Description

Summary

Tempur Sealy International (TPX) is the industry’s leading mattress manufacturer, consistently gaining share and outperforming its many competitors. We believe the mattress market is currently operating at trough-like conditions, following two strong years of growth in the immediate aftermath of COVID. This cyclical downturn is masking secular share gains and margin improvements at TPX. Many market participants view TPX as yet another cyclical play on housing, but we see TPX as a company with a dominant position in its value chain, with that position only growing stronger. We see an attractive opportunity to purchase the market leader at a quite reasonable valuation on what we believe to be trough earnings. We model 2024 and 2025 EPS above consensus even assuming a continued weak industry backdrop, and our estimates would be even more materially above the Street assuming more normalized conditions. While we find TPX to be quite attractive on its own, the pending acquisition of Mattress Firm (should it be approved) would fuel an even more exciting growth story in the years ahead.

Business description

TPX is a designer, manufacturer, distributor and retailer of mattresses and other bedding products. The company’s brands include Tempur-Pedic, Sealy, and Stearns & Foster, in addition to TPX’s private label businesses. TPX is primarily a wholesaler of mattresses, selling its products at third-party retailers, though the company does also have a network of its own retail stores, including ~100 Tempur-Pedic stores, ~100 Sleep Outfitters stores, and ~200 Dreams stores in the UK. TPX also sells directly to consumers on its own website. Blended together, ~75% of TPX’s revenue is wholesale, with 25% “direct.” The company generates ~80% of its revenue in North America and ~20% internationally (sources: TPX 10-K, earnings releases). Of course, TPX is most well-known for its proprietary Tempur material, which adapts to the shape, weight and temperature of the consumer.

In May 2023, TPX announced an agreement to acquire Mattress Firm for ~$4.0B in a cash and stock deal. The acquisition would combine the industry’s largest mattress manufacturer with the industry’s largest retailer (MFRM has more than 2,000 stores), providing TPX with greater vertical integration. The deal is still pending FTC approval, and TPX expects the deal to close in 2H24 (sources: TPX press release 5/9/23, TPX earnings calls).

Industry/company background

Before delving into current industry dynamics, it is informative to understand the context of how TPX has maneuvered in the mattress industry over the past several years. In 2017, Mattress Firm attempted to exert pressure on TPX by introducing its own line of competitive products, referred to as Therapedic. Scott Thompson, hired as TPX’s CEO in 2016, made the gutsy move of pulling TPX mattresses from all MFRM locations and began building owned retail stores more aggressively. This ultimately paid off ~18 months later when TPX re-entered MFRM and cemented further share growth (@tps12 did a very nice job detailing this history and broader industry changes in a June 2022 writeup). Since that time, TPX has established even greater dominance in the industry, as evidenced by holding off upstart bed-in-a-box competitors (many of whom are now in various states of financial distress) and driving (or at least partially driving) Serta Simmons into bankruptcy. All this goes to say that TPX, especially under Scott Thompson’s leadership, has a history of moving deftly in the industry and consistently gaining share. We view the MFRM acquisition proposal the natural next evolution in the company’s journey.

As it relates to current market conditions, the US mattress industry is in the midst of a more than two-year pullback in demand, following post-COVID strength. As one might imagine, the US mattress industry is low growth in nature, generally believed to grow at 1-2% annually, in-line with population growth/household formation. Housing market trends and consumer confidence also play factors in driving demand. As the chart below demonstrates, 2023 US-produced mattress volume is likely to be at the lowest level in 20 years (final numbers not yet released).

Source: TPX investor presentation

There are many ways to slice this data, but almost all analysis points to this being indicative of trough-like conditions. If we view 2017-2019 demand as a “normalized” level (~23.5mm units), then in the two years post-COVID, the industry “over-earned” by ~1.7mm units cumulatively. However, since then, during 2022 and 2023, the industry “under-earned” by ~8.6mm units cumulatively, clearly more than the amount of the initial post-COVID ramp. And even that simple analysis ignored the continued (albeit small) underlying market growth over those four years. While an increase in cheaper, lower quality imports may slightly skew this framing (given the above chart only looks at mattresses produced domestically), the underlying impact does not change much, particularly for TPX, who plays in the higher end of the market.

Another intuitive framing comes from Raymond James research, which uses the 2000-2019 industry demand CAGR of ~1.3% to calculate whether demand is running “above trend” or “below trend.” This analysis is applied to the total US market (inclusive of imports) and shows 2023 to be running ~7mm units below what historical trend would suggest.

Source: Raymond James note 1/19/24

While we do not believe the mattress industry is likely to imminently sharply snap back, we do believe this analysis is supportive of the view the demand is trough-like. We model “only” a 2% industry volume CAGR over the next two years, and still project quite an attractive return at TPX.

Investment thesis

Though buying shares of any market leader in an industry at trough-like demand is an investment thesis in itself, there are many dynamics specific only to TPX that have us particularly excited.

While market share in the mattress industry is difficult to fully triangulate, particularly since reporting from industry group ISPA has changed over the past few years, we are able to calculate market share manually. Simply dividing TPX’s US wholesale revenue (ignoring its Direct business) by ISPA projected US wholesale revenue demonstrates that TPX has shown a steady increase in share since 2017 (with small interruption driven by MFRM negotiations).

Source: TPX 10-K’s, Truist 3Q23 summary of IPSA Wholesale Mattress Industry Results

While the growth in share the past several years has been quite large, we remain quite bullish on the market share growth opportunity still ahead of the company. With Sleep Number recently announcing a plan to permanently close 40-50 of its ~675 stores (source SNBR press release 11/7/23) and Serta Simmons appearing to be in a general state of disarray following its emergence from bankruptcy (and recent CEO upheaval), we see ample opportunity for share gains to continue. Recent competitive wins at Sam’s Club are just one example of the opportunity in front of TPX. We model ~100bps of market share gain each of the next two years, but view that assumption to be quite conservative.

We also see room for TPX margins to increase significantly in the next several years. TPX’s gross margin has compressed from prior peak levels due to a combination of supply chain inefficiency and raw material inflation. We see 2024 as a year when TPX self-help initiatives fully recapture the prior supply chain headwinds and when the price/raw dynamic becomes much more favorable. We were encouraged to hear the company state on its 3Q23 earnings call, “In addition to the benefit of favorable commodity markets, we have signed multiple agreements with certain global suppliers, who have recognized our scale momentum.” We think this is indicative of gross margin tailwinds on the come and we believe TPX will achieve record gross margin in 2024, despite modeling a depressed industry backdrop. This leads us to a 2025 EPS estimate that is nicely ahead of consensus, despite what we believe to be quite conservative assumptions on both industry growth and TPX’s market share. Simply stated, we do not know how long this downturn will last, but we feel quite confident that TPX will ultimately emerge with stronger profitability and higher share.

Combined with falling capex, as TPX winds down spend on prior growth projects, we see a very powerful ramp in FCF. We model a high-teens growth in free cash flow dollars (before even modeling any capital return to shareholders) over the next several years.

The attractiveness of this opportunity is before even discussing the pending acquisition of Mattress Firm. We think TPX is a very attractive standalone investment, and hence will not spend much time discussing the Mattress Firm acquisition here. Nonetheless, should the transaction get approved (and we take no strong view on such a likelihood), we see an incredibly powerful next leg of growth for TPX. For starters, pro forma for the acquisition, TPX would represent an even more levered play on an industry recovery. But far more interesting is the synergy potential, both in the form of cost synergies as well as true revenue synergies. A combined entity would have even greater control over the mattress supply chain, and we would expect to see significant supply chain related savings. We believe that TPX’s guidance of $100mm of synergies (source: TPX press release 5/9/23)  to be realized over four years post deal closing to be potentially conservative. We see the likelihood of significant advertising and marketing savings as a joint entity, in addition to the more obvious procurement and corporate-level savings. And while TPX has already signed tentative deals with current third-party mattress suppliers to MFRM to ensure that these companies will not be fully “boxed out” by TPX, we expect that over time TPX will significantly increase its market share on the Mattress Firm showroom floor. Unlike most acquisitions, this represents real, tangible revenue synergy potential that is essentially fully in the company’s control. We see the MFRM acquisition to be nicely accretive to TPX, and while we are highly enthused by the standalone story, we would be even more bullish should the deal close.

Risks

• MFRM acquisition: It is currently unclear whether the TPX/MFRM deal will be cleared by regulators. Should the deal get blocked we would expect near-term volatility in the stock, though we suspect TPX would immediately begin to repurchase its shares aggressively (following being out of the market since deal announcement)
• CEO Thompson: There is a bit of key man risk here as we view Scott Thompson to be an excellent steward of capital. He has signed an employment contract through 2026 so that risk should be mitigated for now.
• Cyclical/industry risk: While we do believe we are near trough industry conditions, there is of course no guarantee that the market will begin to bounce back. We believe are general conservative industry assumptions properly contemplate that risk.

Catalyst

4Q23 earnings release, 2/8/23

Potential MFRM deal closure, 2H24