Description

Recommendation

I recommend a long position on Sleep Country Canada (“Sleep Country” or the “Company”) and believe the Company's intrinsic value is around $30/sh, offering 35-40% upside from today’s price. Investor sentiment has been held back due to a string of weaker-than-expected same store sales. However, a closer look suggests that the recent weakness is largely attributable to macroeconomic instead of structural factors. In fact, the Company has capitalized on disruption within the industry to strengthen its competitive advantages. While shorter-term investors worry about the effect an economic downturn may have, all signs show that the Company will continue to produce strong returns on invested capital through the cycle. The above factors have created the opportunity to buy a capital-light business with a long growth runway and a strong moat at an attractive valuation. 

Market and Company Overview

Bloomberg suggests that specialty mattress retailers operate under the Consumer Discretionary sector in Home Furnishings. However, mattress sales exhibit different characteristics to typical furniture products. The North American mattress industry has demonstrated steady fundamentals underpinned by population and unit price growth. Since 1974, US mattress and foundation wholesale dollar sales grew by a 5.4% CAGR. In Canada, mattress wholesale gross dollar sales have grown by 2.9% CAGR from 2004 to 2017, but this has been driven primarily by pricing increases. Nevertheless, despite weakness in unit sales over the last couple of years, because mattresses are a necessity, purchases are typically deferred and not lost. Recent below-trend unit sales and a shortening replacement cycle for mattresses suggest pent-up demand and solid long-term growth prospects for the industry going forward. Industry sales forecasts for the next five year are generally accepted to be around 6% to 7% CAGR.

Still, retailers are facing a lot of disruption. Many are closing stores, laying off employees, and facing financial trouble. In the past two years, prominent specialty mattress retailers, such as Mattress Firm and Innovative Mattress Solutions, have entered bankruptcy proceedings. In Canada, Sleep Country's primary competitors have also largely retreated. Sears Canada, which held a 15% estimated market share of Canadian mattress sales in 2014, declared bankruptcy and closed all its stores. Hudson’s Bay has also elected to close all its Home Outfitters stores this year, BMTC Group is letting the leases on their Sleep Gallery stores expire, and Bed Bath & Beyond is rationalizing their footprint across North America.

In contrast, Sleep Country is capitalizing on this upheaval and growing. Since 2015, it has launched 64 new stores while only closing 1, growing its market share from 22% to 31%. Today, it is the only specialty sleep retailer in Canada with a national footprint and operates 275 stores and 17 distribution centers.

Investment Thesis

1. Attractive Unit Economics Protected By A Formidable Moat

The unit economics of a new Sleep Country store is incredibly attractive, particularly in or adjacent to established regions with existing distribution infrastructure (termed “in-fill” and “satellite” stores, respectively). Because there are substantial regional fixed costs in mattress retailing that are independent of the number of stores in a particular region, new stores can leverage Sleep Country’s existing investments in advertising, management, and distribution to ramp up sales quickly. 

Moreover, these new stores have minimal capital requirements. The Company’s mattress sales operate with a negative working capital model – customers pay up-front, but the company has between 30 to 45 days to repay suppliers. There is also little inventory risk as the Company typically orders mattresses after the sale is booked. Finally, low capital expenditures are needed to sustain the earnings power of each store. Because of all these traits, I estimate that a new in-fill store can realize an unlevered IRR of almost 20% on conservative assumptions (see figure below).

These traits form a virtuous cycle that continue to widen the Company’s moat. As Sleep Country leverages its pre-existing network of stores and distribution centers to launch new stores, the additional revenues allows the Company to amortize fixed expenses over a larger base. Higher volumes also improves bargaining power over suppliers. The resulting improved margins and increased cash flows can be reinvested into new stores, bolstering the moat. New entrants simply cannot match the advertising spend, distribution network, or inventory costs that Sleep Country operates with.

This regional market share strategy has largely remained unchanged and resulted in strong returns. From 2014 to 2018, the Company achieved a Return on Incremental Invested Capital (ROIIC) of nearly 25% CAGR.

2. Supplier Captivity – OEMs are Reliant on Sleep Country’s Retail and Distribution

Online DTC companies have grown at an accelerated pace and taken market share from traditional retailers. At first glance, their business model of eliminating the wholesale distribution channel from the supply chain threatens to diminish Sleep Country’s competitive positioning.

However, while this model looks good on paper, mattress OEMs have historically relied on the wholesale channel for a reason: OEMs need scale to profitably churn out mattresses. For instance, Tempur-Sealy, the largest North American mattress OEM, relied on the wholesale channel for over 90% of its sales in 2018. Even formerly online-only DTC upstarts have realized the limits of the direct channel and are expanding into wholesale: Casper has announced a partnership with Target to sell their products in Target stores, Tuft & Needle products can now be found in Walmart, and Leesa partnered with Williams-Sonoma for its retail network.

Specialty mattress retailers are particularly important within the wholesale channel given their rise: from 1993 to 2017, specialty retailers have grown their market share of bedding sales from 19% to 54%. Better customer service, wider product selection, and the big-ticket nature of mattress purchases have all contributed to this growth. This channel is so important that Tempur-Sealy bought Innovation Mattress Solutions out of bankruptcy to protect its distribution network and re-entered into a supply agreement with Mattress Firm - the largest specialty mattress retailer in the US - despite prior bitter legal disputes. 

"But my [strategy] is - generally we like to use third-party retailers. Return on invested capital is fantastic, and if you have a supportive third-party retailer, that is who we want to do business with." - Scott Thompson, CEO of Tempur-Sealy (June 2019)

"We expect as we continue to roll out  more and more wholesale business that that's going to drive profitability. [...] As we look at the short term for DTC, it's going to be tough to be driving high profit,  and the wholesale channel is what is going to enable us to do that." - Mark Watkins, CFO of Purple (Q1 2018 Earnings Call)

For OEMs looking to gain and hold a meaningful share in the Canadian market, they have no choice but to negotiate with Sleep Country. With a 31% market share in Canadian mattress sales and a national footprint, Sleep Country’s retail network is vital. As a result, the Company can extract concessions from suppliers, such as better pricing, volume rebates and “just-in-time” inventory arrangements.

Bears may argue a continued growth of the online channel will allow OEMs to sell direct more easily and lead to an erosion of Sleep Country’s competitive positioning. However, because of the tactile nature of the mattress purchase decision, brick-and-mortar will likely continue to dominate as a distribution channel. Industry trade group The Better Sleep Council found that 85% of consumers still primarily rely on brick-and-mortar stores for new mattress purchases. Moreover, Sleep Country has also invested in their own e-commerce efforts, offering an omni-channel network that is hard for OEMs to match.

3. Multiple Levers for Growth

Sleep Country has demonstrated a strong track record of thoughtfully opening new stores across the country. Since 1994, the Company has opened an average of 11 stores a year and continues to aim for 8 to 12 new stores a year. Management tracks store density, measured as store per population, to measure market saturation. Since IPO, density has grown from one store per 162,000 to one store per 134,000. The Company believes that a store density of one store per 100,000 in population is achievable without oversaturating the market. For context, US mattress retailer Mattress Firm had an average density of one store per 90,000 in 2016 (one store per 50,000 in its most dense markets), and European mattress retailer Beter Beds has an average density of one store per 115,000 in its mature markets.

Assuming a conservative annual population growth of 1.4%, the rate at which Canada’s population grew last year, this suggests that Sleep Country can continue to add 290 new stores for the next 40 years at an average rate of 7 new stores per year. Even assuming no population growth, the Company can open 10 new stores per year for 10 years without oversaturating the market.

Sale of bedding accessories is another key lever for growth. Revenues from accessories have grown by 16% CAGR from 2012 to 2018 and typically carry a 10% higher margin compared to the margins on mattress sets. The continued push into accessories not only allow stores to upsell higher-margin products with mattresses, it also enables higher traffic and conversion rates – the Company has estimated that customers are 75% more likely to buy from Sleep Country after having purchased an item.

Valuation

I arrived at my valuation target of $30 primarily by probability-weighting a combination of DCF scenarios, but also looked at multiples on comparable companies and precedent transactions to benchmark valuations. In my base case, Sleep Country adds 68 new stores and grows sales per store by 1% CAGR, resulting in a 3.6% 8Y revenue CAGR. I believe this is a conservative forecast compared to the industry's forecasted growth of 6% to 7% over the next five years. EBITDA margins normalize after an elevated period of advertising spend and FCF conversion averages 40% throughout the forecast period.

I also contemplated a “Harvest Case”, in which the Company does not open any new stores and focuses solely on operational execution. 8Y revenue CAGR is lower at 2.1% and margins are 500bps lower versus the base case. The added conservatism still provides an upside of almost 18% to today’s price, implying a margin of safety.

Comparable companies also suggest the stock is trading at cheap valuations. Sleep Country is rated meaningfully below peers on multiples of EBITDA, earnings, and free cash flow despite higher margins. A re-rating to median multiples suggest a 20% to 70% upside. Precedent transactions also confirm upside potential. Even in the throes of the Great Financial Crisis, financial sponsors were willing to take Sleep Country private at 9x EBITDA. Since then, similar retailers have transacted at multiples averaging between 9x and 10x. Sleep Country’s closest comparable, Mattress Firm, was taken private at 10.5x NTM EBITDA. Applied to consensus estimates for the Company’s EBITDA, that multiple suggests a 75% upside.

Key Risks

1. A growth in sale of accessories increases working capital requirements. A higher number of SKUs will likely also increase distribution costs and shrinkage rates. However, the upside potential from sales growth and margin accretion more than offset these risks.

2. Greater-than-expected adoption of online delivery may reduce the Company’s competitive positioning, but investments in building an omni-channel platform mitigate this risk.

Catalyst

1. Better than expected earnings in the coming quarters

2. Improving macroeconomic conditions

But ultimately, this is a buy + hold pick