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[Author's note: I have posted an updated version of this article here. Since publication, I have added important details to strengthen my case.]

Summary

I hold a short position in Mattress Firm because it offers multiple ways to win:

  1. The business of selling mattresses is a time bomb for everyone except IKEA and Nebraska Furniture Mart. Virtually every mattress retailer has been through some form of reorganization or outright bankruptcy. After 25 years of operation, Mattress Firm shows retained LOSSES of $172 million and tangible equity of MINUS $286 million. The company is making matters worse by opening too many stores (like Starbucks) and burning out its best salespeople by not paying them on time.
  2. This may be a fraud. Comparable-store sales figures appear to be overstated and startup costs appear to be understated. When asked for important details, management repeatedly says, “we don’t go into that level of granularity because of competitive reasons.” I think the real reason is that business is not as good as it seems. This company has a history of material weaknesses in its internal control over financial reporting and impairment testing for goodwill.
  3. After the lockup period expires in May 2012, MFRM’s majority owner, J.W. Childs, will begin to sell some of its 64.1% stake. As information asymmetry increases between traders, I expect the stock to drop. J.W. Childs has a clear motivation to beautify the reported financial metrics before exiting. Sell-side analysts are taking all the numbers at face value. Big mistake.

My research has involved interviewing Mattress Firm’s current and former employees and competitors, reading public filings, and listening to the earnings conference call. You can see full transcripts of the interviews at mattressferm.wordpress.com.

Growing An Inherently Bad Business Eventually Leads To Ruin

IKEA and Nebraska Furniture Mart are, in my opinion, the only two furniture retailers with a sound business model. Of course they have high overhead costs given the massive size of their stores, but their sales volume definitely covers this in good times AND bad. See Charlie Munger’s thinking on page 8 of this document (pdf).

The model of opening lots of mattress stores has proved to be a fool’s game. It looks attractive when the economy is good because retailers can use internal cash flow to expand the store count. But when the economy takes a dump and people defer purchasing, the cost structure becomes too much of a burden. When it rains, it pours. Over the past 10 years, several mattress retail chains have filed for bankruptcy protection: Heilig-Meyers, Simmons, 1-800-Mattress, Mattress Discounters, Mattress Gallery, and Foamex International (and not all of them finance their customers’ purchases). Moody’s has assigned a speculative grade rating on Mattress Firm’s debt for several years.

A friend of mine who owns a large mattress manufacturer/retailer had this to say about Mattress Firm:

I think Mattress Firm is a scam for investors. Senior management is using the IPO as an opportunity to draw their $400,000 salaries and leave investors holding the bag. They’re expanding too fast. I think they’ll eventually go broke.

Mattress Firm recently bought 55 stores from Mattress Giant and now has over 700 stores. There are too many stores in one town. They have 6 stores in Des Moines that are either open or opening… Eventually Mattress Firm stores won’t generate enough sales to pay for their overhead because they’ve split themselves so widely that there’s not enough pie to go around to feed them all, let alone all the rest us that are gonna fight them tooth and nail because we don’t want them in there.

There was another mattress retailer called Heilig-Meyers that was run by an accountant. Most accountants are just bean counters–they aren’t experienced businesspeople and they don’t understand the business too well. This accountant was like, ‘Well, if the numbers work like this, let’s just multiply and the outcome will look like this.’ He went up to 787 stores and over a short period of time, several years, the company went from AAA to bankruptcy. There was no reorganization. That’s kind of where I see Mattress Firm doing with the 700 stores now… just too big and the cost structure is too expensive.

Mattress Firm’s prospectus confirms that the company is expanding quickly:

In 2010, we ranked first among the top 100 U.S. furniture stores for both growth in store count and percentage increase in sales and second in total sales among specialty retailers according to Furniture Today. Additionally, based on our analysis of information published in Furniture Today and Company data, we believe we have the largest geographic footprint in the United States among multi-brand mattress specialty retailers.

Aggressive Expansion Leads To Cannibalization Of Stores; How Can Mattress Firm Fake Its Comparable-Store Sales Number?

Besides increasing the risk of eventual ruin, growing the store count may lead to over-saturation. The company warns about this in the prospectus:

Pursuant to our expansion strategy, we intend to aggressively open additional stores in our existing markets, including relocations of existing stores. Because our stores typically draw customers from their local areas, additional stores may draw customers away from nearby existing stores and may cause our comparable-store sales performance and customer counts at those existing stores to decline, which may adversely affect our overall operating results.

I did my own check using the company’s Store Locator. It turns out that there are 69 Mattress Firm stores in the Houston area! There is also saturation in cities in AZ, FL, and GA. With so many stores in and around one city, I think economies of scale have reached a point of diminishing returns. Mattress Firm keeps upping its overhead but the volume doesn’t get any bigger.

I also interviewed Mattress Firm employees and ex-employees and learned that new stores are indeed stealing sales from old ones:

Current Employee W:

We compete with a lot of competitors and we are over populated. They try to compare everything based off what Houston and Dallas does and in smaller markets.”

Ex-employee N:

The idea with the new stores is to gain market share, and pick up incremental sales. They are almost on top of another, so existing stores monthly sales drop, and that drop is what the new store nearby sells on average.

Ex-employee C:

As far as the number of stores you mentioned, they do over-saturate a market wanting one darn near on every corner.

In 2011, bedding specialists increased total sales by only 9%. I really don’t think Mattress Firm’s comparable-store sales number should deviate much from the industry average; and taking into account cannibalization, it should actually be LOWER. So I was shocked when the company reported that comparable-store sales grew by 19% in fiscal Q3! Mattress Firm defines comparable-store sales in the footnotes on page 21 of the prospectus. (It is mentioned 17 times in the 10-Q but never defined.)

New stores are included in the comparable-store sales calculation beginning in the thirteenth full month of operation. Acquired stores are included in the comparable-store sales calculation beginning in the first month following the anniversary date of the acquisition. The comparable-store sales calculation includes sales related to our e-commerce and other comparable sales channels. New stores that are relocated within a two mile radius of a closed store are included in the comparable-store sales calculation beginning with the first full month of operations by measuring the growth in revenue against the prior year sales of the closed store. Stores that are closed, other than relocated stores, are removed from the comparable-store sales calculation in the month of closing.

From this description, I can think of several tricks to artificially boost comparable-store sales:

(1) Close underperforming stores, thereby removing them from the comp base. “Stores that are closed, other than relocated stores, are removed from the comparable-store sales calculation in the month of closing.” This is not ideal, because total sales will go down.

(2) Relocate more stores within a two-mile radius. “New stores that are relocated within a two mile radius of a closed store are included in the comparable-store sales calculation beginning with the first full month of operations by measuring the growth in revenue against the prior year sales of the closed store.” I have learned that Mattress Firm is relocating several stores in one of its major markets:

Ex-employee N:

I know in DFW alone, all but 1 Mattress Pro location was closed in 2010 into 2011, to be replaced with new builds.

Relocating stores near underperforming stores is a gimmick. There’s usually a short-term bounce in sales at the relocated store because of the “newness” factor.

(3) I also learned that Mattress Firm internally reclassifies stores:

MF every year will reclassify stores. They have three types….small, medium, and large. If a store (like I did) go from medium to small in a year, then they compare to a small store, then that is making numbers look funny. The classification is based on volume of sales, and when downgraded, it is because sales have fallen. So I can see a medium store get downgraded to a small store, then compared to a small store, look like sales are up. Numbers game?

Small stores $0-75k /mo
Medium 75k-125k /mo
Large was above 125k /mo

The Medium store I ran was usually around 100k/mo before they moved the location. Then sales dropped. They kept it Medium for a while, but average sales were down to like 50-60k. The month before I was downgraded, we shipped 90k, first time that store had done that much in a year. But with the trend, it was doing small store business. The location sucked, and the area I was in and pulled customers from were the highest foreclosure zip in Collin County for 2009. As a result, the store was downgraded to small. That meant the budgets would not be as high, and the bonus payout dropped.

Since Mattress Firm internally reclassifies stores, they may opportunistically choose to put them in or take them out of the comp base. I suspect that underperforming stores (not just the closed stores) are removed from the comp base to inflate comparable-store sales figures.

I wish it was easy to compare the reported comparable-store sales number with the average revenue per store, but Mattress Firm constantly opens and acquires stores.

Store Startup Costs Appear Understated

One of Stagner’s most remarkable claims is that new Mattress Firm stores have a cash-on-cash payback of less than one year. I asked the owner of a mattress retailer/manufacturer what he thought about this.

They say that it costs $168,000 to open a new store. If they get all their money back in a year, that means each store needs to make a $14,000 profit per month. I don’t know what kind of margin they can generate, but I’m thinking they have to do $500,000 a month here in Des Moines in sales across all stores… that can’t happen. Every time I go past their stores, nobody’s in there.

Their inventory floor samples cost about $15,000. When we open a store, we usually figure $40,000 for inventory. We have 4,800 square foot buildings, similar to MF’s. How they can only put $15,000 in there blows my mind. We have stores that are nothing more than a walk-in catalog store, like in Topeka, St. Joe, Lincoln, Omaha… all their deliveries come out of a distribution center in St. Joe, Missouri. So those stores have enough inventory to show in them. Some of the cheaper stuff is cash and carry. The better beds or king size beds, people aren’t gonna screw with those… they just let you deliver…. those beds will come out of the distribution center. They don’t go through the store. For these walk-in catalog stores, we STILL NEED TO SPEND $35,000 to $40,000 and MF does it for $15,000?!

Stagner said on the conference call that new stores typically have 55 floor models. So Mattress Firm’s cost per floor model is $272. That is a little unusual, given that their average mattress sells for $900 and their COGS is 50% of this.

Ex-employee C told me more about the overhead costs of each new store:

I see no way possible that Mattress Firm can pay back their new store locations in a year’s time. The average rent for real estate sufficient for their floor plan is on average between $12,000 to $20,000 depending on location and age of the building. Some leases are older and based on 10% of business and some even older locations are less than $9,000 per month. The start-up cost per store I would estimate based on what I have seen is between $125,000 and $200,000 in floor models, rents, carpet, top of bed, utility deposits, etc.

Before market saturation, there were some stores that would sell between $200,000 and $300,000 per month, but that usually only occurred in two or three stores per market and ONLY in their big markets (Houston, Austin, Phoenix). This was also pre-recession. The average store revenue was about $70,000 with some maintaining over $100,000 per month, but some doing as little as $28,000 per month.

Let’s assume that the average store maintains $70,000 in sales, your budgets are set too high for a manager to receive their budget bonus, and you have a store associate on draw (approx. $2,300 per month). Your rent will average say $13,000 per month, electricity $2,000 per month, insurance, phone/fax/internet guesstimated at $250 per month, cost of product reduced from $70,000 if you run a 50% margin is $35,000, taxes and misc (not even including advertising costs) you can do your math and see that some will exceed this, some will fall short. The whole will support the part and even out to some profitability, but in the long scope of things you are not seeing yourself close your doors, but not raking in buckets of cash either.

A very old location that averages $70k in sales with a lease amount of 7k can certainly be considered a profitable location, but a new store with an average of 100k per month and rents of 18k per month after expenses will not stand on its own. Stores over 100k per month have at least 2 employees per store so you have to double your manpower expenses. Corporate monies will have to supplement.

Employee Turnover Is High; Employees Are Not Getting Paid On Time

Ex-employee C:

My personal opinion is that if Steve Stagner is talking, he’s probably lying. I know people who still work for Mattress Firm in the Dallas market and with their cut in pay to employees they have such a huge turnover rate they are losing sales due to inexperienced sales staff. Sure they are going to do business because in this business the average person will buy within the first 3 stops they make and they like to position themselves around the other two major players in Dallas-Sleep Experts and Mattress Giant. Even more comical is that they chase the tail of Sleep Experts…..a local chain whom they mock, yet all of their major marketing tactics come from from i.e. 1 year Happiness Guarantee.

Current employee W:

I am currently with MF.. We are still waiting to be paid our overtime for this year for any month (starting in June) that we didnt break draw. We had a meeting stating clock in..get OT pay back in June..July goes by..August..no memos..My DM says she didnt know..I call HR..get some bs answer..In Dec we started a new timekeeping sight and have been told By our payroll person we would recieve the OT (if its owed to us) by years end…very reluctantly I might add..If you asked any old timers they dont believe we will see the pay..absolutely no trust in the company we work for and they wonder why there is over a 40% turnover rate at the sales position.”

Ex-employee N:

Two employees named T and D were set to manage the State Fair event MF has in Dallas each year, and that they would be paid an extra sum for the hours, as they would have worked non-stop for 4 weeks. After the fair ended, MF never paid what was promised. D left the company, told people, and MF came at him threatening to sue for slander, but he allegedly told them to prove they paid him, and it was left alone (obviously, if this were true, MF would have had a counter-suit for any funds promised).

Macro Factors

Mattress Firm’s prospectus contains one of the most absurd things I have ever read:

As ‘baby boomers’ (which refers in this prospectus to people born between 1946 to 1964) age and BEGIN TO SPEND THE INCOME THAT THEY HAVE SAVED DURING THEIR TIME IN THE WORKFORCE (emphasis added), it is our belief that they will spend a disproportionate amount compared to the overall population on products that improve their comfort—for example, premium mattresses and related products.

The median baby boomer has negative home equity and a net worth of just $94,000! (Source: here, pdf) So they will have to sell their house and downsize. Then, all of their living expenses will have to fit within a Social Security budget that will be perpetually shrinking in purchasing power. I don’t think baby boomers have enough money to splurge on expensive mattresses.

Accounting Problems

We identified errors that existed with respect to the timing and amount of goodwill impairment recognized in certain prior periods. Under the requirements of U.S. GAAP applicable to our historical financial reporting periods, goodwill impairment is tested at least annually for each “reporting unit.” A reporting unit is defined as an operating segment or one level below an operating segment (a “component”), if the component is a business and operating results for the component are regularly reviewed by segment management. Furthermore, components may be aggregated in determining a reporting unit if they have similar economic characteristics. We have determined that each Company-operated metropolitan market is an operating segment. Our historical accounting policy defined a reporting unit for purposes of goodwill impairment testing as the aggregate of all of our operating segments (i.e., Company-operated metropolitan markets), resulting in a single reporting unit. Upon further review, we have determined that each Company-operated store is a component and that stores in a metropolitan market may be aggregated in determining a reporting unit, as the stores have similar economic characteristics. We evaluated reporting units annually; however, we applied the guidance incorrectly in light of the facts and circumstances of our business. As a result, we have concluded that goodwill impairment should be evaluated for each Company-operated metropolitan market. We have tested goodwill impairment for historical periods based upon the revised definition of reporting units and have determined that errors existed in the previously recorded amounts of goodwill impairment charges. We have restated our consolidated financial statements to correct these errors, which has resulted in goodwill impairment charges, as restated, in the amounts of $43.6 million, $100.3 million, zero and $0.5 million for fiscal 2007, fiscal 2008, fiscal 2009 and fiscal 2010, respectively, as compared with previously reported goodwill impairment charges of zero, $138.1 million, zero and zero for fiscal 2007, fiscal 2008, fiscal 2009 and fiscal 2010, respectively.

Management considers the failure to identify the errors discussed above in a timely manner material weaknesses in our internal control over financial reporting under the standards established by the United States Public Company Accounting Oversight Board, or the “PCAOB Standards.” Under the PCAOB standards, a material weakness is defined as a deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis. We are in the process of remediating these material weaknesses by implementing more effective management review practices on interim financial reporting and reviewing complex technical accounting policies periodically.

J.W. Child’s Exit

Mattress Firm has passed through several different owners since its founding in 1986. In 2002, it operated under Sealy, which in turn operated under Bain Capital. Bain decided to get rid of the underperforming Mattress Firm unit before taking Sealy public, so they sold it to Sun Capital Partners in an LBO. Under Sun, Mattress Firm acquired 98 stores and opened 85 more, growing EBITDA by 22 times.

In January 2007, Sun sold Mattress Firm to the current owner, J.W. Childs, for $450 million. As the housing/credit boom went bust over the next two years, Mattress Firm suffered operating losses of $100 million and net losses of $165 million. This has been a bad investment for J.W. Childs, but they have managed to extract about $400,000 per year in consulting fees.

J.W. Childs owns 64.1% of the MFRM shares outstanding through its investment in Mattress Holdings, LLC. Upon the lock-up expiration in May 2012, the LLC will be dissolved and J.W. Childs will begin to sell some of its stake. According to the prospectus, Mattress Firm expects J.W. Childs to hold at least 50% of the outstanding shares following the lock-up expiration. Over time I expect J.W. Childs to file for more secondary offerings.

27.27 million shares are eligible for sale after the lockup period expires. Current float is 5.55 million shares. 32.98 million shares are outstanding.

Expect Another Secondary Offering If This Company Really Wants To Grow

CNBC reporter:

Let’s talk about proceeds of the IPO. You raised over $100 million, but about $85 million of that is going to go to your previous private equity majority owner and to pay back debt. Not leaving you with a lot of extra capital for your expansion plans. Can we expect a follow-on offering any time soon?

The response:

Well, the great thing about our model is that over the past five years we have doubled the size of the company and we can do it… uh… we’ve done it with internal cash flow and we’re certainly able to do it in the future with internal cash flow because of the fast payback from our new stores. The proceeds from the offering will be used primarily just to clean up our balance sheet… to make us a little healthier… and to get us in a position so that if we approach future opportunities we will be well prepared to do that.

Disclosure: Author holds a short position in MFRM.

Source: Mattress Firm Should Provide More Details To Investors