I have been a spectator of Tempur-Pedic (TPX) shares for the past year, watching the roller-coaster ride and pain that investors and believers in the company have suffered. However, it was not until recently that I became an investor in the company. After thorough due-diligence, I believe this is a classic example of a "fallen angel," or a growth stock that has hit a speed bump that has made investors worried. I acknowledge investor fears, it is hard not to especially after several earnings misses, guidance revisions and clear competitive threats. However, at current price levels I believe each of these risks is priced in and then some. This being said, it will not take much to send shares of Tempur-Pedic much higher and in a hurry.
Since 2003, Tempur-Pedic has seen its revenue grow at a compounded annual growth rate (CAGR) of approximately 17% per year and earnings grow at a faster (due to leverage) CAGR of 26%. During this time, gross margins remained steady in the 45%-50% range and free cash flow grew nicely at a 14% annual rate. During the financial crisis and housing collapse of 2008 and 2009, gross margins declined to 43% and operating margins declined further to 14% compared with the company's 10-year 20% average. Overall, the company has enjoyed consistent growth due to management's deft execution of its business plan and conviction in its mission. (See latest 10-Q for historical financials.)
Management (back to the basics… S.W.O.T analysis? What's that?)
More recently, management has been caught off guard by increased competition from the likes of Select Comfort Corporation (SCSS) and other private mattress manufacturers. I believe that Tempur-Pedic management became complacent and took its eye off the competitive landscape. We all know what happened next as a result. Currently, it seems that management is doing everything it can do fend off this threat and resume the growth trajectory. Mark Sarvary, CEO, has made this very clear on the company's quarterly conference calls, reiterating the commitment several times over. However, as the age-old saying goes, don't listen to what people say, watch what they do. (See June article on increased competition hurting Tempur-Pedic shares and second-quarter earnings call transcript for management discussing increased competition.)
What have they done?
Management has accelerated the product launch of a new line of mattresses, announced wholesale mattress price reductions on certain U.S. models to improve retail customers' margins and extended the warranty on all its U.S. mattress models to 25 years. Further, the company has ramped up spending on advertisement and is extending extremely favorable financing terms to customers. (See third-quarter earnings call transcript for management discussion of recent initiatives.)
I can imagine the bears responding with something like this: So gross margins are going to come under pressure due to retail price reductions, the company is going to have to accrue a higher warranty expense and its operating margins are going to take a hit because it is going on an advertising spending spree…
I should buy the shares why?
The answer is because the best time to purchase shares in a "fallen angel" is when investors' expectations are low and management is aggressively trying to correct the problems. Given where the stock currently trades, it does not matter if next quarter's margins come under pressure due to aggressive promotional activity because much worse is already priced in. Management is defending the Tempur-Pedic brand and setting the stage for the company's next stage of growth.
The Sealy (ZZ) acquisition took many investors by surprise and the timing of the announcement only fueled speculation that the company was in trouble and management was getting desperate. As I mentioned earlier, Tempur-Pedic management took its eye off the competitive landscape and like so many other companies before it, suffered the price of complacency. I believe this was a rude awakening, which took management off of cruise control and into high gear. While I do agree that the timing of the acquisition could have been better, adding more complexity and distraction when the core business is stumbling, I believe that in the long run it is absolutely the right move. (See Tempur-Pedic press release announcing the acquisition.)
Tempur-Pedic is like the Coach (COH) or Tiffany (TIFF) of the mattress world, obviously not in terms of product or end-market, but rather it is the high-end manufacturer in a market full of cheaper alternatives. While these companies enjoy higher margins, it often comes at the cost of greater economic sensitivity. Through the acquisition of Sealy, Tempur-Pedic is effectively reducing the variability of future earnings by having a product that spans multiple price points and expands the company's distribution and reach globally. More importantly, it will have the best portfolio of brand name mattresses of any of its competitors. The value of which, I would argue, is being discounted tremendously by investors.
Two mattresses for the price of one?
On the day Tempur-Pedic announced the Sealy acquisition, shares advanced almost 20% from $27 to $31. Investors cheered the acquisition, and proceeded to tack on the $230 million equity value of Sealy to Tempur-Pedic's share price (approximately $3.15 per Tempur-Pedic share based on 70 million TPX shares outstanding). Since then, shares have slipped back down to the $25-$27 range (thanks in part to a poor earnings report). I look at this two ways: Either the market believes the acquisition is going to be blocked by the FTC (which I do not think is true based on the spread that Sealy's shares are trading relative to the acquisition price) or investors have become so pessimistic on Tempur-Pedic's core business that they are pricing the shares at $22-$24. While there is never a clear answer, I believe investors are getting a free call option on Sealy given where shares of Tempur-Pedic are currently trading. For the bears out there, think of it as a distressed investment with an equity kicker.
It is important to look at both insider activity as well as the composition of ownership. Chieftain Capital Management, a large Hedge Fund focused on value investing, has recently amassed a large position in the company at a price between $25-$33/per share. The most recent filing shows that Chieftain Capital owns 10% of the Tempur-Pedic float outstanding. On December 3, 2012, H Partners Management, value/activist focused Hedge Fund, announced a 5% equity stake in the firm. H Partners held a decent stake in Sealy Corp and is known for being extremely vocal about KKR's involvement in the company. FMR owns 15% of Tempur-Pedic through large investments in the Fidelity Contrafund and Fidelity Growth Fund. What is important is that value-oriented, activist hedge funds are finding value in shares of Tempur-Pedic and aggressively buying shares at current prices. It is important to note that the 15 top institutional investors own 60% of the Tempur-Pedic float. My point? At some point there is just no one left to sell to. (See latest Chieftain 13-F filing and H Partners filing to see reported ownership.)
I modeled Tempur-Pedic's financials out over the next 10 years. I recognize that 10 years is a long time, in fact anything over three years is next to impossible for any company that is not a utility. But a model is supposed to be wrong, right? But I digress... My model consists of three scenarios, bear, base and bull. I use a multitude of valuation techniques including the highly contested DCF valuation, as well various multiple approaches such as EV/EBITDA, Price-to-Sales and Price-to-Earnings.
My base-case estimates have both organic revenue growth and earnings growth declining to a compounded annual rate of 10% over the next 10 years, with a perpetual growth rate of 3%. I do not factor in any benefit from financial leverage, which is why both revenue and earnings growth remain the same. (Mind you, I am not trying to model out next quarter's earnings.) I also assume the Sealy acquisition goes through, which adds an incremental $1.15 billion in annual revenue in 2014 and partial recognition in 2013. I am also assuming little growth in revenue derived from Sealy, less than 5% per year. I am not a believer in fairy tales, therefore I do not believe that the acquisition is going to be seamless. Especially since Tempur-Pedic has limited experience in acquisitions. As a result, I expect gross and operating margins to decline over the first two years, with synergies not seen until year-three and beyond.
Based on a DCF valuation and an equity discount rate of 12.5%, total discounted free cash flow of $1.5 billion, and a $4.6 billion terminal value, I estimate an enterprise value of $6.2 billion. Subtract from this approximately $2 billion in total debt after the Sealy acquisition and add cash of $75 million, I get to an equity value of approximately of $4.2 billion or $62/per share.
I recognize the flaws in DCF valuation and sensitivities to the discount rate. Therefore, using an EV/EBITDA multiple of 7x on $480 million in estimated 2014 EBITDA results in a price target of $49. Applying a 15x multiple on 2014 estimated earnings per share of $3.27 results in a price target of $48. Applying a 1.2x multiple on 2014 estimated sales per share of $40.00 results in a fair market value of $48.
My worst-case scenario for Tempur-Pedic would be a 6% increase in organic annual sales over the next 10 years, a botched acquisition of Sealy, which results in a 7% hit to operating margins from 2013-2015 and a permanent 5% impairment in gross margin due to higher costs and lower prices. DCF valuation suggests a fair market price of $21/per share should this scenario occur. Applying a 4x EV/EBITDA multiple on 2014 EBITDA estimate of $373 million results in a target price of $22/per share. Applying a 10x P/E multiple on 2014 estimated earnings of $2.11 results in price target of $21/per share. Applying a 0.5x P/S multiple on 2014 estimated sales per share of $35 results in a fair market price of $18.
The bull-case for Tempur-Pedic has the company firing on all cylinders. This assumes a 14% annual growth rate in revenue and earnings over the next 10 years. DCF valuation suggests a fair market price of $95/per share should this scenario occur. Applying a 8x EV/EBITDA multiple on 2014 EBITDA estimate of $494 million results in a target price of $57/per share. Applying a 18x P/E multiple on 2014 estimated earnings of $3.40 results in price target of $61/per share. Applying a 1.5x P/S multiple on 2014 estimated sales per share of $39 results in a fair market price of $59.
I believe that Tempur-Pedic will overcome its recent missteps and unlock value for shareholders. Investors' expectations are extremely low and therefore it will not take much to spark a big rally in the shares. Insider buying by Hedge Funds Chieftain Capital Management and H Partners is an encouraging sign. I also believe at current price levels investors receive a free call option on Sealy. Not to mention the company should benefit from any improvement in the housing market.
The worst-case scenario prices shares of the company at about $20/per share while the best-case scenario projects the shares are worth almost $70. With shares currently trading at $27 per share, this leaves downside risk capped at approximately 25% with the potential for a 160% return should the bull case materialize. The base case price-target of $50 will still provide investors with a decent 90% return. This is attractive risk/return.
Disclosure: I am long TPX.