Sleep Country: Growth Catalysts And Attractive Dividend Outweigh Risks

Summary

• Sleep Country is the leading specialty retailer of mattresses and sleep accessories in Canada.
• The company delivered solid top-line growth in Q3-19; however, slow same-store growth is a concern.
• There are several potential catalysts that can aid future growth, and with the company's market leadership position, it can take full advantage.
• Shares are fairly valued; however, the dividend yield is quite attractive with no threat of a dividend cut.
• Investors should consider establishing a long position.

Investment Thesis

Since our last article, Sleep Country (OTCPK:SCCAF) has delivered decent Q3-19 results and has various catalysts at its disposal to continue growing. Having said that, there are some areas of concern such as organic same-store growth and a general slowdown in the industry. The stock price has taken a bit of a plunge and is currently trading at a fair valuation. Given the current valuation and the attractive dividend yield (~4.2%), which we feel is quite safe, investors should consider establishing a long position.

Stock price since last article; Source: Yahoo finance

Company Overview

Founded in 1994 in Vancouver, Canada, the chain has since grown to over 275 stores across Canada. The company’s products consist of top brands geared towards providing a better sleep with the main source of revenue being mattress sales. The other product category sold by the company is sleep accessories including pillows, duvets, sheets, headboards, frames, mattress protectors, pillow protectors.

Sleep Country is Canada’s largest mattress retailer and the only retailer in Canada to offer Sealy, Serta, Simmons, Kingsdown, Tempur-Pedic, Dormeo, Bloom™ and Sunset Collection beds all under one roof. The company has ~31% national mattress market share and reaches customers through its retail stores and e-commerce platforms. The company operates under 3 mattress banners and has 17 distribution centers across all major Canadian provinces. Sleep Country’s stores average approximately 5,000 square feet and are all corporate-owned.

Sleep Country's national footprint; Source: Investor Presentation

In Q2 2017, the company launched its new e-commerce platform and the Bloom™ brand in response to the growing popularity of online mattress sales and new online-only vendors chipping away at market share. This ultimately culminated in the acquisition of Endy which was arguably the most popular online-only mattress brand in Canada. This has also allowed the company to reach more customers in existing markets, as well as introduce the Sleep Country brand to customers outside Canada (although international sales are likely nascent).

Analysis of Q3-19 Results

The company released decent Q3 results that although appear to show a fair bit of top-line growth (14% YoY), a deeper view left investors disappointed leading to a stock price decline. Two main areas of concern emerged, firstly the same-store sales growth was a menial 0.5% YoY leading to questions over whether the company can grow organically. Secondly, net income was ~10% lower YoY, meaning that EPS came in below analyst consensus. On the bright side, the company opened 4 new stores and is on track to close the year with 25-30 new stores as benchmarked at the beginning of the year. This was a key driver of growth along with ramp-up in new stores opened during the first two quarters of the year. Revenue growth was also driven by sales in accessories along with growth within Endy. Both of these are positive signs and can lead to additional growth for the company as we will discuss in our growth vector section below. Online and in-store KPIs released by the company were both positive with higher traffic and average unit sale price; however, lower conversation rates where the impediment to further revenue growth. Going forward, the management indicated that same-store sales growth of 3-6% is a reasonable target as the overall market picks up.

Source: Company disclosures

Growth Vectors

• Accessory sales: Sleep Country has ~7% share of the Canadian accessory market which is sized at ~$1.5B-1.75B. Given the company's leadership position within the mattress product and broad distribution (i.e. physical stores with growing online presence), we expect it to grab a higher share of the Canadian accessory market. Note that gross margins on these products are higher than the mattresses sold by the company and hence we can see a fairly sizable growth in gross margins between Q3-19 and Q3-18.
• New stores: The company has a stated goal of opening 25-30 new stores per year to increase its market presence. To date, the company has exhibited a healthy IRR on new store investments; however, we expect this to deteriorate as the market saturates and there is risk of cannibalization from existing stores. The company believes that the Canadian market can support ~325 stores without a significant amount of cannibalization and has mentioned that payback period on new store investments is ~1 year.
• E-commerce platform: The company has increased its e-commerce presence with the launch of Bloom and the acquisition of Endy, and this platform will likely grow at a higher rate than retail. In Q4 2019, the company will be launching its new cloud based Oracle e-commerce platform. The new website is expected to provide the customers an enhanced omnichannel experience by offering them a larger selection of mattress sets, lifestyle bases and accessories (including pillows, mattress pads, sheets, duvets, headboards, footboards and platforms). This should also allow the company to further expand margins as online sales will usually result in higher margins.

Valuation

We have chosen a collection of peers to compare Sleep Country's valuation to, including furniture retailers, sleep product manufacturers, etc. Based on a straight average, we can see that the company is trading above peer average; however, it is trading well below Tempur Sealy (TPX) which is arguably a better comp in this set. We believe that given Sleep Country's leadership position in the Canadian mattress industry, a slight premium to peers is warranted. Also note that top-line growth and margins are well above average as well, which further justifies a premium valuation. Barring any unforeseen hiccups, if the company can execute on some of the growth levers discussed above, we believe it can close the valuation gap with the likes of Tempur Sealy. This along with a higher EBITDA base should provide decent upside to shareholders. Additionally, following the Coronavirus market rout, the company is now delivering a 4.2% dividend yield, and the recent interest rate cuts should make this quite appealing. It has a payout ratio of ~52% on earnings, and on an LTM basis, cash flow from operations net of capex and dividends shows a positive position of ~$58M. Therefore, we feel that the overall dividend is quite safe.

Source: CapitalIQ

Key Risks

• Execution Risk: With the development of the e-commerce platform along with other digital initiatives, there is always risk for legacy companies like Sleep Country to run into roadblocks especially because they are heavily reliant on outside vendors. This can slow down the company's e-commerce push and weigh on valuation.
• Dependence on key suppliers: Sleep Country is dependent on a few key suppliers (Sealy, Serta, Simmons, etc.) and any impacts on input costs to these suppliers can permeate down to Sleep Country. For example, impacts from tariffs on Chinese imports that may be used in the mattresses.
• Continued threat from online retailers: Although Sleep Country has build up its e-commerce presence with the acquisition of Endy, there still remains strong competition on this platform.
• Store cannibalization: Part of Sleep Country's growth depends on new store openings and there is a risk that the Canadian market may not be able to absorb this growth result in cannibalization of existing store sales.

Conclusion

Sleep Country has a market leadership position within its industry in Canada and with an established store base and digital initiatives underway, the company could be poised for continued growth. Having said that, the company needs to deliver additional same-store growth, part of which will be dependent on a pickup within the market (which could come from lower interest rates). Shares are fairly valued today, and with the safe dividend, we feel there is enough upside for investors to establish a long position.

Analyst’s 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.