Sleep Number Makes You Sleep Better - Its Numbers Are Not Sleeping Though

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About: Sleep Number Corporation (SNBR)
by: Dilantha De Silva
Summary

Sleep Number revenues are increasing.

Financial position of the company remains a risk for investors.

The industry is set for a major growth phase driven by technological advancements and increasing health issues.

I see value in Sleep Number at the current market price.

Investment thesis

Sleep Number Corporation (NASDAQ:SNBR) will benefit greatly from the ongoing technological advancements, mainly from the shift toward "smart" equipment. Despite the deteriorated balance sheet position, Sleep Number is paving the way to create an economic moat by developing smart beds and is currently undervalued based on growth prospects.

Overview

Sleep Number Corporation, formerly Select Comfort Corporation, is a designer, manufacturer, marketer and a retailer of a line of Sleep Number beds. The company offers consumers individualized sleep solutions and services, which include a complete line of Sleep Number beds, bases and bedding accessories. Its Sleep Number beds offer SleepIQ technology sensors that work directly with the bed’s DualAir technology to track each individual’s sleep.

Financial statements evaluation

For the six months ended June 30, 2018, Sleep Number revenues increased 4% to $705 million. Net income increased 3% to $24.3 million. Second quarter net sales of $316 million is an increase of 11% in comparison to the corresponding quarter last year. Reported EPS of $0.10 is a substantial improvement from the loss of $0.02 per share Sleep Number reported for the second quarter last year.

One of the key traits that I look for in a small-cap company is its ability to grow revenue on a consistent basis. Even though there could be value in companies that are not generating any revenues at the moment, I stick to the basis of searching for companies that are not only generating revenue but also growing their revenue over time.

Revenue growth of Sleep Number from 2012

(Source – Interactive Brokers)

Revenue has grown constantly since 2012 and is expected to grow in the future for reasons that would be discussed separately in this report.

The company has been spending cash aggressively on advertisements to keep up with the growing competition for market share. This has resulted in an increase in operating expenses, but it is my belief that such spending on advertising is well worth the course as this has resulted in revenue increases.

The bottom line of the company has been primarily in an uptrend as well, which establishes the management’s ability to convert sales into profits.

(Source – Interactive Brokers)

A revenue breakdown by sales channels indicates that a portion of revenue is generated via online and phone sales. This is seen as an important development for the future sustainability of the company since the world is increasingly moving toward an era dominated by online transactions rather than in store sales.

Revenue by sales channels

(Source – Form 10K)

Sales completed via online and phone channels recorded an increase of 19%. This development would be discussed further in the “future outlook” segment along with plans laid out by the company management to tackle the changing consumer spending habits.

The balance sheet position of the company might not be as resounding as its income statement at the moment. Current liabilities have officially surpassed its current assets and this was expected all way along as the company was making capital intensive investments in the form of new store openings. In addition, the relatively low current ratio of the company is partly supported by the board-approved share repurchase program through which $143 million worth of shares were repurchased and retired in the last year, which has resulted in a low cash balance. Growth comes with inherited risks, and in Sleep Number’s case, the inherited risk is the not-so-attractive balance sheet.

Sleep Number has a revolving credit facility of $300 million out of which $114 million was available as of June 30, 2018. A quick look at the balance sheet of the company suggests that the remainder of this revolving credit facility might not be sufficient to offset the liquidity concerns that might arise due to the hefty current liabilities the company is carrying forward.

Current assets vs current liabilities

(Source – Interactive Brokers)

A point to note is that the company has been spending aggressively on their expansion plans, primarily on rolling out the 360 smart bed. Debt incurred in the process of bringing the 360 smart bed to the market accounts for the balance sheet deterioration as well from what would be an acceptable level. On the flip side, transition to the 360 smart bed is now almost complete and this would boost the balance sheet strength of the company imminently, assuming operating cash flows would be possible in the foreseeable future (in the same manner it has been for the last few years).

This brings us to the cash flow statement of Sleep Number. Operating cash flows have increased over the last 6 years, mainly driven by higher net income figures. In line with revenue growth estimations and margin improvements, I believe the company is set to report even higher operating cash flows in the years to come. Generating a sufficient level of cash through operating activities is one of the traits that I look for in a company, especially a small-cap company since this would enable the company to focus on its expansion plans and approach the future aggressively.

Sleep Number has generated positive operating cash flows constantly

(Source – Interactive Brokers)

Moving on down the cash flow statement, it is apparent that Sleep Number has never had a positive net change in cash for the last 6 years due to two resounding reasons.

  1. Capital expenditures.
  2. Share repurchases.

Whilst I am a believer that a company should focus on retiring their common stock only when the company is mature, negative net changes in cash resulting from share repurchases and increasing capital expenditures is not a negative thing in its own right. Moving forward, the company would be able to tackle these issues with the expected growth in sales, reducing capital expenditures and probably by cutting back share repurchases if a requirement arises.

Industry analysis

The future outlook of a company broadly depends on the prospects of the industry it operates in, which is valid for Sleep Number as well. Using a top-down approach, it would be possible to assess how the macro-economic factors of the industry will affect Sleep Number Corporation.

Identifying sleep as a major health concern

In the recent past, medical professionals and health institutions by large have identified and considered sleep as one of the most contributing factors to leading a healthy, long life. A good night’s sleep is increasingly associated with the most read topics of living a healthy life such as fat burning, reducing intake of calories and reducing the risk of heart attacks.

These revelations have boosted the consumer interest in products related to improving sleep and Sleep Number is set to benefit from this renewed interest.

The global mattress market is expected to reach a whopping $43 billion by 2024 according to Zion Market Research, and this represents a CAGR of 6.5% between 2018 and 2024. Sleep Number is well poised to participate in this growth story by offering a one of a kind experience to its customers.

(Image source – Zion)

Improving disposable income

Disposable income in the United States of America; the primary business location of Sleep Number is improving and is expected to rise in the foreseeable future. Tax cuts and a growing economy are expected to boost personal disposable income in the States.

(Source – TradingEconomics)

When disposable income rises, consumers tend to spend more on luxury products as well as on products that would enhance the living standards and lifestyle. Sleep Number would benefit immensely from this development by way of being able to target consumers that could not have been targeted had the disposable income remained lower.

Hotels adopting smart technology

In a time period in which the global community is concerned on being smarter in doing everything from using a phone to driving a car, the hotel industry is having its say by adopting smart technologies such as using chatbots, robots and Artificial Intelligence to serve customers. Competition for market share on the other hand is ever increasing in the global tourism industry since there is a new breed of backpackers and travelers who have redefined the tourism industry.

Under these circumstances, I predict that hotels would soon adopt the smart bed technology as well and this would serve as one of the major catalysts for growth in the respective industry. In fact, First Hotels and ibis have already taken initiatives to embrace smart beds. In my opinion, it would not take too long for hotels to use smart beds as a customer attraction in its own rights.

Other factors that contribute to the growth story of the industry include increasing infrastructure developments, increased use of technologically advanced products and the adoption of smart home concepts by property development companies. All these trends and developments are expected to drive the industry growth and I expect this industry growth will form the base for Sleep Number to grow as a company.

Future outlook of Sleep Number

Sleep Number has laid out plans to let the positivity in the industry and macro-economy to flow through to the company and result in higher revenues and profits. The future outlook of the company is discussed by considering the development of innovative products, market penetration capabilities and marketing plans. Marketing plans play an integral role in shaping the future outlook of the company since the company is offering a niche product that is by no means a must have for a household.

360 smart bed

The unraveling of the 360 smart bed was one of the most anticipated milestones of Sleep Number.

Image result for sleep number 360 smart bed

(Image source – Sleep Number)

Stand out features of the 360 smart bed include:

  1. Automatically adjusting the base of the bed to suit the sleeping position.
  2. Automatically adjusting the firmness of the mattress.
  3. Tracking sleep.
  4. Absorbing excess heat and releasing it when necessary.
  5. Longer lifespan than average mattresses.

(Source – Sleep Number)

What’s more, the smart bed comes with a 25 year limited warranty and a 100-night trial period. All this speaks of one thing – Sleep Number is serious about its business and is trying to change the way people sleep for the better.

Prices start from $5,099 for the 360 smart bed. Whilst the price is on the expensive side, the smart bed should be considered and analyzed as a niche product that is not for everyone. The same way Apple (NASDAQ:AAPL) has created value to its shareholders by developing high end products, the business model of Sleep Number is to manufacture products that would stand out from the rest and serve a niche market.

Comparison of smart beds

(Source – CNET)

There is no better way to rate a product than by observing what its users have to say.

(Source – Sleep Number)

Customers are visibly loving the product and the room for growth is massive considering the limited market penetration.

Partnership with NFL and aggressive ad spending

Sleep Number has struck a deal with the National Football League and this partnership is expected to result in increased popularity of their products. NFL being one of the most watched sports events in America, this partnership will leverage products offered by Sleep Number. On top of this, Sleep Number has unveiled a new advertisement campaign; “this is not a bed,” which focuses on how the 360 smart bed could improve the overall sleeping experience of consumers. This advertisement campaign is already proving a success as cited by the management in the most recent earnings call.

Market penetration through increased number of stores

Sleep Number has been focusing on opening stores aggressively in the recent past and the management expects the trend to continue in the future.

(Source – Form 10K)

This would enable Sleep Number to penetrate into localities that are not yet touched by its competitors and would certainly bring in more revenues for the company. Better yet, the company is experiencing same store sales growth and this provides a health line for the company to move on with its store expansion plans.

(Source – Form 10K)

Risks of investing in Sleep Number

The primary risk of investing in Sleep Number is its short term liquidity concerns. However, the company would be able to partly manage this with the already available revolving credit facility and Sleep Number always has the option of cutting back its share repurchase program for which they have been spending upwards of $100 million.

The business model of the company looks promising but an increase in competition for market share is in the horizon as major home developers would want to get a piece of the smart bed market by introducing their own products. Currently, the market is dominated by a few players including Sleep Number and none are large scale players in the home furnishing industry. A pending entry of a large scale home furnishing company to the smart bed market will deteriorate the profit potential of Sleep Number substantially. The company needs to ward off this risk by building a loyal clientele around its products, which is underway at the moment.

Recommendation

The analysis I conducted indicates that Sleep Number is currently trading at a discount to its intrinsic value at a TTM P/E of 22 times. The main thesis behind the recommendation is the growth potential of the company that would result in line with the presumed growth in the industry. Whilst the book value of the company is meaningless with the denominator being in the negative, the financial position of the company is expected to improve in line with the estimations related to capital expenditures and share repurchases that were discussed earlier.

The share price of the company has shown little response to the increasing profitability and positive future prospects of the company, which creates the opportunity for prudent investors to purchase a stake of the company at a bargain price.

I suggest to play this opportunity by entering Sleep Number at the current price level and holding it on for a time period not less than 1 year.

Chart SNBR data by YCharts

The coming year would be crucial for the company and would probably result in Sleep Number establishing a name in the home furnishings industry. Value of the company will unlock thereafter and investors can avoid the risk of paying a higher price (from a valuation standpoint) for Sleep Number by locking in an investment at the current level.

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.