Description

Thesis: Weary of unsustainable gains to sales and margins, the market has mischaracterized Tempur as a pandemic beneficiary and ascribed a conservative valuation to the business; however, there is significant evidence that the company’s gains to sales and margins have largely been structural. In short, the market is throwing the baby out with the bathwater when it buckets Tempur in with the other Retail and Consumer names that have seen large gains due to Covid. This creates an opportunity to buy a high quality and growing business at a steep discount to intrinsic value and its own historical valuation multiples. I see a 61% base case 1-2 year return to 16x our ‘23E EPS estimate and expect limited downside of about (23)% due to a margin of safety provided by the equity’s conservative valuation. I also see a base case 34% 3Y IRR to 17x our ‘24E EPS estimate including the impact from anticipated share repurchases.

 Recent Performance & Valuation

• 2021 Sales are expected to be up about 62% vs. 2019
• 2021 EBIT margins are expected to be up about 620bps vs. 2019’s 12.4% margin
• Valuation multiples based on consensus numbers
• 9.2x ’22 EBIT vs. ’17 – ’19 average of 13.8x EBIT
• 10.9x ’22 EPS vs. ’17 – ‘19 average of 17.2x EPS.

12-18 Month Upside & Downside Cases

• Base Case: +60.5%
• 16.0x ‘23E EPS of $3.95
• 7.3% FCF Yield, $3.01 FCF / Share
• Bull Case: +108.1%
• 19.0x ‘23E EPS of $4.34
• 8.0% FCF Yield, $3.32 FCF / Share  
• Bear Case: (23.4)%
• 12.0x ‘23E EPS of $2.47
• 4.8% FCF Yield, $1.96 FCF / Share
• Additional Upside from Repurchases: +22% in our base case
• Leverage is 0.5x to 1.0x below the company’s target
• $350mn of excess cash on the balance sheet
• Could repurchase up to 20% of the market cap

Market Perception: At first brush, Tempur’s performance looks very similar to that of my favorite (read: least favorite) pandemic beneficiaries such as Dick’s Sporting Goods, Williams-Sonoma and Crocs. Despite uninspiring growth trends in the years immediately preceding Covid, these businesses have each seen significant boosts in sales of 45-90% vs. 2019. They’ve also seen significant gross margin expansion due to the low promotional environment that these companies have been operating in. On the surface, Tempur’s 60% sales gains and 620bps of margin expansion vs. 2019 appear to mirror this. As a result, the market has applied meaningful valuation discounts to Tempur and other businesses with this performance pattern, as seen in the table below.

Where Tempur is Different – Structural Gains to Sales: My estimates for '21E and '22E sales are 59.5% and 74.3% above 2019's levels. The vast majority of Tempur’s gains to sales can be explained by a combination of increased distribution, new business lines, M&A, share gains and price increases. Unlike categories such as sporting goods, outdoors goods and furniture, the mattress industry has not seen indiscriminate growth. Tempur’s largest competitor, Serta Simmons is currently seeing LTM sales (8)% below 2019 sales and LTM EBITDA margins (510)bps below 2019 margins. DTC players such as Casper and Purple have started to struggle to grow units over the last two years, leading to equity prices that have declined by (68)% and (49)% from pre-covid levels.

“New distribution” refers to the agreements Tempur signed with Mattress Firm and Big Lots at the end of 2019 as well as increased distribution into other smaller retailers. When Tempur lost Mattress Firm in 2017, the company lost 21% of its sales but was able to build sales back up by the time they signed with Mattress Firm again in 2019. Sales trends in Q1’20 (FQE: 03/31) illustrate the impact of these agreements. Despite Covid impacting the quarter both in the US in March and throughout the quarter in international markets, Tempur’s sales in Q1’20 were up 19.8% vs. 2019. When Tempur announced those agreements in 2019, the company explained that they would not hit their maximum size right away and would continue to ramp throughout 2020 and into 2021, implying additional structural increases to sales. Management claims that there are even more retail distribution customers who are waiting to sign on with Tempur next year when production can scale to meet additional customers.

Since 2019, Tempur has also purchased a direct to consumer retail business in the UK called Dreams which is expected to contribute $450mn in sales, equal to about 14.5% of ’21 sales. Dreams is only one component of the company’s significant international growth opportunity which could drive above consensus growth. Tempur has also entered into the OEM business which produced $150mn in sales in 2021, equal to about 4.8% of ’19 sales. I estimate that the combination of new distribution and M&A will account for 44.2% growth in sales vs ’19 in 2022.

In additional to these sources of sales gains, the industry has seen a large ramp in pricing due to commodity inflation. I have heard estimates for Tempur’s price increases over the last two years ranging from 11% to 25%. After accounting for a 17.5% increase to sales from pricing and 44.2% growth from new distribution and M&A, it appears that the balance of the '19 - '22E growth has come from a 12.6% increase in units from a mix of broader industry growth and increase in share. While this level of growth is above trend, it is worth noting that the overall mattress market declined in sales from ’17 to ’19 in part due to the fallout from the split between Tempur and Mattress Firm which led to Mattress Firm’s eventual bankruptcy. As a result, it is possible that some of the recent acceleration in units could be considered a catchup after that period of tepid growth. While pricing growth has certainly outpaced the long term trend, these gains are considered very sticky – especially for Tempur who has a 35% US market share and an incredibly strong brand. The table below illustrates the components of our estimated ’22 sales gains over ‘19 sales.

Where Tempur is Different – Gains to Margins Through Leverage: Whereas most retailers in categories such as sporting goods or furniture have seen increases to gross margins as a result of a decreased promotional environment, Tempur’s gains to margins have largely come from below the gross profit line as the company leverages fixed costs. Whereas only about 17-22% of Sonoma’s and Dick’s gains to margins have come from below the gross profit line, 87% of Tempur’s LTM margin gains have come from leveraging SG&A and other opex. The table below compares where margin gains have come from for various retailers and manufacturers with discounted valuations.

Tempur has also seen pressure to gross margins due to significant raw materials inflation. The company has been able to mitigate the impact of these pressures on profitability due to its strong pricing power. To the extent commodity pressure alleviates, there could be a material boost to margins which could also drive profitability above consensus estimates.

Underappreciated Capital Structure Opportunity: Tempur is currently operating with net leverage of about 1.5x consensus ’22E EBITDA. The company has stated that they are below their leverage target and will look to get back to their target leverage profile of 2-3x. They have alluded to the possibility of significant share repurchases but may also look at M&A opportunistically. Management could issue north of $1.25bn of new debt in order to reach their leverage targets. In combination with the ~$350mn of excess cash on the balance sheet, the company could use this capital to repurchase upwards of 20% of the $7.7bn market cap. At 16x EPS, this alone could add an additional 22% return to my base case return assuming a 5% cost of capital.

Conclusion: Because Tempur Sealy has been bucketed in with Covid winners, the market has discounted the company’s forward earnings power creating an attractive entry point for the equity. Gains to margins are primarily the result of leveraging fixed costs. This means that if sales are sustainable, margins are sustainable as well. There is significant evidence that the company’s +60% sales gains since 2019 have been structural and will be sustained. This creates an opportunity to own a market share leader in a growing category at a discounted valuation.

Catalyst

• If retailers and product manufacturers who have benefitted from Covid tailwinds begin to see sales and margins normalize while Tempur's sales and profitability remain strong, the equity may re-rate higher to reflect the company's long term profitability and growth algo.
• Tempur also has an opportunity to repurchase a significant amount of shares. If the company issues debt to repurchase shares, this may help realize value for shareholders.