Mattress Firm: 'Roll-Up' Strategy Backfires, As The Risks Do Not Justify The Potential Benefits

| About: Mattress Firm (MFRM)
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Mattress Firm has engaged in a roll-up strategy in recent years, allowing the business to grow rapidly.

High leverage, slower organic growth and recent high-profile roll-up collapses have weighted on the shares.

The shares appear to be fairly valued, and I will watch the future developments closely going forward.

Mattress Firm (MFRM) is a roll-up company which is involved in serial acquisitions in order to expand its mattress empire. Given the increased focus on these kinds of "roll-up" businesses, it is time to carefully examine how the company has operated in recent years.

With the acquisition of Sleepy's, Mattress Firm has taken on a bit too much leverage for my taste. This leverage, a recent slowdown in comparable growth numbers and high-profile collapse of other "roll-up" companies have weighed on the shares. While good execution leaves real potential for shareholders going forward, the valuation is not appealing enough, in my eyes, taking into account the elevated risks.

Rationale Behind The Roll-Up Strategy

Mattress Firm justifies its roll-up strategy, as it believes that the mattress industry remains very much fragmented, while operators can benefit from increased scale. The large and stable replacement demand and favorable dynamics justify the aggressive approach, at least according to company management. With more people understanding the importance of a good night's sleep, the market has gradually shifted towards specialty retailers, which now make up roughly half of the total market.

On a pro forma basis, Mattress Firm operates more than 3,200 stores, which generate over $3 billion in annual sales, thereby commanding a 21% market share in the US market for specialty retailers. Note that this number does not fully take into account the impact of the recent acquisition of Sleepy's. What is clear is the dominance of the company within the category. Its largest competitor, Sleep Number (SCSS), posts sales of merely $1.1 billion per annum.

A Look At The Acquisition Strategy

Slide 11 of Mattress Firm's most recent investor presentation lists 18 acquisitions which the company has made since 2007. While most of these purchases have been relatively small, involving anywhere between 10 and 100 locations, a couple of larger deals have been made as well.

Mattress Giant was acquired in 2007 for $47 million, adding 236 stores to the business. The next 100+ store acquisition was the 2014 purchase of Back to Bed, which added 135 locations to the store base. The same year, Sleep Train was acquired for $425 million, adding another 310 stores to its operations. The acquisition spree peaked (at least for now) when the company acquired Sleepy's last year. The $780 million deal added more than 1,000 stores at once.

All in all, the purchase of 18 companies since 2007 has added nearly 2,200 stores to Mattress Firm. Besides acquiring stores, it has been fairly aggressive in opening new stores as well.

By looking at the cash flow statement from recent years, it appears that Mattress Firm has spend some $1.4 billion in order to acquire all these business. Note that this amount excludes the organic capital expenditures being made to grow the business "organically".

Growth Is Set To Continue

Continued dealmaking spurred a 40%+ increase in revenues for 2015, which have grown to $2.54 billion. The company largely relies on these deals for growth, as organic growth came in at just 2.1% over the past year. Comparable sales growth slowed down to just 0.7% in the fourth quarter of last year, as the quality of this growth has been particularly poor. Prices rose by 5.9% in the past quarter, offset by a nearly 5% drop in volumes. Part of this can be explained by a shift towards premium products, which sell in lower quantities.

GAAP earnings amounted to $64.5 million last year, equivalent to $1.82 per share. The company reported an adjusted profit number of $83.7 million ($2.36 per share) as well. The major differences between both numbers results from a $14.5 million charge related to acquisitions, which are more or less structural given the strategy.

Of course, the numbers will gain see a big jump in the upcoming year, as the purchase of Sleepy's only closed after the fiscal year, in February 2016. Based on projected comparable sales growth of 4-5.5%, and taking into account this purchase, revenues should be able to reach $3.95-4.00 billion this year.

GAAP earnings are only expected to rise from $1.82 to $2.00-2.05 per share. The modest growth results from increased financing costs, the less compelling margin profile of Sleepy's, and the fact that Mattress Firm will be closing some underperforming stores.

Cracks in The Growth Story?

The growth story of Mattress Firm is based on a couple of factors. This includes, first of all, aggressive dealmaking. It should be said that own-store openings and organic growth have contributed to overall growth as well. To reduce leverage following the purchase of Sleepy's, Mattress Firm is reducing the pace of own store openings this year. The company will furthermore focus on execution of the current store base, while it engages in some sale-and-leaseback constructions as well.

All these investments and acquisitions came at an expense. Total debt stood at $689 million as of the end of the fiscal year, while the company held merely $2 million in cash. It is important to recognize that this number excludes the $780 million purchase of Sleepy's. This means the current net debt load comes in at $1.4-1.5 billion at the moment. At the end of the current year, Mattress Firm anticipates that its net debt load will fall towards $1.35 billion.

Based on projected EBITDA of $365-370 million, the leverage ratios are elevated at 3.7 times. This is somewhat high, in my opinion. Historically, mattress sales have fluctuated alongside the economic cycle, as a slowdown in growth can hurt the business. Other concerns include the fact that restructuring of underperforming stores will hurt the results in the near term as well. The biggest concern with regard to the leverage employed is the rosy comparable growth assumptions for the upcoming year. Given the poor growth numbers being reported in the fourth quarter, I see real risks to the anticipated EBITDA number for the upcoming year, and thereby, the targeted leverage ratio.

Worries about the leverage position, the recent slowdown in sales and concerns about some store closures have weighed on the shares. The 35 million outstanding shares have lost quite some value after they peaked at $70 in the spring of 2015, to reach current levels of around $40 per share. This has wiped out roughly a billion in terms of the company's market value.

These shares are now valued at just $1.4 billion, which implies an enterprise valuation of $2.8 billion. This reveals how large the debt portion is in terms of the valuation of the chain.

Binary Outcome In The Future?

With earnings projected to come in around $2.00 per share this year, shares of Mattress Firm now trade at 20 times earnings. This seems a fairly high multiple for a retail business which is somewhat dependent on the economic cycle and consumer confidence, certainly given the debt load.

In a favorable scenario, Mattress Firm manages to improve its margins and stabilize comparable sales growth. If the company can return to margins of 8% on sales of $4 billion, its operating profits could total $320 million going forward. Assuming $75 million in interest costs (5% on $1.5 billion in debt), pre-tax earnings amount to $250 million. After the application of corporate taxes, earnings could come in at $160 million, or roughly $4.50 per share.

If the company can deliver on these goals, it is not unthinkable that the shares will set fresh all-time highs in the future, surpassing the previous highs in the $70s. By integrating the recently acquired businesses and delivering on $40 million in synergies from Sleepy's, this should be attainable, if management delivers.

While leverage works well on the way up, it can be killing if conditions deteriorate, as many platform businesses have experienced. I do not need to remind you of high-profile cases like Valeant (VRX) or even special purpose acquisition vehicles such as Platform Specialty Products (PAH). The high leverage position, ambitious targets with regard to comparable sales growth, and a recent CEO transition are matters of concerns for some. That said, the recent correction in the share price has already priced in quite some of these concerns.

Final Thoughts

Leverage works both ways, and that favors investors who make contrarian bets, given that the situation indeed reverses to "normal". While it is true that shares of Mattress Firm have fallen 40% from last year's highs to current levels at $40, the enterprise valuation has only fallen by 25% (taking into account the impact of debt financing invoked with the purchase of Sleepy's).

While I would normally advocate buying on dips for stable businesses, the trouble is that high leverage can have a self-fulfilling impact if things turn for the worse.

In other words, I would have been much more likely to buy this dip if it were not for the excessive leverage taken on. A forward leverage ratio of 3.7 times is fairly high. This is certainly the case if credit markets deteriorate and economic growth slows down, and the company might see a negative impact of slower growth on its margins. Remember that the projected 3.7 times leverage ratio is one year ahead in time and assumes a roughly 5% increase in comparable sales!

There is still much to lose for investors who buy shares at these levels, as a very adverse event can wipe out their investment. The trouble is that the longest-dated options of the company already mature in October of this year, which I do not consider as a long enough time frame for a bet to work out.

As a result, there are valid arguments to be made for both the upside and downside, as I find the shares largely fairly valued in a wide $30-50 range. For now, I will keep a close eye on the integration process in the coming year, and revise my opinion based on the operational performance and levels of the shares.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.