Tempur Sealy (TPX) shocked the market by issuing a big profit warning for the current third quarter as solid sales growth abruptly reversed. Shares rightfully sold off as they traded at premium valuation multiples before the warning while the company employs quite some leverage.
While we have seen nice earnings multiple contraction following this move, leverage remains on the high side for me given the cyclical nature of the operations. While the 15 times earnings multiple does not look demanding, sales are flat at best at the moment, as I am simply not that comfortable with the leverage targets which seem quite aggressive. This is even the case as management has the potential to generate solid cash flows given the absence of dividend payments.
A Bedding Giant
Tempur Sealy sells premium beds and related products across the globe, but it is mostly active in the US. Roughly 5/6 of the total sales are generated in a concentrated North American market, with the remainder generated in fragmented overseas markets.
When you think about beds, you think about mattresses as well and sales are quite cyclical. With no fixed "maturity" date of any mattress or bed, sales tend to fluctuate alongside the economy, although over time consumers shift towards premium solutions as they understand the value of a good night of sleep.
The company is best known from its Tempur-Pedic brand, a premium brand which generates half of sales. With the acquisition of Sealy and the launch of COCOON, the company is catering the value segment as well. The company claims to be very flexible to changes in demand. Accordindg to management: 85% of cost of goods are variable and roughly half of SG&A costs are of a variable nature.
Growth, Driven By Sealy Purchase
Tempur made a huge move back in 2012 when it announced the purchase of Sealy. Note that shares of Tempur only traded around the $30 mark at the time, before embarking on a multi year run which would take this tock towards the $80s. While the equity component of that deal was just $230 million, Sealy was saddled with debt, increasing the deal value to $1.3 billion. That was roughly equivalent to annual revenues of little over $1.2 billion.
Note that Tempur was just a $1.4 billion business at the time, as the purchase of Sealy almost doubled the revenue base, although Tempur was much more profitable of course. With the purchase of Sealy, the company grew sales to $2.6 billion on a pro-forma basis and towards +$3 billion by now. The trouble is that margins have been lagging, as we will discuss later.
The good news is that leverage ratios have come down from +5 times EBITDA in 2013 to little over 3 times by now as the company recently made some progress with margins while debt balances have gradually come down. I have to give management credit for another development. Despite the rapid growth, with sales having increased some 3 times since 2006, the company has managed to reduce the outstanding share base by roughly 30% over the past decade.
The Warning, Operational Momentum Slow Down
Tempur issued a sizable profit warning for the third quarter. Sales are falling short of expectations, expected to fall by 1-3% on an annual basis. This stands in sharp contrast to the 5.2% growth rate reported for the second quarter.
The third quarter revenue declines are in part offset by continued initiatives to drive long term margin expansion. The sales headwinds results in a $25 million reduction in the full year EBITDA guidance, now seen at $500-$525 million, while the company projects 20% growth in terms of adjusted earnings per share.
Note that adjusted earnings came in at $3.19 per share for the year of 2015, suggesting that earnings per share come in around $3.80-$3.85 this year. As adjusted earnings per share totaled $1.60 in the first six months of 2016, earnings are seen at $2.25 per share in the second half of the year. While adjusted earnings grew by 48% in the first half of the year, earnings growth is expected to come to a near standstill, given that earnings came in at $2.11 per share in the second half of last year.
The Valuation, Fair But Leveraged
Tempur Sealy ended the second quarter with $138 million in cash and $1.68 billion in debt, for a net debt load of $1.54 billion. With EBITDA still seen at $500-525 million, leverage comes in at 3 times which is equivalent to the target of the company. This targeted leverage ratio is a bit high in my eyes, even if Tempur can adjusted the cost structure in unexpected downturns. Excluding debt extinguishment costs, adjusted earnings pretty closely mimic GAAP earnings, making them useful to use.
That results in a $3.85 earnings per share number, for a 14-15 times earnings multiple with shares trading in the mid-fifties. On the one hand that looks quite appealing, but note that growth has slowed down (is actually falling) while Tempur has a 3 times leveraged balance sheet as well. The good news is that maturities are of a long duration with no dividend commitments being "signed upto" towards equity investors.
What is worrying its the lack of insight of management into the business. When the company released the strong second quarter results on the final days of July shares rose from $60 to $80 in the time frame of just a few days. Just two months later, management has to issue a profit warning, causing shares to give up all their gains, and some more.
What Can Margins Look Like?
When Tempur acquired Sealy back in 2012, the pro-forma adjusted EBITDA number totaled $504 million on a $2.7 billion revenue base. Four years forward in time, revenues have risen by nearly half a billion while EBITDA numbers are flattish, despite the promise for $40 million in cost synergies. That is clearly disappointing and shows that the real benefits are still to be seen.
If we assume 20% margins for the premium Tempur segment and 10% for the remainder of the business, a blended 15% margin should be attainable. If that is the case, operating profits should come in at around $475 million on this revenue base. After adding back $75 million in D&A charges, that results in an EBITDA number of some $550 million.
Interest costs now come in at $100 million, but refinancing and gradual decrease in debt should be able to lower that cost base to $75 million. With a 30-35% tax rate, net earnings could come in at $260-$280 million, equivalent to $4.30-$4.70 per share. If that is more realistic, leverage concerns come down automatically as earnings multiples compress to just 12-13 times.
Not Pulling The Trigger
While a 25% fall in the share price is dramatic, I do not seen automatic opportunities here as the warning is quite severe and shares were priced on relatively high multiples if you factor in debt. While a 15 times earnings multiple looks nice, Tempur operates with quite some leverage, a bit too much to my taste.
While shares trade at a 30% discount in terms of sales multiples compared to the ten year average, that is not fair given that the company acquired the low margin Sealy operations. If we look at EBITDA and earnings multiples, valuations are more or less in line with the past, but they do not point towards undervaluation yet.
While shares are down 20% over the past year and so far this year, I am still not happy to pull the trigger. Shares trade at fair multiples in relation to historical numbers, as I require a margin of safety to account for the high tolerance for leverage which management employs. If shares might re-test levels in the high-forties I might start to accumulate a few shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.