Description

Tempur-Pedic common stock is poised for a significant short squeeze that could drive the stock up 50% in the next few months. Catalysts and facts to consider:

1) Short-sellers have no room for error: 32 million of 75 million outstanding shares are sold short. Management and board members (including TA and Friedman Fleischer) currently own approximately 12 million shares. Other core/stable holders of the stock include Invesco (14m), Ziff Asset Management (6m), and Kayne Anderson (5m). This implies that the “effective” float of TPX is only 38 million shares. The 32 million shares sold short are 84% of the “effective” float of 38 million shares.

2) Short-sellers are underestimating the variability of TPX’s cost structure: TPX is a branded manufacturing business with a highly variable cost structure. Approximately 85% of COGS are variable and 67% of SG&A costs are variable. In Q1 2008, the company budgeted expenses assuming 10% sales growth. Instead, sales fell 7%. The excess expenses caused Net Income to be cut in half versus Q1 2007. Having observed a change in sales patterns in the middle of Q1, management is aggressively right-sizing COGS and SG&A expenses. This will dramatically improve profitability starting in Q2. For example, we estimate media spend in Q1 2008 was 12% of sales. In a typical year TPX spends 9% - 10% of sales on media expenses. We believe management will bring overall media spend levels down to 9% of the new, lower sales estimate in 2008. This implies media expense will run at ~8% of sales starting in Q2. This item alone can improve operating margins by 4% versus Q1 2008. We estimate that SG&A as a percentage of sales should improve from 32% in Q1 to 28% in Q2 and then 27% in Q3 and Q4. Gross margins in Q1 2008 declined significantly to 43.7% versus 48.3% in 2007, a decline of 4.6%. We estimate that 2% of the 4.6% margin contraction came from a 12% increase in chemical costs (56.3% COGS * 30% chemicals * 12% increase). Approximately 2.6% of the 4.6% gross margin contraction in Q1 was due the fact that management ran its plant, distribution, inventories etc. assuming 10% sales growth instead of a sales decline. The company should recover 2.6% gross margin points as management right-sizes the business. Assuming only the media spend can be cut by 4% of sales and gross margins can recover by 2.6% implies 6.6% of operating margin improvement from Q2 onwards.

3) Highly profitable at significantly lower sales levels: Our recent channel checks, which include a private domestic branded mattress company, indicate that the mattress sector is stable in Q2 2008 versus Q1 2008. Despite this, our 2008 projections conservatively assume that domestic sales degrade further through the rest of 2008, declining 20% y-o-y versus 15.7% in Q1. We assume International sales trends also get worse, dropping from a 3% constant currency decline in Q1 to 10% in Q2 and 15% in 2H 2008. We assume that gross margins rebound by 2.6% in Q2 and then decline to approximately 43% in 2H 2008 as the company absorbs a 20% chemical price increase. SG&A is estimated at 28.3% of sales, 2% higher than 2007. Even in this grim scenario, TPX generates $97 million of free cash flow before any contribution from working capital. It is important to understand that TPX is not a retailer with fixed costs such as store leases. Even the 33% of SG&A that is not “variable” can be adjusted down. We believe management can and will cut these “fixed” SG&A costs. The table below shows historical and projected EBITDA, EBIT, Net Income, EPS and FCF levels for TPX based on current shares outstanding and current capitalization. The table shows that if TPX regressed to a 2005 sales run-rate, the company would generate EPS of $1.40 and FCF / Share of $1.55. The 2005 sales are almost 25% below 2007 sales, yet it implies significant profitability and a FCF yield of 18% at the current stock price. Even assuming 45% gross margins on the 2005 sales level implies $1.00 of EPS and $1.14 of FCF / Share.

		2004	2005	2006	2007	2008	2009
Sales		685	837	945	1,107	968	1,016
% of 2007 Sales		61.9%	75.6%	85.4%	100.0%	87.4%	91.8%
% Growth			22.2%	12.9%	17.1%	-12.6%	5.0%
Gross Profits		361	424	461	535	425	456
% Margin		52.7%	50.7%	48.7%	48.3%	43.9%	44.9%
SG&A		(210)	(233)	(251)	(291)	(276)	(282)
% of Sales		30.7%	27.9%	26.6%	26.3%	28.6%	27.7%
EBIT		151	191	209	244	148	175
% Margin		22.0%	22.8%	22.1%	22.1%	15.3%	17.2%
D&A		23	25	25	33	33	33
EBITDA		174	216	234	278	182	208
% Margin		25.5%	25.8%	24.8%	25.1%	18.8%	20.5%
Interest		(30)	(30)	(30)	(30)	(30)	(30)
Pre-Tax Income		121	161	179	214	118	145
Taxes @ 34.5%		(42)	(55)	(62)	(74)	(41)	(50)
Net Income		79	105	117	140	78	95
Shares		75	75	75	75	75	75
EPS		$ 1.06	$ 1.40	$ 1.57	$ 1.87	$ 1.03	$ 1.26
P/E at $8.50 Price		8.0	6.1	5.4	4.5	8.2	6.7
Free Cash Flow
EBITDA		174	216	234	278	182	208
Interest		(30)	(30)	(30)	(30)	(30)	(30)
Taxes		(42)	(55)	(62)	(74)	(41)	(50)
Capex		(14)	(14)	(14)	(14)	(14)	(14)
FCF		89	116	128	160	97	114
FCF per Share		$ 1.18	$ 1.55	$ 1.71	$ 2.13	$ 1.29	$ 1.52
Yield at $8.50 Price		13.9%	18.2%	20.1%	25.0%	15.2%	17.9%

4) Investors are excessively concerned about a debt covenant violation: At Q1 2008, debt outstanding was $597 million, and cash was $47 million with approximately $40 million held abroad, which is subject to a withholding tax estimated at 3%. Assuming this cash is repatriated to the US, the effective cash and net debt balance is $45.8 million and $551 million, respectively. The Debt / EBITDA covenant is 3x. Even in the very conservative 2008 scenario described above, TPX generates $97 million of free cash flow. Assuming this is used to pay down debt implies the company is at 2.7x debt / EBITDA at year-end. In addition, the company had inventories of $112 million at Q1. We believe TPX is reducing these inventories to ~$80 million, most of which should occur in Q2. This will generate ~$30 million of cash which can further reduce debt. There may also be opportunities to reduce receivables and stretch payables. Note that TPX has only $14 million of capex this year, and management has indicated that capex will remain at this low level for the next 5 years as the company has ample excess capacity for future demand increases.

5) Tempur-Pedic can manage higher chemical costs: We estimate that approximately 30% of TPX’s COGS are chemical-related which may be impacted by oil prices. TPX has managed its gross margins through previous periods of rising oil prices. From January 2004 to January 2006, oil prices almost doubled. Gross margins declined from 52.7% in 2004 to 48.7% in 2006. Assuming the 4% gross margin contraction was caused by chemical price increases implies that chemical prices may have increased by 33% (assuming they started at 24% of COGS in 2004). In 2007, gross margins were relatively stable.

		2004		2005		2006		2007
COGS			%		%		%		%
	Chemical	11.3%	24%	13.3%	27%	15.3%	30%	15.3%	30%
	Other	35.9%	76%	36.0%	73%	36.0%	70%	36.3%	70%
	Total	47.3%		49.3%		51.3%		51.7%
Gross Margin		52.7%		50.7%		48.7%		48.3%

Gross margins contracted from 48.3% in 2007 to 43.7% in Q1 2008. Management said chemical costs increased 12% in Q1. This implies that ~2% out of the 4.6% margin contraction was due to chemical costs (56.3% COGS * 30% chemicals * 12% increase). The remaining 2.6% may be related to excess costs incurred because the company was budgeting for higher sales. Hence, going forward, we could reasonably expect that gross margins could improve by 2.6% as management corrected this problem. However, since April 17 when the company last provided EPS guidance of $1.20 – $1.65 which incorporated the 12% chemical price increase, crude prices have risen from $115 to $136, an 18% increase. Assuming the chemical costs are 100% correlated to crude oil (which has not been the case historically) suggests that 20% higher chemical costs could have a 3.4% gross margin impact (56.3% COGS * 30% chemicals * 20% increase).

		2008
		Q1	Q2	Q3	Q4
COGS
	Chemical	17.2%	17.2%	20.6%	20.6%
	Other	39.1%	36.5%	36.5%	36.5%
	Total	56.3%	53.7%	57.1%	57.1%
Gross Margin		43.7%	46.3%	42.9%	42.9%

The table above shows gross margins improving by 2.6% in Q2 2008 as the cost structure is right-sized. Margins then contract sequentially by 3.4% in 2H 2008 as a 20% chemical price increase takes effect. This assumes that TPX has no ability to pass through a portion of the cost increase. The company could raise prices modestly to mitigate the chemical cost impact, or implement “productivity” measures (reduced usage of the most expensive chemicals). Management has already indicated they would evaluate pricing if they faced higher chemical costs.

6) Competition is contained: In our previous VIC write-up dated July 10, 2006 we outlined in detail why TPX has a significant competitive advantage and why margins are sustainable. Whereas the 3 S’s spread precious media, co-op, and marketing dollars across multiple specialty categories and legacy spring-coil mattresses, TPX is entirely focused on visco-elastic / foam mattresses. The company has already spent over $500 million marketing and developing the Tempur-Pedic brand. In recent channel checks, retailers told us that TPX is a “must-have” on their shop floors because it is the only brand that consistently drives customers to the stores. TPX’s slots per store have increased from 3 in 2005 to 5 in 2007. Each retailer we spoke with said he would not consider reducing slots for TPX. Our discussions with TPX management and observation of competitive dynamics in the foam sector suggest that competitive intensity is cyclical. Simmons launched its Comforpedic brand earlier this year, but we have heard that Simmons’ support for this product has declined in recent months. Given the challenges in the overall mattress sector and their high levels of leverage, the 3 S’s have their hands tied and cannot compete effectively with TPX.

7) Insider Buying / Potential Buyout: Friedman Fleischer and TA Associates previously owned TPX. Friedman Fleischer recently invested $50 million acquiring a 6% stake in TPX at approximately $11-$12 per share. Chris Masto of Friedman Fleischer sits on the board of TPX. The $50 million public market investment is unusual and significant for a private equity fund which manages $1 billion. There is a distinct possibility that Friedman Fleischer and / or TA Associates re-acquires TPX.

8) Q2 Earnings Call: Look for management to either re-affirm full-year guidance of $1.20 - $1.65 in earnings per share or to guide down marginally based on potentially higher chemical costs. Even if management provides a new range as low as $1.00 to $1.30 EPS (implies $1.30 to $1.60 of free cash flow per share), but demonstrates that debt levels are lower and the business is generating significant cash flow, the stock should gap up significantly. If the market applies a 10% free cash flow yield on the new low-end FCF / share of $1.30, the stock will rip to $13 as short sellers face an aggressive squeeze.

For investors who can hold the stock through 2008, we believe TPX stock offers significant upside. Historically, the mattress industry has been one of the most stable, defensive consumer sectors in the US (with no down years in dollar terms the last 20 years, even in recessions). This year is unusually difficult for mattress manufacturers. TPX at $8.50 offers exceptional value because you are buying the leading specialty manufacturer with very high brand awareness in one of the most defensive consumer sectors at a 23% discount to its historical trough P/E multiple and an almost 50% discount to its historical trough FCF yield (using our conservative, below-guidance 2008 projections!). We believe that current all-time low trough multiples for TPX will expand significantly as the drivers (consistent replacement cycle, substitution in favor of specialty mattresses, etc) that historically led to the sector’s out-performance and TPX’s out-performance within the sector start to play out again.

		LTM	LTM
YE Price	Price	P/E	FCF Yield
2007	$25.97	13.7x	8.1%
2006	$20.46	15.2x	6.8%
2005	$11.50	10.7x	5.3%
2004	$21.20	27.8x	4.0%
2003	$15.50	40.1x	2.6%

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

Catalyst

- Significant cost reduction
- Stable sequential sales
- Manageable chemical cost increases
- Cash generated from operations and working capital used to reduce debt
- Excessive short interest
- More insider purchases
- Potential buyout