Tempur-Pedic Will Help Your Portfolio Sleep Better

| About: Tempur Sealy (TPX)

No, I'm not talking about the mattress. I don't know if it will make you sleep any better or any worse. I don't own one. But after Friday's large drop, I do own shares of Tempur-Pedic (NYSE:TPX). The mattress and bedding firm saw its shares plunge more than 20% after its first-quarter earnings report. The stock continued lower on Monday. However, the report wasn't bad at all, and I believe that Friday's drop was a complete overreaction. I'll tell you why I bought the shares, and why long-term investors should use this opportunity to buy shares at a discounted price.

First Quarter Earnings

Tempur-Pedic reported record first-quarter revenue of $384.4 million, which was up 18% over the prior year period. Earnings per share rose from $0.68 in 2011 to $0.86 in 2012, beating analyst expectations by two cents per share. The following table shows key income data for the company's fiscal first quarter over the past four years, with the numbers in the thousands (so 2012 was $384.4 million).

Q1 Results 2009 2010 2011 2012
Revenues $177,104 $253,889 $325,838 $384,393
Gross Margin $81,861 $124,809 $170,310 $205,986
Operating Income $25,881 $52,290 $75,280 $86,065
Net Income $13,338 $33,148 $48,260 $56,218
EPS $0.18 $0.44 $0.68 $0.86

As you can see, the company has made significant progress, more than doubling its revenues over the past three years. Operating income has more than tripled, and net income is up even more. This fact is evident in their margin progress, which I've detailed in the following table.

Q1 Margins 2009 2010 2011 2012
Gross 46.22% 49.16% 52.27% 53.59%
Operating 14.61% 20.60% 23.10% 22.39%
Profit 7.53% 13.06% 14.81% 14.63%

Now, you can see that gross margins continued to increase in this year's period. While revenue was up 18% year over year, cost of goods sold only increased by 14.7%, which resulted in the 122 basis point improvement in gross margins. However, you can see that operating margins decreased a little. That is due to sales and marketing expenses increasing by 29.4% year over year, and general and administrative expenses up by nearly 19.5% year over year. Even with those added expenses, operating margins only decreased by 71 basis points, thanks to the rise in gross margins. The company also recognized a small income tax benefit, which lowered its effective tax rate. That helped to offset some of the expenses, so profit margins only decreased by 18 basis points, much less than the decrease in operating margins. Still, the company is increasing its gross margins, and with a little cost control, operating and profit margins can easily increase. The company is in a good position with these margins. As a comparison, Tempur-Pedic's operating margins are twice those of competitors Select Comfort (NASDAQ:SCSS), which is at about 12.2%, and more than twice that of Sealy (ZZ), which is at 7.3%.

Balance Sheet

Tempur-Pedic has increased the size of its balance sheet in the last year, and has taken out some more long term debt. I've compiled some key balance sheet numbers in the following table (in thousands).

Balance Sheet 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12
Current Assets $301,318 $349,963 $380,458 $379,470 $425,904
Total Assets $746,512 $802,025 $828,636 $828,640 $874,460
Current Liabilities $169,030 $167,763 $186,040 $167,078 $166,594
Total Liabilities $599,330 $678,062 $729,199 $797,849 $774,049
Cash & Equivalents $59,360 $86,739 $103,015 $111,367 $134,016
Long Term Debt $395,000 $475,000 $508,500 $585,000 $565,000

The long-term debt is a revolving credit facility, through and due in June of 2016. I know that some may be concerned with the large increase in debt over the past year, but the company did decrease debt by $20 million in the first quarter. Also, a number of financial ratios improved this quarter, and some of them have improved for consecutive quarters. Just a few are detailed below.

Financial Ratios 3/31/11 6/30/11 9/30/11 12/31/11 3/31/12
Current Ratio 1.78 2.09 2.05 2.27 2.56
Working Capital $132,288 $182,200 $194,418 $212,392 $259,310
Liabilities to Assets 80.28% 84.54% 88.00% 96.28% 88.52%
LT Debt to Assets 52.91% 59.23% 61.37% 70.60% 64.61%
LT Debt to Liabilities 65.91% 70.05% 69.73% 73.32% 72.99%
Cash to LT Debt 15.03% 18.26% 20.26% 19.04% 23.72%

Except for a small drop in the third quarter, the current ratio has continued to increase, and at a nice pace. Working capital has steadily increased, and is nearly double that of a year ago. The company did increase liabilities in 2011. In 2012 so far, the decrease of debt plus some other liabilities has the liabilities to assets ratio down to levels comparable to the third quarter. With that decrease in debt, the long term debt to assets ratio improved nicely. Also, the company has significantly improved the amount of cash on its balance sheet. That should ease some fears over the increased debt.

Growth and Valuation, Compared to Competition

I mentioned above the two main competitors to Tempur-Pedic, Select Comfort and Sealy. I've compiled a table below showing the currently expected revenue and earnings growth for all three companies in fiscal 2012 and 2013. As a side note, Sealy's fiscal year ends in November, while the other two companies use calendar years.

Revs 2012 17.10% 1.50% 24.9%
Revs 2013 14.00% 3.50% 16.70%
EPS 2012 24.84% N/A* 33.64%
EPS 2013 19.14% 150.00% 26.57%

*Sealy expected to swing from a 6 cent loss in fiscal 2011 to 4 cent profit in fiscal 2012.

Now, for the purposes of this argument, Sealy probably can be eliminated, with almost no revenue growth. Select Comfort offers more revenue and earnings growth this year and next, although the gap between the two narrows a bit in 2013. If you are looking for growth, Select Comfort is your stock. However, you have to ask, how much are you paying for that growth. In terms of earnings, you are paying a lot more in my opinion. Here's why.

Valuation TPX ZZ SCSS
P/E (2012) 16.40 52.75 22.49
P/E (2013) 13.77 21.10 17.77

For the extra few points of revenue and earnings growth, you are paying 37% more based on this year's earnings for Select Comfort. I think that's a bit too much of a premium, and that the gap should be a little less. I believe a fair current valuation for Tempur-Pedic is about 18.5 times this year's earnings, and about 16 times 2013 earnings. That gives you an approximate current price in a range of $73 to $76, so I think Tempur-Pedic is undervalued by a fair amount currently.


Now, the guidance is what drove down the stock, and it should not have. Why? Well, the company didn't lower guidance. It maintained it, but the numbers were below the street estimates. To me, this is not a problem. Here's why.

So the company maintained its previous 2012 guidance of $3.80 to $3.95 for earnings and $1.6 to $1.65 billion in revenue. Current street estimates were for $1.66 billion in revenue and $3.97 in earnings. That means both numbers are below expectations. I say so what. Why? Well, let's just look at the two prior years. The following table shows the guidance they gave after the first quarter's earnings report, and the subsequent full year numbers.

Guidance Revenues ($B) Earnings ($) Actual Revs Actual EPS
2010 $1.02 to $1.06 1.70 to 1.85 $1.105B $2.16
2011 $1.31 to $1.36 2.80 to 2.95 $1.418B $3.18

As you can see, the company has consistently beat estimates. In fact, in both years, the earnings guidance they gave after Q1 ended up being extremely conservative. The revenue guidance has been as well. Now, I understand that people were expecting more. However, I don't think that this was a good reason for a 20% plus drop in the stock. It didn't decrease earnings guidance or warn on future quarters, it maintained guidance. In fact, I wouldn't be surprised if when it reports next quarter, it raises guidance. Remember, the company already beat Q1 earnings by two cents a share. If it beats again, which it has the past four quarters, it will raise guidance, and then the stock will soar, perhaps back to pre-drop levels.

Conclusion / Recommendation

The company is doing extremely well. Gross margins increased year over year, and while other margins didn't, it can always cut selling and general costs. Its overall balance sheet improved markedly over last quarter's numbers. It repaid $20 million in debt, which will lower interest costs. Its operating margins are double that of its competitors. The company trades at a steep discount to both of its competitors, one of which has almost no revenue growth right now. Also, its guidance has always been on the conservative side, and it maintained it this quarter. It did not lower guidance.

I hope that I've provided enough information to show you why I bought this name on the drop Friday. As a short-term trader, I may look to sell this week. However, don't take my stock sale as a lack of faith in the company. I do expect a rebound. There are just a ton of other companies reporting this week, so as a trader I may need to move funds elsewhere.

To me, the stock should be worth at least $73 right now, based on my earnings multiple. Even at that price, we would have seen a decline on Friday. Now, I again say that we should not have seen this drop. I think the company will end up raising guidance next quarter, when it reports another record quarter. At that point, I wouldn't be surprised to see us back at $85. Friday's drop took out nearly three months of gains, as you can see by the following chart.

(Source: Yahoo! Finance)

In this market, that unfortunately happens. The question is are drops like these justified, and in this case, I say no. Whether you are a trader or a long-term investor, Tempur-Pedic seems very attractive at these levels. Friday's drop was a complete overreaction, and I took the opportunity to pick up some shares. I think the company is doing great right now, so I expect this stock will rebound in the short term. Friday was ugly, but sometimes ugly can be beautiful if you take advantage of opportunities like these.

Disclosure: I am long TPX at time of writing, but may exit position sometime this week.