Description

Thesis summary

• Largest specialty mattress retailer in Canada levered to a deteriorating Canadian consumer and housing market, with outsized exposure (25% of store base) to the greater Toronto area (GTA), which is facing material declines in both housing transactions and ASPs

• Slowing growth story as comps decelerate from +DD in 2015 and 2016 to +8.8% in 2017 and +5.1% in Q118, despite 2 years of sales-transfer tailwinds from SHLD Canada store closures (and bankruptcy in June 2017)

• Accelerating bed in a box competition eroding both in-store volumes and pricing power of traditional mattresses, and ZZZ’s own Bloom products likely cannibalizing legacy supplier sales

• Muted EPS growth story facing growing margin headwinds as fixed cost base expands (adding 15 new stores in 2018), advertising costs rise in support of shift to e-comm / Bloom, and wage inflation accelerates as 70% of ZZZ’s retail footprint facing min wage hikes of 10% or more in 2018, with further increases slated for 2019

• Valuation elevated at 18x 2018 EPS presents good short risk/reward, with 15-20% downside in base case and closer to 40% downside under a larger housing correction

• Net net, we view ZZZ as a decent business in a very competitive industry facing both cyclical and structural headwinds, trading at full value, with downside optionality on a step down in the GTA housing market

GTA market

• GTA home sales transactions peaked in 2016 and pricing peaked in mid-2017.  Housing transactions didn’t begin to decline until April 2017 and ASP growth was trending positively yoy until January 2018.  Our assumption is that contraction in the GTA market has only just begun and that mattress sales in the region will follow the trend lower.  Charts below show the meteoric rise in ASP in the GTA market in the past 10 years and how recently things have turned over (second chart).

• Record rise in GTA housing prices largely driven by speculative buyers.  Toronto brokerage Realosophy Realty Inc. found 16.5% of low-rise houses in the GTA were purchased by investors during Q117 (peak of the bubble), vs in 2012, investors accounted for only 4.8% of purchases.  Without investor purchases, sales in Q117 would have actually fallen, suggesting that regular buyers stepped back from the market as investors stepped in.  The chart below shows the difference in investor participation btwn 2012 and 2016, and further detail can be found in this article: https://www.macleans.ca/economy/realestateeconomy/how-speculators-inflated-the-toronto-housing-bubble/

• ZZZ has 58 stores within the GTA, which is 72% of their Ontario store count, and 25% of total store count.

Comps, SHLD Canada, and Bed in a Box

• Comps +5.1% in Q118 after tracking up an avg +10% per year since 2015; 2-yr stack and TTM comps average shows a steady deceleration in the business

• We estimate the SHLD Canada store closures provided an incremental comp tailwind of 1.5-2.5% per year since 2015, with the peak contribution in 2017, and a waning effect in 2018 and 2019.  Sell-side analysts routinely ask ZZZ if they’ve “seen” the big inflow from the SHLD Canada bankruptcy yet (which happened in June 2017), when the reality is SHLD has been closing doors to ZZZ’s benefit since 2013.

• Competition of Bed in Box offerings is accelerating, with formerly online-only players like Casper opening retail locations to drive further awareness / traffic (http://business.financialpost.com/news/retail-marketing/bed-in-a-box-maker-casper-to-bring-retail-stores-manufacturing-to-canada)

• Bed in box sales are not only cannibalistic to the existing product offering and store footprint, but also pressure overall top-line growth (with ASPs 24% below company avg) and limit the ability for salespeople to upsell customers and drive attachment rates of accessory products (20% of total sales), which carry a 1000 bps margin premium

Margin headwinds

• In addition to the diminishing gross margin tailwinds from a slowing accessory attach rate, Media / advertising + salaries / wages / benefits combined are 60% of the SG&A cost base, and both are facing significant inflation

• Media /ad spend (36% of SG&A) has outpaced sales growth the last 2 years (+16% / +19% yoy vs sales +15% / 12%) as ZZZ ramped its online offering and began to promote the Bloom product.  Bed in box competition is fierce and maintaining a constant media / online presence is paramount to remain relevant w/ consumers. Q118 media / ad spend was +39% yoy, well-above ZZZ’s guide of +DD growth for the full year, and significantly above the 5.1% comp

• Wages / benefit costs (24% of SG&A) were +17% in 2017, and +7% in Q118; on a per-box basis, wages / benefit costs are +13% yoy in 2017 and +32% in Q118.  70% of ZZZ’s retail locations are in provinces facing min wage hikes in 2018 (Ontario +23%, Alberta +10%, and BC +11%), and while employees are salary + commission based, this rising threshold for base compensation acts as another margin headwind

Valuation

• Peak margins and slowing sales in 2018/2019 with considerable downside risk if GTA demand continues to contract suggest minimal EPS growth the next 2 years, vs street ests at +DD EPS growth thru 2020

• Good risk / reward with 20%+ downside ($26-27 stock) as comps and EPS growth slows and multiple contracts towards 15-16x 2019 EPS

Catalyst

Q2 and 2H EPS misses, Canada housing data, GTA housing data