- SCSS is down almost 40% over the past six months due to weak results attributable to a weak marketing strategy and lack of product innovation.
- On the company's recent earnings call, the company announced a new marketing campaign and the introduction of a new product cycle, something analysts have been waiting for.
- If these new initiatives work, EPS could double to $2 and the stock could have 70% upside.
- If they do not work, the company's clean balance sheet and free cash flow generation enables management to repurchase shares at a discounted valuation to its peers.
Select Comfort (SCSS) reported quarterly earnings last Wednesday, and the stock has reacted favorably since (up about 10%). Though guidance for the coming year is less optimistic than previously thought, the stock is down 40% over the past 6 months and I think SCSS is setting up for a big run over the coming year. The company is in the process of introducing a new, most-ever tested marketing strategy and rolling out a refresh of its product lines by the end of the quarter (something the industry has been waiting for). If these initiatives work, we could see EPS grow to $2 per share, which would support a price target of $30.
Even if the new marketing strategy and product introductions do not work, the company will still be growing its free cash flow and has the capex levers necessary to increase that free cash flow. Considering the fact the company will have $120MM in cash on the balance sheet by year end and no debt, the company could begin to become a slower-growing company that repurchases a significant amount of its float.
Select Comfort serves the high-end mattress market (price points $999 and up), which a focus on the Sleep Number bed that allows for dual-control on firmness of each side of the mattress. SCSS sells its product directly to the consumer, with 440 locations nationwide.
Source: SCSS Investor Presentation
The company has attributed its weak performance in 2013 to a marketing strategy that did not reach the consumer in the way it was intended to and a lack of product innovation. We will highlight each of these issues later in this article.
Recent Results Support a Turnaround
Last week, the company reported 4th quarter results, which left something to be desired. But when we dig deeper, we see results that are better than first thought; results were strong through Cyber-Monday, but fell off significantly in December, attributable to an 18% decline in overall mall traffic, but January performance returned to pre-Cyber Monday results. This is the opposite of what its competition, Tempur Sealy International (TPX), saw during the same period, which is quite bullish when you consider that TPX increased its marketing spend during the holiday season/January (SCSS did not do this). Because of this, I believe we need to look past December results and attribute it to weak mall traffic due to the compressed holiday season. Another important point to note is that ASPs increased 4% during the quarter.
SCSS also provided guidance for FY 2014:
"The company expects full-year 2014 earnings per diluted share to approximate full-year 2013 adjusted earnings per diluted share of $1.07. This outlook assumes mid- to high-single-digit total revenue growth and the addition of 20 to 30 net new stores during the year.
The company currently anticipates that 2014 capital expenditures will be $70-$80 million, including investments in new, relocated and remodeled stores, as well as information technology."
This is pretty weak guidance, but management noted that performance will improve throughout the year. This fact, combined with January outperformance, signals to me that we have reached the bottom in the business.
Additionally, even with the increased capex, the company expects to generate free cash flow for the full year, and should have a cash balance above $120MM (12.5% of market cap) by the end of the year.
The New Initiatives Should Right the Ship and Support a $30 Price Target
The company laid out two initiatives on the call that should help the company begin to turn the corner: a new marketing initiative and new product introductions.
On the marketing side, the company found that its old marketing campaign was not resonating with the consumer in the way it thought it would, so management recently introduced a new advertising campaign called "No Better Sleep" to support new product innovation and drive brand awareness. This work is the "most tested creative ad ever produced, and testing results suggest that this campaign can break through and increase brand awareness."
Additionally, the company has been testing adjustments to its marketing mix in order to reach customers more effectively, including a nationwide TV campaign, which you have probably seen in recent weeks. To support this new campaign, SCSS recently recruited Kevin Brown as its new Chief Marketing Officer. I will note, the competition will be ramping its marketing spend, as opposed to SCSS, which will keep dollars basically flat. I expect the industry to be very competitive going into 2014, but the new campaign has seen early success, which gives me more confidence going forward.
On the product side, the company is about to roll out some of the most significant advancements to the product portfolio in the company's history. The company will leverage the technology in its x12 bed (such as DualAir technology and technology that comprehensively tracks and monitors your sleep without the need for any wearable devices - it then communicates how you slept via your personal Sleep IQ score, and shows what support and comfort adjustments you can make to your Sleep Number setting and your daily routine to improve your sleep). Other product introductions will include all-new Classic Series beds, with increased comfort and support and prices still starting at $999. The company will also expand the FlexFit adjustable base series with new consumer benefits, such as the Partner Snore feature, as well as a new design, FlexTop, which will be available across the entire product line.
The main point to note - the industry has been waiting for a big product innovation cycle, and commentary by SCSS and TPX seems to be showing that this cycle is upon us. By the end of Q1, both companies will be pushing out new products, which should be a positive for the entire high-end mattress industry. The analysts were very excited about this announcement, and I believe this is the major driver for SCSS over the coming year.
So if these initiatives work out, 2015 could be a year in which the company will have 500 stores and do about $2.5MM in AUV (up from $2.1MM per store and on the way to the company's stated goal of $3MM per store), and low double-digit margins, which comes out to about $2 per share (a double in current earnings guidance). As growth is invigorated, we could put a 15x multiple on these earnings, with a price target of $30 (70% upside).
Bear Case Supports a Price of $12, but Share Repurchases Provide a Floor
The bear case comes down to this: The initiatives don't work as hoped. First, competitors are going to be spending even more money on marketing this year, as opposed to SCSS, which will be using the same dollars. If the new marketing campaign does not resonate as expected, the company may have to not only revamp the program once again, but also spend more dollars which put pressure on margins.
On the product side, it's very much the same story - TPX is coming out with all-new product lines, and the consumer will have to choose which one to buy. On top of that, there has been a shift towards buying lower-priced mattresses, even below any of the price points in which SCSS plays in. I think SCSS is acknowledging this pressure by offering new products with new features on the low-end of its price range. Even if they can keep demand up in units, there could be a mix shift towards the low-end price point, which would contradict SCSS guidance of higher ASPs throughout the year.
When you consider the fact that the company's lowered guidance still projects 40 Bps of gross margin expansion this year, there is still downside to the company's estimates. If you assume that the initiatives do not work as expected and gross margins do not improve, I get a 2014 EPS number of $1.02, which would miss estimates. So if the initiatives don't work, we're looking at a flat-to-slow grower that is making about $1 per share. Under this scenario, I would put a 12x multiple on earnings, or a price target of $12 (30% downside).
This doesn't look good at first glance, but as we noted above, the cash position should improve. With $120MM of cash and no debt (as opposed to TPX that has $1.8B in debt), the company could begin to repurchase its shares. If the company goes into a slow-growth mode, it could normalize capex into the $45MM range, which would drive annual free cash flow of about $50MM. In a slow growth environment, 2015 could be a year in which the company repurchases 10% of its outstanding shares, and then could continue to repurchase 5-10% of its float annually. This could be raised if sales per store increases or if the company gets a boost from increased homes sales (consumers buy furniture usually within 18 months of buying a new home).
So overall, we have 70% upside if it works and 30% downside if it doesn't, but even if it doesn't work, the company will most likely begin to aggressively repurchase its stock.
Let's take a look at SCSS' valuation compared to TPX:
I believe EV/EBITDA is the best way to look at these companies on a like-for-like basis because of the different capital structures these companies have. As you can see, SCSS trades at a deep discount to TPX, even though we have already noted that SCSS has the ability to double earnings power over the next 2 years. Valuing SCSS in line with TPX, and excluding the upside opportunity in performance, we get a price target of $27. My downside scenario includes increased marketing costs and weak sales performance, or EBITDA of $80. If we valued this performance at its current multiple (since it is already well under the TPX multiple), we get a value of $14 per share. These valuations actually come pretty close to the scenarios we described above.
Short Interest Supports Upside
Even with the stock down 40% over the last 6 months and the announcement of these new, exciting initiatives, it looks like investors are betting on an even further downward move. Short interest is currently at 12%. This creates a scenario where all the company needs to do is exactly what it said it is going to do in order for the stock to go higher. A low bar has been set at earnings that could double over the next two years.
The market has been waiting for some time to see new product roll-outs, and that moment has come. When we combine this with early results from the new marketing campaign and the improving outlook in home sales, I believe that there is value in the high-end mattress industry. SCSS is the way to play this trend because of its suppressed valuation, company-specific initiatives, and its clean balance sheet, which should help create a floor on the stock due to the opportunity for share repurchases.