Wall Street Loves Lovesac But Customer Love Appears To Be Waning

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About: The Lovesac Company (LOVE)
by: Lord Baltimore
Summary

Lovesac’s share price has performed extremely well since coming public at $16 per share in June 2018, appreciating 89% to $30.30 as of March 5, 2019.

Same-store sales have been eye-popping coming in at 33% through the first three quarters of fiscal 2019 fueled by an aggressive marketing campaign financed in part with the IPO proceeds.

However, recent customer reviews have been trending negatively suggesting same-store sales trends could slow and that the company may not be managing its rapid growth particularly well.

Lovesac has yet to turn an annual profit, although it is expected to in the seasonally strong fourth quarter when it reports. In terms of full year results, I estimate that the company is unlikely to be profitable in at least the next two years.

The company trades at an enterprise value to revenue multiple of 2.3x.   I believe a multiple of 1.0x to 1.2x revenue seems more appropriate for this furniture merchant which would imply a share price of $15 to $17 per share.

The Lovesac, a provocatively-named, eight-foot wide, Durafoam-filled bean bag chair, was invented in 1995 by then 18-year old Shawn Nelson in his parents’ basement. Mr. Nelson founded The Lovesac Company (LOVE) in 1998 to make and market Lovesacs as a business. The Lovesac’s irreverent name, outlandish size and styles and the company’s effective guerilla marketing made it a cult favorite among teens, Silicon Valley entrepreneurs and celebrities. While I am in neither of those three camps, I bought a Lovesac in 2005, and my family continues to enjoy it to this day. (That is not me pictured below.)

Supersac in Elk Phur

Supersac in Elk Phur

Source: Lovesac.com

In 2006 the company broadened its product line to include Sactionals which are sectional couches designed to be reconfigured to suit a customer’s changing environs and lifestyle. The average first time purchase cost of a Sactional was $3,789 in fiscal 2018 according to the company’s IPO prospectus, so it is a premium priced couch system. The company’s product philosophy is “Designed for Life.” Mr. Nelson continues to run the company as CEO.

Sactional Under Construction

Sactional Image

Source: The Lovesac Company S-1 filing

The company sources its Lovesacs (or just “Sacs”) from a manufacturer in Texas and its Sactionals from China according to the IPO prospectus. (Its outdoor Sactionals are made in Vietnam.) It markets its products through 77 Lovesac-branded show rooms, primarily in high-end malls, and online. Show rooms represented 67% of sales in Q3 2018 and online sales represented 19%. The remainder of sales were generated from temporary shop-in-shop stores primarily in Costco, which has been a source of high growth, albeit at lower than average margins.

A Lovesac Showroom

Showroom

Source: The Lovesac Company S-1 filing

Since the company went public it has reported two quarters of exceptional same-store sales growth of 34% and 41%, respectively, and overall revenue growth of 60% and 71%, respectively, driven largely by increased marketing spending from proceeds raised in its IPO and a recapitalization in 2017. In 2018 year-to-date the company generated an EBITDA loss of $12.5 million and an adjusted net EPS loss of $0.83. Wall Street analysts forecast a fourth quarter EPS profit of $0.47 and a full year loss of $0.41 for fiscal 2019 (ending February 3, 2019) and an EPS loss of $0.34 in fiscal 2020. The company has yet to announce when it will report its fourth quarter earnings.

If there was ever a contest for the world’s most lovable company one might think Lovesac would be an excellent candidate. What’s not to love? Well, from an investment standpoint I have found a few things, not the least of which is a worrying trend in customer product reviews.

Customers Showing a Little Less Love

On the face, Lovesac’s product reviews appear very positive. According to its website its Sactionals (76% of its revenues) have an average 4.7-star out of 5.0-star customer review rating over 1,212 lifetime reviews (as of March 4, 2019). Its Sacs are rated even higher at 4.9-stars across 1,095 reviews. However, recent ratings have deteriorated significantly, especially from Sactional buyers. The past 50 ratings of the company’s Sactional products, which covered the past two years, dropped to 3.1 stars and 28% were just 1-star (the lowest possible rating) compared to just 3% 1-star ratings on a lifetime basis.

The Last 50 Sactional Customer Rating Average is 34% Below the Lifetime Average

Ratings

Source: Lovesac.com as of March 4, 2019, Lord Baltimore charts

Even Sacs customer ratings deteriorated somewhat from an impressive 4.9-star lifetime average to 4.2-star average over the past 50 reviews.

A common complaint among recent customers is the quality of certain coverings, lack of communications regarding the deep seat configuration and the discontinuance of certain styles and fabrics which seems to fly in the face of the company’s “Designed for Life” philosophy. Here are a few excerpts from recent reviews from the company’s website:

Would not buy for long term use!! – 1-star review

“The couch is very comfortable and versatile, but the covers do not last. As soon as the warranty expired the cushions began peeling and are now falling apart. I can not recommend this product for long term use.”

Don't align with the existing system – 2-star review

“Bout [sic] 5 bases and 6 sides in 2006. Decided to purchase 3 more sides and a base because of the big sale. Bases don't align with the existing system and neither do the connecting clamps. I'm not looking forward to dealing with customer service! Might have to send everything back ☹️

discontinuing 5 series – 3-star review

“We bought the 5-series based on space. We had a hard time fitting the pegs in to wood bases and after a while we finally go it worked out. The customer service made everything right. Sent us replacement parts. Now a year and a half later I just happened to find out they are discontinuing the whole 5 series. I was told I could always buy add on pieces. Now I can't and I'm so disappointed. I just wanted an ottoman. Also over time the back cushions don't have any back support. I always have to line up extra throw pillows but that doesn't last for long either. A very expensive couch with little support. I guess we will be looking for something else.”

In the past 50 reviews, 30% of Lovesac’s Sactional customers did give the product a 5-star rating but that is down from 79% 5-star ratings lifetime.

Great for a house with Dogs – 5-star review

“I love this couch. While It was a bit more than I wanted to spend, it is so so comfortable. We have already expanded it since purchasing to add an extra couple seats and sides. My favorite feature is the machine washable covers. We have three dogs in our house and I really wanted a light colored fabric couch. Leather scratches and is just not very comfortable. It is amazing being able to throw the covers in the wash. They clean up beautifully.”

So easy and versatile – 5-star review

“I got my couch about a month ago and it is the best couch ever. I love that we can change it up and every single cover comes off. My dog has puked on it so I just popped the covers off and threw them in the wash. Good as new! We also had a problem with one of the seat covers so I emailed customer service and we got a new one right away. We will definitely be adding more pieces in the near future. I would recommend this to everyone!”

And oddly even some of the company’s recent 4- and 5-star ratings included surprising criticisms in the comments section (which beg the question: why were they rated so high?):

Genius product, comfortable couch with deep setting – 4 star review

We just received our 8 seats 9 sides padded velvet Taupe this weekend. Its a lot of pieces so took the better part of the afternoon for my husband and I to put together. He wishes we would have paid extra to have it assembled. Once together, its beautiful but we want the seats to be deeper. Wish the sales person would have talked more about the option to have the seats set up 35" deep instead of 30".”

Great product with a couple cons – 4-star review

“I love my couch but I wish I would have upgraded my fill to the lovesoft- The standard is fine but takes forever to break in especially if you have a favorite seat in the living room and have to keep swapping out cushions to even the couch out. I guess there is not [sic] going back now. Other things I noticed and wasn't super happy about where the quality of the feet. For such a pricey couch I would think they would use solid instead of compressed wood. I know you will never see them but I thought it was worth mentioning. I chose the padded velvet fabric and love it. It's durable, pet-friendly and cleans very easily....but I noticed some of the stitching becoming loose on some parts of the seams. I cut off the loose and am hoping that the seams do not come apart. So far they haven't.”

My hypothesis is that these ratings coincide with the company’s recent decision to grow rapidly following a ten-year period of retrenchment and stasis after its bankruptcy filing in 2006. I suspect the company may not be managing this rapid growth as well as it should, and this is showing up in deteriorating customer reviews. While the company’s same-store sales have performed incredibly well despite these customer reviews (although some of the most damning have occurred recently), I suspect this may catch up with them and same-store sales growth could slow abruptly when it does.

Déjà vu All Over Again?

In its marketing materials to both customers and investors Lovesac positions itself like a “start-up” that is a “tech enabled disrupter” disrupting the $100+ billion furniture market and catering to Millennials. However, the company is not a start-up at 21 years of age, and its “disruptive” Sactional product has been around for 13 years and has barely made a dent in the overall market. Lovesac filed its IPO prospectus under the JOBS Act which allows a small company to go public without the requisite disclosures of a larger company. Thus, there is limited historical financial disclosure and no mention of the company’s bankruptcy in 2006. Based on articles from that time, it appears Lovesac went bankrupt because it grew too fast and couldn’t pay its suppliers, landlords and other creditors. When it filed for bankruptcy it had 78 retail stores and ultimately shuttered 58, leaving 20 when it emerged from Chapter 11 in late 2006. Coincidentally, the company has grown back to 77 stores as of Q3 2018. With the $59 million in cash proceeds from its IPO and no debt, the company is much better capitalized than it presumably was in 2006, so I am not suggesting it is likely to go bankrupt again, but I believe it could experience growing pains like it did in the mid-2000s if it doesn’t keep its customer base happy.

Financial Performance and Valuation

Chart Data by YCharts

Because the company has only reported two quarters of financial results since going public and because its IPO prospectus provided only a limited glimpse at its historical financial performance, there is not as much financial history available to evaluate the company’s performance through time and seasonally. For instance, when analyzing a furniture retailer, it is important to understand how inventory needs build and subside seasonally. Because the company only provided a balance sheet for its fiscal years ended January 29, 2017 and February 4, 2018 and the subsequent quarters in fiscal 2019, we cannot look to prior years by quarter to understand what the company’s seasonal working capital needs are and whether it is managing inventory better or worse than in year’s past. We do know the company burned $23 million in cash in the first three quarters of fiscal 2019 (year ended February 3, 2019) including operating losses, working capital needs and new store builds and other capital expenditures. Inventory per show room increased 81% from $176,000 to $320,000 from fiscal Q4 2018 to fiscal Q3 2019, but that may not be a fair comparison given Lovesac’s likely seasonality. While difficult to analyze given there has been no disclosure of the company’s fourth quarter of fiscal 2018 cash from operations, from the latest 10-Q we can back into it and see that it was a seasonally strong quarter in which cash flow from operations was positive last year and presumably should be again this year.

Sales growth has been truly impressive at 62% in fiscal 2019 to date and 33% on a same-store basis. Online sales, which make up 19% of total sales grew 74% in response to more aggressive direct-to-consumer marketing. (I see the company is using Criteo for an aggressive retargeting campaign, at least based on my web experience.) Sales per square foot were high at $1,262 in the last fiscal year. Gross margins have also been attractive at 56.2% in fiscal 2018 and 54.4% through the first three quarters of fiscal 2019. This compares to Williams-Sonoma and RH gross margins of 36.5% and 34.8%, respectively. Despite strong growth and an attractive margin profile, Lovesac is still not profitable after 21 years in business. This is primarily a function of its small scale (some might say niche) and, more recently, heavier marketing spending.

Snapshot Source: Company filings and press releases

I believe Lovesac is a bull market story predicated on extrapolating recent rapid revenue growth trends to justify the company’s premium valuation relative to its current size. Investors seem focused entirely on revenue growth and are willing to ignore losses as the company “invests” in growth much like a Silicon Valley start-up (which it is not). Wall Street analysts all have “BUY” or “STRONG BUY” ratings on the stock. The company’s enterprise value based on a recent share price of $30.30 (as of March 5) and third quarter financials is $365 million. Its market capitalization is $410 million. Thus, it trades at 2.3x fiscal 2019 consensus revenue and 1.7x fiscal 2020 consensus revenue, premiums to comparables Williams-Sonoma, RH and even Wayfair.

Comparables Source: Yahoo! Finance, Marketscreener.com, Company reports

Because the company has neither earned an EBITDA profit nor an EPS profit, it is difficult to value using EV/EBITDA and P/E multiples. Book value was $5.19 per share as of November 4, 2018. If sales falter relative to elevated investor expectations I believe the shares could trade back down to 1.0x to 1.2x revenue or approximately $15 to $17 per share. My fund is short some shares, although it is not the fund’s biggest short position. The shares are easily borrowed. There were only 1.0 million shares short as of February 15th representing 7% of shares outstanding and 16% of the estimated share float.

Risks to My Short Thesis

  • Same-store sales – Shorting a retailer that is generating 30% to 40% same-store sales growth would appear to be “suicidal,” so caution is advised. Timing is important and this might take some intestinal fortitude as a short. My hypothesis is that based on increasingly frustrated customers, elevated investor expectations and tougher comparisons this year same-store sales could decelerate enough in calendar 2019 to lead to investor disappointment in the next 12 months. If I am wrong, then the stock may continue to enjoy momentum in share price regardless of the company’s premium valuation.
  • Impressive looking board – Following its bankruptcy in 2006 the company attracted private equity to recapitalize the company. They in turn installed an impressive looking board of directors with MBA degrees from Harvard, Wharton, etc. and extensive retail investment experience. Private equity/venture firms, SAC Acquisition LLC, Mistral and Satori control the company with a combined 56% of the shares (following a secondary offering in October 2018). Founder and CEO, Shawn Nelson, owned 0.5% of the shares as of the company’s secondary offering prospectus. The pedigree and control of this board suggest it will not tolerate the excesses that caused the company to go bankrupt in the mid-2000s.
  • Cash and no debt – In its IPO in June 2018 the company raised $59 million enabling it to pay off its debt, convert its preferred to common and have a cash balance remaining of $45 million as of November 4, 2018. Thus, it has sufficient cash to grow its business for a while and/or withstand a recession should one occur in the coming year or two. I do not view Lovesac as a terminal short at this point.
  • Product sourcing concerns assuaged? In late 2018 Lovesac’s share price swooned 38% from a high of $27 to a low of $17 in part in sympathy with the overall stock market swoon, but also I believe due to concerns about tariffs given the company sources its Sactionals from China. Recent press indicates that China and the Trump Administration may be nearing an agreement to roll back recent tariffs and threatened trade sanctions which likely has assuaged investor concerns over this potential sourcing issue.
  • “Lovability” – I want to love this company, but can’t love the stock at this price and worry the company’s lovable product image may be at risk if its customer experience is deteriorating. However, like its customers who complain but still give Lovesac a 5-star rating, investors may be willing to overlook its growing pains and emerging company financial status and focus on its rapid expansion, fun image and hip irreverence instead.

As always, I encourage readers to share their thoughts. Please do your own research and think for yourself before investing!

Disclosure: I am/we are short LOVE. 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.