Author: PM

The first investment thesis posted on the site outlined the bear case against Tempur Sealy International (TPX). As with any stock it is crucial to understand the people steering the ship alongside the company’s position in and economy and industry. We’ll explore the current management team’s history and provide more support to the bear thesis on this stock.

Who’s who?

Scott L. Thompson – CEO as of September 2015, former CEO of Dollar Thrifty Automotive, founder of Group 1 Automotive, and currently sits on the board of Asbury Automotive Group Inc., a public automotive retailer.

Bhaskar Rao – EVP and CFO as of October 2017 and longtime Tempur Sealy employee having joined in 2004.

Richard W. Anderson – EVP and President, North America as of July 2006. Previously a 23 year employee with The Gillette Company.

David Montgomery – EVP and President, International as of February 2003. Previously with Rubbermaid and longtime Black and Decker employee before that.

Cliff Buster – EVP Direct to Consumer as of September 2017. Previously CFO at Berkshire Hathaway Automotive and with prior employment at Exeter Finance and Dollar Thrifty.

Why this is important

All companies require the right people in the right positions in order to deliver value for customers and investors. This is especially true for companies operating in industries that were once stable and slow growing but are experiencing headwinds or significant threats to its business model.

A recent example of a management team that failed to quickly adapt to a changing industry is General Electric. Long held as the ultimate blue chip stock under CEO Jack Welch, the company has dramatically underperformed since his departure and is trading near its post-financial crisis low.

GE was under similar pressures facing Tempur Sealy today – a shrinking market for one of its core business units. And, like Tempur Sealy, the approach the company took to solving the problem was mismanaged.

GE’s power division failed to understand that electric grids were already overbuilt, cheap renewables were digging into the gas turbine business, and overall consumption was actually on the decline in the developed world. Yet the company still purchased a large gas turbine manufacturer only three years ago.

Tempur Sealy’s path is alarmingly similar in a very different industry. Management has chosen to put capital into the declining brick and mortar retail business while upstart competitors focus on the direct to consumer markets. Investing capital into a market segment in decline is not a sustainable way to deliver value for shareholders.

When is important as well

Current CEO Scott L. Thompson was installed after a bitter battle between the company and the current top shareholder, H Partners (holding ~20% of float). This activist investor demanded a change of leadership from then CEO Mark Sarvary and ultimately got what it wanted after taking its case public. A change for change sake is never truly a change though, is it?

The management and director changes that ultimately occurred in the middle of 2015 resulted in the stock soaring from the mid-$50s to near $80 highs. All was great for the activists who won big.

But we’re still in the mid-$50s today on the stock as one of the longest bull runs to date continues to break into new highs. The fact that the same CEO picked by the activist investor is still in place today is troubling.

It is especially troubling when we consider the direct to consumer strategy was launched under the old CEO. And the new person leading the direct to consumer strategy within TPX has a finance resume with roots in the automotive retail industry. And some of the other managers are longtime employees who are at an increased risk of managing with blinders on.

Any management or board shakeup ultimately results in a difficult transitional phase in which the company may be left without a clear strategic direction. Therefore it is important that the new leader is able to set a new direction and has the autonomy and backing in order to do so.

In this case it is unclear that the direction was set or the new leadership had the full backing of the existing board of directors to set a new path. Investors may be left with a rudderless organization in choppy waters.

Where do we go from here?

A popular saying in the past few years has been ‘Every company is in the tech industry’. This is increasingly true and is an apt summary for a portion of this investment thesis. If a mattress company needs to transform itself to survive, the place to start is by hiring talented individuals from outside the traditional retail industries.

Tempur Sealy International (TPX) is a multibillion dollar mattress and bedding  manufacturer. You’ve likely heard of them as the leader in the home furnishings industry with a global footprint and multichannel distribution strategy. Millions enjoy plopping down onto the company’s premium bedding products at the end of a tough day. Unfortunately those soft mattresses seem to be emulating the soft strategic direction at the company – and the stock will suffer as a result.

There are three major issues with TPX at the moment:

 

• The company is not moving quickly enough into the e-commerce space
• The competitive pressures from start-ups combined with commodity inflation will squeeze margins in the near future
• The strategy to reduce leverage will be difficult and unlikely in the next twelve months

For those that haven’t shopped around for mattresses, Tempur Sealy sells premium mattress products. Typical price points for the product are about $1,500 with some models surpassing $5,000. Most people sleep a third of their lives and investing in a quality mattress is a great decision.

TPX has done well in building its business and selling premium products. Prior twelve month sales of $2.7B solidifies its position as the leader in global bedding products. The messy breakup with Mattress Firm, the previous distributor, is largely behind the company at this point. In terms of public peers only Sleep Number (SNBR) comes close to TPX’s in market size.

But Tempur Sealy is in an interesting inflection point in the industry. If you happen to live in suburbia you may have noticed the proliferation of mattress stores. They are seemingly everywhere. This article, although dated,  summarizes the current state of the industry quite well – which is that the industry has been somewhat isolated from the e-commerce invasion and was able to maintain high margins.

More recent news that Mattress Firm is planning for bankruptcy is an indicator of how poorly the retail bedding industry is performing. What was interesting about this announcement is that the market took this as good news for TPX as the stock rose about five percent. Rather than an indication that TPX can retake market share from Mattress Firm, it is more likely that the entire industry is facing these headwinds as a result of e-commerce start ups beginning to make inroads.

TPX management is making changes in response to the competitive landscape, although they are misguided and slow.

The first mistake in the Tempur Sealy strategy is that the company is not investing enough in its direct to consumer business. Or rather, they are investing it where the industry has been rather than where it is going.

TPX has been building retail stores to the tune of seven per quarter. The company claims fast payback periods on the investment and the sales growth here is impressive – double digit gains in both North America and International. However the restructuring of Mattress Firm points to more significant troubles in the retail store segment. Mattress Firm was a prior customer for Tempur Sealy until recently, and TPX investors cheered on the news that the former customer and competitor is having difficulties. But these are difficulties faced by TPX as well given it is expanding into Mattress Firm’s territory. Any direct to consumer gains are simply taking some market share back from Mattress Firm in what is a smaller and smaller market. This is ultimately not that impressive.

Tempur management should focus on the bed-in-a-box strategy, not retail store footprints. In the age of everything online with free shipping in two hours – who wants to spend a weekend afternoon at bedding stores listening to a salesperson pitch the latest in hybrid memory foam? TPX seems to understand that the industry is in transition but is missing the mark and congratulating itself on marginal market gains in a smaller pie.

The company needs to be disclosing is the growth of its bed-in-a-box product – which would be comparable to the start ups that are keen to gobble up market share. TPX’s entire direct business is doing ~$250M in annual sales. Meanwhile the competitors in this space are startups that are likely exceeding that number today based on early valuations and limited information released. These companies also invest relatively little in delivering these sales – no expensive sales commissions or prime retail space to pay for. Building a few warehouses to serve entire regions is simply a more efficient way to deliver mattresses.

This leads us to the second issue – the competitive and supply chain environment is not getting better.

Which is more appealing to you? Spend time talking to a salesperson about the finer points of bedding on a Saturday afternoon or having a well-reviewed mattress shipped to you risk-free by Monday.

There will always be those that want to test new purchases, especially when those purchases are a few thousand dollars. But the better price point and zero risk bed-in-a-box offering is hard to ignore.

With pressure on revenues, the focus of the management team needs to be on maintaining strong margins through cost control. It is reasonable to assume that variable opex should be well controlled in a declining environment. Skepticism increases when we look at gross margins. Tempur Sealy is a price taker for large input costs – metal and lumber used in mattresses. Any recent headline will direct you to the price headwinds here. The company should be able to pass along some of the increased costs to consumers in what is a somewhat price inelastic consumer group – but not all cost increases.

Management has acknowledged headwinds in the global supply chain in its most recent earnings call.

“The second headwind facing our business is the rapid rise in commodity prices. Input costs are a large percentage of cost of goods sold and have experienced large headwinds and we’ve experienced large headwinds across almost all categories including steel, wood, chemical, and transportation. We’ve demonstrated a history of passing these commodity price increases on, but these increases take a time to pass through the industry, which results in temporary earnings pressure.”

Price and cost pressures lead us into the third area of significant weakness for TPX. The company is simply overleveraged and has a weak capital position heading into a disruptive cycle in the industry.

It is important to acknowledge here that management is making efforts to improve the company’s capital structure. The leverage ratio that management is targeting is for year end is ~14x adjusted EBITDA/Debt. We currently see the company hovering around 30x through the midpoint of the year on an unadjusted basis – up from 17x one year prior.

In order to maintain its credit rating the company will need to maintain the levels of profitability it has seen in 2017 – higher than 10 percent EBIT margins. It has failed so far through the beginning of 2018, with EBIT profitability declining to 8.3 percent in each of the first two quarters.

Current credit ratings are speculative, as noted by Moody’s (B1) and Standard and Poors (BB).

The company’s ability to pay down this debt binge will be slower than anticipated. We break down some credit ratios in the charts and tables section below.

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Valuation

Tempur Sealy is worth $42, which is about 20% lower than it is currently trading.

We use a combination of forward P/E, EV/EBITDA, and Price/Sales to arrive at the target. Download the valuation summary here:

TPX Valuation Summary 09_2018

 

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What would cause a shift in thinking from an investment perspective?

The company needs to begin publishing numbers from its bed-in-a-box segment. Just how much growth is attributable to this versus the traditional retail store business? If the company is failing in this business model, is it able to acquire one of the newer start ups to gain a foothold before it is too late? Right now, the company simply can’t afford these fast growing companies and the poor balance sheet will erode profitability and growth.

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