Description

Long: Tempur Sealy International (TPX) – Misunderstood Consumer Category Leader

Thesis Overview

Tempur Sealy is an increasingly dominant category leader trading for <15x our recession case normalized free cash flow (~50% sales decline peak-to-trough). We believe that Tempur’s current valuation fails to reflect its earnings power in a normalized demand environment, which has structurally improved due to actions taken by CEO Scott Thompson since 2015. In particular, we believe market participants are overlooking (1) medium-term value creation drivers in domestic Wholesale & DTC and (2) material whitespace in International. While mattress demand is undoubtedly cyclical, Consensus fears that the mattress industry has seen a ‘rising tide lifts all boats’ phenomenon and anticipates significant downside as revenue declines couple with NWC impairments. We believe this is now fully priced into the equity and see significant upside despite these concerns.

We believe the market is myopically focused on near term volume declines and overlooking the LT benefit to Tempur’s underlying earnings power and durability that has taken place over the last 5 years from: (1) industry consolidation, (2) improved balance sheet, and (3) improved distribution power due to reduced Mattress Firm dependence. Critically, Tempur is positioned to take pole position in the DTC channel given its technology, brand, and recent hires. This would negate long-standing bear arguments around the stock and eliminate the disruption risk overhang that has persisted. 

Unlike the Tempur of the past, we believe the Company now has the balance sheet strength and route to market muscle to control its own destiny to an extent that was not possible in the past when levered >3.0x and beholden to Mattress Firm. Tempur balance sheet is now levered <2.5x EBITDA on a trailing basis (Capacity to delever <2x quickly ex-buybacks). In contrast to its highly levered principal competitor Serta Simmons, whose 2024 Term Loan trades at 45% of par (Eikon data, 6/23/2022. Bid price: 40, Ask Price: 50). This makes Tempur equity a far more anti-fragile investment relative to its own history and creates relative win potential if Serta either (1) remains hamstrung by its levered capital structure or (2) is forced to retrench/sell assets during a restructuring process. 

10x levered FCF or 8x EBITDA on our mid-cycle/normalized estimates for an increasingly dominant consumer business with clear line of sight/levers to grow EBITDA is sensible in our view/not overly demanding. Low entry multiple, operating growth together with assumed buybacks (which we do not believe are unreasonable given Scott Thompson’s track record of using buybacks to accelerate value creation) create an exciting opportunity. 

We see a path to $85 per share on our 2026 assumptions (Dec. year-end), corresponding to a >30% IRR on a 4-5 year view. Incremental upside can be driven by share repurchases over and above our assumptions, stronger Direct/International growth than expected as well as hard to model/quantify EBITDA drivers (discussed below – see “Additional EBITDA drivers” section).

Business Introduction 

We believe Tempur to be the demonstrably best business in its industry. It is run by a management team that focused on growing EBITDA over the long-term, even if it means risking/throttling back sales in the short-term. Taking short-term pain to achieve multi-year wins has defined Tempur’s success under Thompson’s tenure. By being vertically integrated (from owned manufacturing to DTC to wholesale), they possess the ability to meet customers wherever they are – whether it be at a specialty mattress retailer, home goods store, Tempur owned store, or online. Tempur possesses brands with leading consumer recognition across price points (Sealy is the #1 brand and Tempur Pedic is the #2 brand). They have unmatched scale to dictate best terms with retailers. Cumulative R&D advantages that allow it to roll out mattresses and ancillary products such as bed bases and pillows on the leading edge of the industry. This contrasts particularly with the Bed-in-a-Box (BIAB) native players, many of whom are marketing front ends/customer acquisition engines reliant on contract manufacturing.  

Since joining as CEO in September 2015, Scott Thompson has taken actions to impose more ecosystem control over the mattress value chain. Tempur has acquired a regional store chain (we believe this provides unique consumer insights without overly burdening the balance sheet with lease obligations), bolted on OEM manufacturing opportunistically, renegotiated Tempur’s agreement with leading retail partner (Mattress Firm; more on this below), expanded Tempur’s experiential retail base and acquired the leading UK mattress retail chain, Dreams.   

Scott was previously CEO of Dollar Thrify, which sold to Hertz in Nov. 2012. During Scott’s tenure, the company went from the verge of bankruptcy to selling for $87.4/share (took EBITDA from negative to >$300M in 4 years). Jana Partners spoke extremely highly of Scott’s track record at Dollar Thrifty and can be found here.   

Why do we like the business? 

1. Mattresses are a necessity item with a relatively predictable replacement cycle. Long-term demographic trends (population growth and household formation) in the United States drive demand while product innovation and health awareness drive consumer interest. 

2. Replacement cycles are consistent at ~7-8 years. Technology and an increased focus on health and wellness is driving replacement cycles lower.

3. Unit volumes in the bedding industry have been driven by population growth, rising homeownership, increasing square footage of single-family homes. Industry growth closely mirrors GDP growth.

1. For excellent detail on the mattress industry, we recommend Mattress Firm’s recent S-1 filing.   

4. Tempur Sealy are the leading player (technology, scale, route to market) in a growing consumer segment with durable advantages 

1. Dominance in core markets with reinvestment runway at high incremental rates of return

1. Sealy and Tempur have become the dominant brands in the industry with #1 and #2 positions leapfrogging Serta Simmons

2. Omnichannel strategy firing on all cylinders

3. Strong opportunities for growth internationally

4. Competitors experiencing ongoing balance sheet stress 

5. De-risked Balance sheet

5. Management’s demonstrated ability to make the tough, but necessary, decisions to drive long term value on a per-share basis

1. Mattress Firm walkaway

2. Simplifying the Tempur-Pedic product line (1/2017 investor presentation details this)

3. Shrinking shares outstanding by ~24% since 2016

4. DTC execution (Cliff Buster who was head of DTC and now President North America has driven huge success internally at Tempur; he previously was Scott’s right hand man at Dollar Thrifty)

5. Clear focus on dominating North America before attacking International

Source: Mattress Firm S-1 (Filed 2/8/22)

Source: TPX February 2022 Investor Presentation

Source: TPX April 2022 Investor Presentation

Key Thesis Points 

We see three main drivers of our investment view: (1) rationalized industry structure, (2) Tempur’s DTC dominance continuing, with International providing white-space growth opportunity and (3) balance sheet flexibility and cash flow provide significant upside to drive per share value.

Rationalized Industry Structure

1. Material industry consolidation and supply rationalization over the last five years – This really gets at the heart of concerns I’ve heard, which is what happens if consumers spend less on their homes, furniture, etc. 

1. Despite a potential slowdown in volumes, we do not believe the Tempur business will be impaired

2. While Tempur has benefitted from flush US consumers due to stimulus checks coming through, the benefit has largely been concentrated in lower end product offers. While this will ultimately impact volumes, Tempur’s underlying profitability is primarily driven by its higher end products

2. Tempur has been able to mitigate inflation much better than in the past through price increases

1. This is partially driven by the Tempur brand’s consumer mind share and product differentiation, but also partially driven by supply consolidation and better pricing discipline

3. The import dynamic has changed in the US following tariff implementations. This has taken out pricing pressure from the low end of the market.

1. In February of 2019, China had ~90% of the mattress import market in the US (in units) and ~25% of total unit share through dumping efforts

2. China’s market share is now ~1%

3. This has been one of the huge drivers for Sealy’s success and capture of #1 market share in the US

4. Tempur expanded into the OEM manufacturing pool. “We began leaning into this new sales stream last year and sold about $150mn of OEM products in 2020. Looking forward we believe that in 5 years, the run rate of this business could exceed $600 million of annual sales” (Q4 2020 earnings call). On January 31, 2020, Tempur acquired the Sherwood Bedding business. Sherwood Bedding is a major manufacturer in the U.S. private label and OEM bedding market.

5. From a retail perspective, Mattress Firm’s retrenchment while in Ch. 11 bankruptcy proceedings has improved conditions 

1. Previously, the industry was oversaturated, with Mattress Firm locations competing against each other for volumes and hence driving down ASPs for key wholesalers including Tempur 

2. Between 2007-2017, Mattress Firm increased store count by >8x – aggressive expansion strategy saw Mattress Firm engage in a roll up of other brands (Sleep Train in 2014 and Sleepy’s in 2016 most notably) alongside organic store openings. MFHC completed ~25 acquisitions. Increasing its store base to ~3.5k stores at peak including ~2k acquired stores. 

3. MF utilized Ch. 11 to exit ~700 retail stores in order to drive an uplift in sales and profitability of the remaining store base. At the time of filing, was the largest mattress specialty retailer with ~3230 stores and sales of ~3.2bn for LTM Sept 2018.

4. ~700 stores were exited immediately during Ch. 11, ~900 total through 2018 and ~1,100 cumulatively through today

5. Steinhoff, the troubled South African retail conglomerate, acquired Mattress Firm for $3.8bn in August 2016.

6. Marketing and sales promotions prior to bankruptcy depressed pricing in the industry. 

7. As the COO described at the time of Ch. 11, “There are many examples of a Mattress Firm store being located literally across the street from another Mattress Firm store.” The map below highlights the degree of store proximity that resulted in sales cannibalization and excessive competition (sales associates offered a commission-based compensation structure that incented chasing volume) 

Source: Mattress Firm COO/CFO Hendre Ackermann Declaration Statement, Filed 10/05/2018

Source: MFRM Historical filings; Independent research

Tempur and Mattress Firm have a unique relationship. They mutually agreed to terminate the relationship in 2017, with the implication being the largest bedding manufacturer in the world no longer doing business with the largest bedding retailer in North America. Then in June 2019, announced new distribution with Mattress Firm. In Q1 2020 completes new distribution with Mattress Firm. This move allowed Tempur to reset its relationship with its historically largest customer. 

Following these changes, both parties came together two years later and restructured their agreement, and today, Tempur Sealy has distribution in ~2,400 Mattress Firm doors (YE21 Mattress Firm disclosed 2,344 stores). Today, Mattress Firm accounts for ~15% of overall sales, down from a peak of ~21% sales contribution in 2016. 

At the same time, Tempur announced an expansion of its supply agreement with Big Lots across 1.4k stores with the objective of growing volumes of entry-level Sealy products below $1k price points. And a supply agreement with Better Bed, one of the largest European specialty mattress retailers, which helps to underpin international growth (i.e. greater distribution visibility). 

Source: Mattress Firm S-1 (Filed 2/8/22)

Increasing DTC Strength

1. Prior to the Dreams acquisition and the COVID windfall in H2 2020 and 2021, TPX was building an excellent DTC business that was compounding >30% and outpacing all peers

Source: Public Filings and independent research

2. In 2021, TPX had ~$900mn of direct sales (~$600mn before the Dreams acquisition), which makes this segment of the business the largest of any mattress manufacturer other than Sleep Number

3. 90% of consumers want to physically experience a mattress before making a purchase decision. 

1. Tempur is ideally positioned to capture market share given its share of mind with consumers. Flagship retail stores + increased capacity to provide sales incentives in a weak market provide increased upside to capture a higher % of dollars in North America

Source: Public Filings; Investor Presentation 3/2/18 disclosed 24 open stores

4. Direct sales, including through recent M&A, Company-owned Tempur stores (~80 today) and eCommerce increased from 4% of sales in 2016 to 18% in 2021

1. Company is talking about potential for 125-150 stores over time. AUV of $1.5-2mn. 6-12 month paybacks are impressive for retail concept. Contribution equivalent to 20-30 wholesale accounts and 20 Mattress Firm stores.

2. Often overlooked is Tempur’s acquisition of Sleep Outfitters in April 2019 for $24mn. This business was acquired out of bankruptcy, with Tempur completing integration in Q2 2019. 100 units carrying the full range of brands: Tempur-pedic, Sealy, Stearns & Foster

1. 100 stores with AUVs of $0.8-0.9mn

2. We estimate TPX have realized >5x their MOIC in FCF from this business

3. Much of the DTC is staggering towards consolidation. Fundamentally a few things will prove a thorn in the side of most DTC players in the near term. With capital drying up, new entrants will have difficulty getting scale. Incumbents are getting better faster than new entrants can disrupt.

1. Most new entrants are focused on the same compressed mattress product produced by contract manufacturers. Brands reliance on contract manufacturers means they possess none of the R&D based advantages/product quality-based advantages of Tempur

2. Also note that many target the same customer demographic

3. What was originally the novelty of buying a high-quality mattress for competitive prices has eroded into perceived quality issues by consumers, reinforcing the quality advantages of vertically integrated manufacturers and legacy brands 

4. To capture their fair share in the BIAB category, Tempur deployed two products across its Sealy and Tempur Pedic brands. Cocoon by Sealy (Launched in 2016; ~$800 - 1,000 AUSP) and the TEMPUR-Cloud (Entry-level Tempur-Pedic mattress launched in 2019; $1,300 – 2,000 AUSP)

5. Serta Simmons distress – How can Scott Thompson & team capitalize? 

1. While the mattress category has been perceived as a ‘COVID winner’ by many observers given its connection to the home buying/improvement trend, this rising tide has not lifted all boats equally

2. Serta remains highly levered, with a capital structure that highly constrains its ability to reinvest and we believe is unsustainable 

3. The financial sponsor controlling the business, Advent International, is locked in negotiations with creditors, including distressed credit groups like Apollo and LCM

6. Dreams Acquisition highlighted that Scott Thompson and the team are willing to think creatively (and opportunistically) about the future of the industry

1. August 2021 purchased the leading UK omnichannel mattress retailer for $476.7mn (we estimate the purchase was ~12x EBITDA)

2. ~200 brick and mortar stores as well as manufacturing and distribution capabilities

7. OEM protentional and Stearns and Foster revamp driving an incremental $1bn

1. As mentioned above, management see the OEM business delivering a ~$600mn Sales run-rate by 2025 (>$450mn incremental since Sherwood acquisition)

2. Stearns & Foster targeting $1bn brand (double from today’s size); 2022 will be a big marketing push with innovation launched in Q4

Balance Sheet Position Allows for Material Buybacks on 3-5 Year View

1. Cash flow generated over TTM has de-risked the balance sheet and provided flexibility that Tempur have not had in past cycles

1. Management have been conservative in their optimization efforts as they prepare for a market slowdown. A fortified balance sheet should be an asset as they continue to execute against the long-term plan

2. Management have used the COVID windfall to focus on re-pricing the debt stack and ensuring that interest expense is modest relative to the cost structure (~$25mn saved on a run-rate basis over the course of 2021)

3. Given the rapidly deleveraging capital structure even after accelerated marketing investment (est. ~$500mn in 2022), we believe Tempur has capacity to repurchase ~30% of shares outstanding by 2026 

1. Maintain ~2x net debt to EBITDA over time (within management’s guided 2-3x range). This could arguably be higher, but we would prefer management to maintain the optionality to emerge from any crisis in a stronger competitive position rather than enter with an overly optimized balance sheet

2. This will drive material FCF/share growth over that period.

Additional EBITDA drivers

1. International volume growth, particularly in China – In this market, the Tempur brand is perceived as a premium product 

1. The Company has guided to international product initiatives accretive to earnings in early 2023 (delayed from 2022 due to supply chain issues)

2. Management have tempered expectations for International in the short-term, saying they are focusing on International over the next few years, but are willing to be patient to get it right

2. Sleep health unlocking consumer discretionary spend – core consumer health product / quality of product / R&D / unlocks something special

1. There continues to be opportunity in the health & wellness space for sleep technology

2. Tempur have been relatively modest in their technology roll-outs, but there is meaningful upside here if they can get the technology right

Key Operating Risks

1. Drawn out recession risk

1. Market has clearly priced in a recessionary scenario and a significant haircut to underlying earnings.

2. Are management prepared for sales to decline >25%? 

3. Can the cost structure support significant declines over the next 18-24 mo in a worst case?

2. Serta Simmons emerges from restructuring as a stronger competitor

1. A weak Serta Simmons has provided a tailwind to Tempur, who have been allowed to contend with a weak principal competitor 

2. Despite the myopic focus on BIAB competition (i.e. Casper, Purple), Tempur’s true threat are other players with scale, specifically Serta Simmons

3. International Execution

1. Will the success in North America translate to the International expansion?

2. Serta’s China business was sold to Hillhouse in 2021 providing the potential for a well-capitalized strategic competitor in the world’s largest market

Catalyst

• Durability in recessionarry environment
• Buybacks above expectations
• DTC/International upside