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Tempur-Pedic (NYSE:TPX) is a wide-moat business with strong brand equity, pricing power, industry-leading cost structure, high returns on capital, and favorable long-term growth prospects. We believe investors underestimate the variability of the company’s cost structure and the its ability to service its debt in a difficult market environment. The discretionary nature of Tempur-Pedic’s high-ticket products makes the stock an easily conceptualized short. The high short interest could, however, result in explosive stock price upside once the market refocuses on the company’s significant normalized earnings power. We value Tempur-Pedic at $11-18 per share, based on 7x trailing EBIT and 12x estimated normalized EPS.

BUSINESS OVERVIEW

Tempur-Pedic provides premium branded mattresses and pillows in two segments: Domestic consists of two U.S. factories and a distribution subsidiary. International consists of a factory in Denmark and distribution subs.

SELECTED OPERATING DATA

FYE December 31

2005
2006
2007
YTD
9/30/08

% of revenue by geography:

Domestic
64%
66%
66%
63%
International
36%
34%
34%
37%

Revenue growth by geography:

Domestic
25%
16%
17%
-15%
International
18%
8%
18%
2%
Total revenue growth
22%
13%
17%
-10%

EBIT margin by geography:

Domestic
18%
19%
19%
9%
International
32%
29%
29%
23%
Total EBIT margin
23%
22%
22%
15%

Revenue growth by channel:1,2

Retail
31%
19%
21%
-8%
Direct
4%
-17%
-7%
-38%
Healthcare
-2%
-2%
12%
3%

Third party

-1%
12%
3%
2%

Revenue growth by product:3

Mattresses
31%
15%
18%
-11%
Pillows
-9%
0%
12%
-9%
Other
27%
16%
18%
-3%
U.S. door count4
n/a
6,050
6,350
6,800

International door count5

n/a
4,450
4,990
5,100

1Products are sold through four distribution channels in each geographic segment: retail (furniture, specialty, and department stores), direct (direct response and Internet), healthcare (chiropractors, medical retailers, hospitals), and third-party distributors in countries with no owned subsidiaries.

2In 2007, the company derived 83% of revenue from the retail channel, 7% from direct, 5% from healthcare, and 5% from third-party distribution.

3In 2007, the company derived 69% of revenue from mattresses, 13% from pillows, and 18% from other products (foundations, adjustable beds, etc.).

4The company plans to increase door count to 7,000-8,000 "over time"; the total available market is estimated at 10,000 stores.

5The company has identified 7,000 international stores as appropriate targets.

INVESTMENT HIGHLIGHTS

  • $13 billion global mattress market, with 22 million mattress units sold in the U.S., and a similar number of mattresses sold outside the U.S., in 2007.1 In addition, domestic pillow sales were $1.1 billion, with roughly equivalent international sales.
  • Leader in growing specialty mattress category, which comprises non-innerspring mattresses, including foam mattresses, airbeds, and waterbeds.
  • Comfort and health advantages over standard bedding products. The company uses temperature-sensitive material that has a high density and conforms to the body to reduce neck and back pain. The company holds 70 U.S. and foreign patents.
  • Thomas Bryant (60) became CEO in 2006 after five years with Tempur-Pedic. He was previously CEO of Stairmaster. Other senior executives joined the company in the past two to five years.
  • Commencing “most extensive new product launch” in company history, with new and upgraded products slated for launch globally.
  • Stock price implies 30% trailing FCF yield, 5x trailing P/E and 8x forward P/E.

INVESTMENT RISKS & CONCERNS

  • Guiding for revenue and EPS decline of 14-16% and 43-48%, respectively, in 2008, with estimated revenue of $930-950 million and EPS of $0.90-1.00, reflecting “the most challenging… environment in memory.” Management reduced guidance when it reported Q3 results in October. Retail partners have reported store traffic “down sharply” in 2008, average selling prices have trended lower, and trends have weakened in several European markets.
  • Net debt of $431 million at Q3-end. The company has eliminated dividends and is reducing expenses and working capital. The goal is to “operate without risk of breaching our credit facility covenants even if the market continues to deteriorate.”
  • Inflationary cost environment. The company has experienced margin compression due in part to the rising cost of chemicals and proprietary additives.

COMPARABLE PUBLIC COMPANY ANALYSIS

($mn)
MV
EV
EV/Rev
P/TB
08 P/E
09 P/E
438
561
.6x
1.6x
12x
9x
ZZ
212
961
.6x
n/m
5x
5x
23
77
.1x
1.5x
n/m
n/m
503
934
.9x
n/m
7x
8x

WHAT ARE THE SHARES WORTH?

  • We value Tempur-Pedic at $11-18 per share, based on the valuation analysis summarized below.
  • Our estimate is supported by an analysis of free cash flow. FCF per share should exceed EPS by up to $0.25 due to D&A significantly exceeding capex. FCF may be ~$1.15 per share in 2009, implying an FCF yield of 6-11% based on our valuation range.

Tempur-Pedic — Valuation Summary

($ in millions, except per share data)
Low
Value
High
Value
Negative value of net debt:1

Cash and equivalents

$88
$88

Long-term debt

(519)
(519)
Total
($431)
($431)
Value of core business:
LTM EBIT
$176

Fair value multiple of LTM EBIT

7x

Estimated normalized EPS power

$2.00

Fair value multiple of EPS power

12x
Total
$1,234
$1,800
Estimated fair value of TPX
$802
$1,369
per share
$11
$18

1Based on balance sheet values as of September 27, 2008.

2Represents MOI estimate.

Source: Company filings, The Manual of Ideas estimates and analysis.

WHY THE SHARES MAY BE MISPRICED

  • Fundamental underappreciation of company’s superior operating model. Tempur-Pedic is the lowest-cost producer in the mattress industry, with efficient production, low inventory requirements, and low overall capital intensity. This, coupled with strong brand recognition and preference by higher-end consumers, should enable the company to sustain superior returns on capital.
  • Large short interest; sellers may underestimate company’s ability to remain profitable. Tempur-Pedic fits the typical target profile of many short sellers: the company sells big-ticket consumer items dependent on discretionary spending. With pricing squeezed both on the input and output sides, management lowering guidance, and net debt of $431 million, momentum appears to be favoring the short sellers’ thesis. 17 million of 75 million outstanding shares were sold short as of November 11 (stock was until recently on NYSE list of Reg SHO threshold securities). The short sellers’ aggressive stance against Tempur-Pedic has not only depressed the shares, but also opened the door to a massive short squeeze if/when their thesis is proven wrong.
  • Debt covenant worries. Investors may be overly concerned about the potential for Tempur-Pedic to bust debt-related covenants. The company took on debt to recapitalize the balance sheet, spending more than $500 million on share repurchases from 2005-07. Tempur-Pedic reduced debt by $38 million in Q3 and is repatriating cash from overseas. The company must maintain a ratio of funded debt to trailing EBITDA of not more than 3x. The ratio stood at 2.45x at the end of Q3. Trailing EBITDA and funded debt are likely to decline going forward. With debt expected to be cut materially in the near term, the company appears highly likely to stay within the boundary of 3x debt to EBITDA.

Disclaimer: Copyright 2008 by BeyondProxy LLC. BeyondProxy and its affiliates may have positions in and may make purchases or sales of the securities discussed in this report. It is the policy of all Related Persons to allow a full trading day to elapse after the publication of this report before purchases or sales of any securities discussed herein are made. No Related Person held a position in TPX, ZZ or SCSS as of the date of publication of this report. Use of this report and its content is governed by the Terms of Use described in detail at http://www.manualofideas.com/terms.html.

Source: Tempur-Pedic: An Easy But Misguided Short