Description

 

Summary 

 

We believe Tempur-Pedic stock is worth over $22 versus its present price of $13.65.    We arrive at this price target using a 15x P/E of 2006 estimated EPS of $1.50 which we believe is conservative given the company’s historical and projected EPS growth of over 40% per year.

 

At present, TPX the stock is trading at 6.1x 2006E EBITDA, 9.2x 2006E P/E and generates over a 10% free cash flow yield.  Even if TPX only traded at Sealy’s valuation  the stock would trade at over $19.25.  We believe a substantial premium to Sealy (“ZZ”) is justified given that TPX is growing faster, has higher margins, significantly less leverage, and does not suffer the overhang of a large shareholder/former sponsor still looking to get out.

 

We see several important potential catalysts on the horizon for TPX:

 

-         Over 25% of the float is sold short based on a thesis that is, at best, stale.  We believe that the short thesis reflects an understandable, but erroneous view of TPX’s business model.

 

-         We believe management will materially exceed guidance in coming quarters.  The results from Q1 2006 already provide strong evidence that the company’s 2006 growth rate is tracking well ahead of company guidance and consensus estimates.

 

-         TPX has an underleveraged balance sheet and a management comfortable with leverage.  While the company has already repurchased almost 15 million shares since the fourth quarter of 2005, we believe that more aggressive alternatives will be under consideration in the near future.

 

-         Entry into new specialty bedding categories.  The company views itself as a leader in the specialty bedding area, not just visco-elastic mattresses.  Its core competency is marketing, not manufacturing.   The new manufacturing facility in Albuquerque comes on line in Q4 2006, and has adequate capacity to manufacture new products.

 

-         Hotel Partners.  Tempur-Pedic does not currently supply mattresses to hotel partners.  We believe the company is negotiating with hotel companies to become a large supplier.

 

Business

 

Tempur-Pedic is the world’s largest manufacturer and distributor of visco-elastic mattresses, with approximately 80% market share of visco-elastic mattress sales in the U.S.[1], and a 25% market share of specialty mattress sales in the U.S.[2]  TPX uses a unique distribution method which has established huge brand equity verified by our channel checks and the continuing strong operating performance of the company.

 

The mattress is, counter intuitively, both growing and defensive.  The mattress industry posted 6.1% sales CAGR from 1984 to 2004 (2.6% unit volume growth and 3.4% pricing growth) and no down years even during recessions.

 

The premium/specialty bedding segment demonstrates even better fundamentals than the category as a whole -from 2000 to 2004 sales for high-end mattresses at prices above $1,000 grew 19% versus 3% growth for mattresses below $1,000 (Tempur-Pedic mattresses retail for $1,199 to $5,499).[3] 

 

The 2005 Short Thesis

 

The short thesis on TPX originated in the middle of 2005 when TPX stock was trading at over 20x P/E.  The short thesis was/is basically that TPX’s margins and sales growth were/are not sustainable due to competitive entrants in the category. 

 

While we believe that there has been some impact on TPX of these entrants, that impact has already been absorbed and more than reflected in the stock price (TPX declined from over $24 in June 2005 to below $10 in October 2005).  Shorts we have spoken to seem to be taking the lazy approach of making a 2005 trade a 2006 investment based on a misplaced view that implosion of the housing market will hurt TPX. 

 

Competitive Entrants

 

“The Chinese”  -  only 5% of a mattress’s delivered cost is labor.  Transportation is a very large percentage of product costs.  The realty is that Chinese visco products have been available for years and have yet to capture any real market share.

 

“The Three S’s”  (Sealy, Simmons and Serta) entered the visco segment in the second half of 2005, rolling out products at a 20-30% discount to TPX.  The thinking here is that “big guys will crush TPX” but interestingly, TPX is actually the largest player in the industry in terms of EBITDA.

 

Experience To Date

 

TPX’s unit and dollar sales growth over the last five quarters is shown below:

 

			2005					2006
			Q1	Q2	Q3	Q4	2005	Q1
Dom Matt Unit Growth (y-o-y)			51.0%	30.0%	15.0%	14.0%	25.8%	5.9%
Total Sales Growth (y-o-y)			45.2%	27.0%	13.4%	8.7%	22.2%	2.8%

 

While there was some deceleration in sales growth from Q1 2005 to Q1 2006 this is clearly exaggerated by the extraordinarily difficult comparisons faced in the first quarter – up 51% in Q1 2005.  This was due to a price increase on TPX’s Celebrity product line effective 2/1/05.  In anticipation of this price increase, retailers increased their orders of the Celebrity product line prior to 2/1/05.

 

With respect to the second half of 2005 management has attributed the slowdown in 2H 2005 to weakening consumers impacted by oil prices and weak consumer confidence figures shown after last summer’s hurricanes.  The reality is that TPX’s sales were probably impacted to some degree by competitor products.  That said, we will take the double digit unit and revenue growth at a 6x EBITDA/10% free cash flow yield any day.

 

At the end of the day, TPX missed its 2005 guidance of $1.10 to $1.13 and reported actual

earnings came in at $1.07 – a ‘miss’ of 4%.  For this, the stock was taken down from $24 in June 2005, to below $10 in October 2005. 

 

It is interesting to note that these competitive discounts have already begun to ease in 2006 – Sealy is currently only pricing at a $200 discount versus the $300-$400 discounts in 2005. Management confirms that the competitive environment in 2006 is much more rational than 2005.

 

Competitive Entrants Part II – ‘The Margins Aren’t Sustainable’

 

The other component to the “competitive risks thesis” is that TPX margins (which are much higher than its competitors) would be competed away as new entrants pressure the category.

 

We believe that this risk is way overblown for two reasons:

 

-The power of the brand/growth of the category

 

- The TPX retail model

 

Brand Power/Growth of Premium Category

 

TPX enjoys unrivaled brand recognition in the visco category.  Channel checks indicate that consumers come in looking for “the wine glass” mattress or “the Swedish mattress”.   When customers are sold on the visco product they generally want “the real thing”.  We also observed that most retailers seemed to have 4 visco product offerings – three of which were TPX.  We also believe that TPX’s expanded product offerings will result in the addition of another visco slot for them, further diluting competitors share of floor space.   TPX has paid its dues in the form of 100’s hours and millions of dollars in “infomerricials.”  TPX spends almost 20% of revenue in sales and marketing expenses. As its revenue base increases, management has indicated that they will continue to maintain sales & marketing spending as a percentage of revenue.  We believe this will reinforce TPX’s lead in the specialty bedding category.

 

Away from TPX’s position in the premium segment it is important to note that the premium segment itself its growing extremely rapidly.

 

 

 

Retail Model

 

While it is tough to quantify the value of the things such as qualitative views from dealers perhaps the best evidence of the value of the TPX brand comes from the fact that it has been able to sustain fundamentally different retail economics than Sealy, Serta, and Simmons mattresses.  The table below illustrates this.  Assuming the cost of goods for both companies is the same, but Sealy’s selling price for the same product is 20% less, we arrive at 12.5% gross margin for Sealy.  This level of margins is not sustainable, because Sealy will also incur overhead costs. 

 

			TPX
Retail Sale Price			2,000
Cash to TPX			(1,000)
Retailer Gross Profit			1,000
TPX Selling Price			1,000
COGS			(500)
Gross Profit to TPX			500
	Margin		50.0%
			Sealy
Retail Sale Price			1,600
Cash to Sealy			(800)
Retailer "Co-op $" from Sealy			200
Retailer Gross Profit			1,000
Sealy Selling Price			800
COGS			(500)
Co-op $ to Retailer			(200)
Gross Proft to Sealy			100
	Margin		12.5%

 

The advantage that TPX has versus competitors is that it does not provide retailers like Sleepy’s and Mattress Firm with “co-op” advertising dollars.  Shorts have continued to claim that TPX was about to blink and make these payments – causing TPX’s margins to converge with Sealy etc.  This has not happened (and we will believe will not happen as TPX does not use a special event sales driven model).  

 

TPX has its own national advertising campaign while competitors like Sealy allocate advertising dollars to retailers who typically do their own local advertising.  However, it is unclear how much of the co-op dollars are actually spent on advertising to support the brands – a large portion may be retained as additional profits for the retailer. 

 

We spoke with a former CEO of one of the 3 S’s, who told us that these companies cannot compete with Tempur-Pedic on price on a sustained basis because of the math we have described above.  Ultimately, their sales strategy is driven because their visco-elastic products do not have brand recognition like Tempur-Pedic and hence have to rely on retailers to push their products because of lower prices.  However, a retailer is typically indifferent between selling a TPX mattress versus a Sealy mattress because the gross profit dollars are similar or often higher for TPX because of TPX’s high retail prices.  In our channel checks, we found that retailers often like TPX because customers come into stores already well-educated on TPX because of the company’s extensive TV advertising.

 

We believe the company will materially exceed guidance in coming quarters -

 ---Q1 2006 Sales Growth Implies 26% Sales Growth in 2006

 

We have evidence from Q1 2006 that suggests the sales growth weakness in the second half of 2005 has abated, and is likely to improve significantly in the next 3 quarters.  The table below shows adjustments to each quarter’s year-over-year sales growth versus the 22% annual sales growth for 2005.  We observe that in 1H 2005, the company had excess growth versus the annual run-rate, and this reverses in 2H.

 

			2005
			Q1	Q2	Q3	Q4
			Actual	Actual	Actual	Actual
Sales Growth			45.2%	27.0%	13.4%	8.7%
Less: 2005 Full Year Growth			(22.2%)	(22.2%)	(22.2%)	(22.2%)
'Excess' Growth vs. Annual			23.0%	4.8%	(8.8%)	(13.5%)

 

The key question is, if you had to predict what the company’s year-over-year growth should have been in Q1 2006, how would you do it?  Assuming there are no known exceptional events in the quarter (such as the Celebrity Bed price increase in Q1 2005), you would take the company’s 2006 annual sales growth guidance, which is approximately 14% (mid-point of company’s sales guidance), and adjust it for the excess quarterly growth we saw in each quarter in 2005.  So our predicted growth in Q1 2006 would be 14% - 23% = -9%.  In other words, a -9% growth rate in Q1 2006 would correspond with 14% annual growth in 2006. 

 

But instead, the company reported growth of +2.8% in Q1 2006, which is very impressive considering the huge comp from Q1 2005 the company was facing.  If we add the 23% adjustment from Q1 05, it implies an annualized run-rate growth rate of over 25%.  The 25.8% annual growth rate implied by Q1 suggests the reported growth rates for the next 3 quarters are likely to accelerate significantly.

 

			2006
			Q1		Q2		Q3		Q4
			Actual		Projected		Projected		Projected
Reported Sales Growth			2.8%		20.9%		34.6%		39.2%
Add: '05 Excess			23.0%		4.8%		(8.8%)		(13.5%)
Implied FY 2006 Growth			25.8%		25.8%		25.8%		25.8%

 

 

Remember that since Q1 2005, the business has supposedly been subject to ‘significant’ competitive pressures and erosion of market share, so in the span of one year we should intuitively have seen a much worse result than the +2.8% reported. 

 

It is also worth noting that Tempur-Pedic’s growth rate will be positively impacted in the next 3 quarters by the recent (May) launch of two new, high-end mattresses – the Rhapsody Bed at a $3,099 retail price, and the Grand Bed at a $5,499 retail price.  The company has not given specific guidance on the retail penetration of these beds but when we spoke to managers at Mattress Firm (largest retailer of mattresses in the U.S.), we were told they are adding the Rhapsody bed to all stores, and are selectively adding the Grand Bed to stores in high-income neighborhoods.  The table below shows Tempur-Pedic’s historical slots per store, and the average mattress sales prices.

 

		2005				2006
		Q1	Q2	Q3	Q4	Q1
Slots per Store		2.3	2.4	2.8	3.1	3.2
Avg Selling Price		$836	$855	$809	$808	$ 819

 

 

The introduction of these 2 new products will boost not only ‘slots’ allocated to TPX per store, but will also put upward pressure on TPX’s average selling price.  This is an incremental positive as we try to extrapolate from growth rates observed in Q1 2006. 

 

One important question – if our projections are true, why is management providing such conservative projections?  In 2005, the company had its first earnings miss in its history.  Our conversations with management suggest they are deeply embarrassed by the miss, and are now taking extra precautions to avoid any potential misses in the future.

 

The table below shows 2006 sales and EBITDA estimates under management guidance, consensus, and our projections from the above analysis. 

 

			Company
			Guidance		Consensus		Projections
Sales			$940 - $970		$931		$1,052
% Growth y-o-y			12% - 16%		11%		25.8%
EBITDA					226		256
% Margin					24%		24%
EPS			$1.26-$1.31		$1.25		$1.50
Free Cash Flow:
EBITDA					226		256
Interest					(25)		(25)
Taxes					(65)		(75)
Capex					(35)		(35)
Change in NWC					-		-
FCF					101		120
Implied Multiples:
EBITDA					6.9		6.1
P/E					11.0		9.2
FCF Yield					8.6%		10.3%

 

 Valuation/Catalysts

 

The table below compares TPX’s sales growth, EBITDA margins, leverage, and valuation to Sealy.  TPX is growing faster, has higher margins, significantly less leverage, but trades at a lower valuation to Sealy.

 

	Tempur-Pedic			Sealy
	2005	2006		2005	2006
	Actual	Projections		Actual	Consensus
Sales	836.8	1,051.7		1,470.0	1,590.0
% Growth	22.2%	25.7%		11.9%	8.2%
EBITDA	215.9	255.6		233.0	244.6
% Margin	25.8%	24.3%		15.9%	15.4%
Net Debt / EBITDA	1.8	1.5		3.5	3.3
EBITDA Multiple	7.2	6.1		8.5	8.1
FCF Yield	0.3%	10.3%		7.0%	5.4%
TPX Valuation at Sealy Multiples:
2006 EBITDA	19.34
2006 FCF	25.91

 

 

Other Data Points:

 

KKR acquired Sealy for 9.0x EBITDA in 2003, and financed the purchase with 5x debt / EBITDA.  At 9x EBITDA TPX would trade at $22 per share. 

 

TPX’s in only leveraged at 1.8x EBITDA.  If the company were to leverage up to Sealy’s level (3.5x EBITDA) TPX could pay a dividend of $5 per share or buy back over 1/3 of its shares.

 

TPX is investing $15 million in a capital project this year, but maintenance capital spending is only $20 million, meaning the company generates $236 million in EBITDA-CAPX

 

TPX is posting +20% annual revenue gains, and over 40% EPS growth.  In the first half of 2005, the stock had traded at a P/E multiple ranging from 15x to 25x.   At only a 15x P/E multiple on our $1.50 EPS estimate we get a $22.5 stock price (65% upside). 

 

DISCLAIMER: This does not constitute a recommendation to buy or sell this stock. We own shares of the company, and we may buy shares or sell shares at any time.

 

Catalyst

- Excessive short interest
- Earnings ahead of guidance/consensus
- Additional leverage leading to sharebuybacks or dividends
- Annoucement of entry into new specialty bedding category
- Annoucement of mattress supply agreement with major hotel company