienced a 6% CAGR since 1980.

As an indication of the stability of the market, the Canadian mattress industry has not had a negative year of growth in the last 10 years. Within the US, 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 US since 1980 (negative 0.3% in 2001).

Going forward, we agree with the Company that growth will be driven 2-3% by inflationary price increases, and 2-3% by annual growth in unit demand, producing a CAGR of 4-6%. Unit demand is spurred by increases in the general population, trend towards larger number of rooms in homes, growth in recreational properties, housing starts, etc.

In case you are wondering, a customer typically replaces their mattress every 11-12 years. While customers may defer a replacement purchase during a severe economic downturn, a replacement purchase can not be avoided forever.

Why We Think Sleep Country Can Grow Faster Than the Market
An underappreciated growth driver is the fact that 30% of the store base is less than three years old. History shows that stores have grown at 34% in their second year, and 22% in their third year. Similarly, SSS have been positive for the past seven years. While their may be a bump in the road if the consumer ever throws in the towel, we will leave it to smarter men than ourselves to determine when this time will come. That being said, the dynamic of the mattress industry discussed in the previous section provides us with some superficial comfort that this business will not fall off a cliff.

At present Sleep Country operates 85 stores. We see this total expanding by approximately 5-8 stores per year. With respect to highly profitable infill stores, management believes it can probably add another 10 stores in the Greater Toronto Area, and 2-5 in other areas. In terms of new markets, the biggest opportunity is Quebec. Sleep Country management believes it could increase sales by 35-50% just by going into Quebec. This would imply that Quebec alone could handle 30-40 stores. Other markets that the company will eventually penetrate include Winnipeg, Halifax, and Dartmouth.

It should be noted that we think the shares are currently trading at an attractive valuation primarily because the investment community does not appreciate the tremendous growth opportunities that are still available. Which brings us to our next discussion regarding capital allocation.

Does the Business Have Good Economics and Does Expansion Create Value
EBITDA margins have fluctuated between 12-14% over the last three years. To summarize, when the Company enters a new market, margins are temporarily depressed. Management believes that if the Company were to stop growing, stabilized EBITDA margins would be roughly 14%. Regardless, as the store base grows, the impact of new markets will have a smaller impact on a larger enterprise, implying that margins should increase over time.

Unit store economics for infill stores (in existing markets) and new markets are attractive. An infill store costs $50k in net capex to open ($100k gross capex less $50k in tenant inducements). The only other investment in $50k for floor inventory, which for all intents and purposes is more or less a capital investment. Based on annual sales of roughly $2m per store and a conservative assumption of a 15% direct store contribution margin, an infill store will generate $280k in direct contribution. To fully load the stores, a distribution centre costs about $400k and covers 12-14 stores - $30k per store. This would imply the fully loaded store payback is approximately five months - ($130k/$300k)*12. Maintenance capex per store is roughly $17k per year, which implies an ROIC at the store level of $263k/$130k, or 200%+ on an annualized basis for a mature store. Keep in mind that this ignores the negative working capital element, which would further increase ROIC if you deducted payables from invested capital.

For a new market, historical experience has suggested that it takes roughly 18 months to reach system-wide margins and obtain the ROIC that we described above.

Other Stuff We Like
Management owns over 7% of the outstanding stock.
Sales people are paid 100% on commission. Only 5% a year turnover within the sales force.
Management incentive plan aligns management with shareholders. Long Term Incentive Plan (LTIP) has management receiving an increasing percentage of EBITDA based on distributable cash thresholds. Given the phenomenal ROIC cost of capital spread, we are content with the bonus metric being driven by profit rather than asset productivity. Payment is made in units which vest a third the first year, a third the second year, and a third the third year.


No immediate catalyst. We believe a patient investor will earn a mid-to-high teens IRR over the next two to three years with relatively low risk. As growth materializes, the dividend will increase and the stock will be awarded with a higher multiple. In the meantime, you can collect your monthly dividend and sleep soundly at night.
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