Scott F. Yarnell shares his view and analysis on Tempur-Pedic (TPX, Financial)
With all of today’s gloomy economic prognostications, including warnings about recession, inflation, falling home values, high unemployment, tight credit, rising interest rates, over-extended consumers, etc., a business that sells expensive luxury consumer items for the home might not seem to be a wise investment. As usual, however, the market’s current turbulence presents an opportunity to investors who enjoy accumulating wealth by owning businesses as long-term investments.
Tempur-Pedic (TPX) is the largest manufacturer and distributor of premium mattresses. Unlike conventional mattresses which are made using metal innersprings, TPX’s products are made of proprietary foam formulations. The company’s products are widely in demand for their distinctive feel and comfort, and they command high prices relative to standard innerspring mattresses. As a result, the company possesses strong financial characteristics. TPX’s profit margin last year was over 12% and in the three previous years it was over 11%. Using figures from 2004 to 2006 to be conservative, the company had an annual average of about $61 million in true owner earnings (operating cash flow minus capital expenditures). Based on that figure, the company has enjoyed returns on equity of well over 20% for the past few years. Inventory turnover for 2007 was nearly 7 times.
On the other hand, the company is highly leveraged. That seems largely the result of stock repurchases, but it is a concern nonetheless. Operating income and free cash flow substantially exceed the $30 million interest expense reported for 2007 and at year end the company had about $33 million in cash: this somewhat, if not completely, mitigates that concern. Another concern is the discrepancy between reported net income and true owner earnings in previous years. Thus, it is necessary to closely watch the quality of earnings going forward.
Founded in 1991, TPX enjoyed substantial growth at least from the time it went public in 2002 until the first quarter of this year when sales and profits fell substantially, 7% and 55%, respectively. Sales grew from about 367,000 mattress units in 2003 to about 774,000 units in 2006. TPX’s recent sales and earnings shortfall is not surprising given the current economic climate, particularly with respect to the housing market (new mattress purchases may somewhat correlate to new housing purchases). The company has also largely penetrated its targeted retail channels in the U.S. with a presence in about 6,000 of the about 7,000-8,000 targeted stores out of a total of 10,000 retail stores. International penetration is also high with a presence in about 4,450 stores out of about 7,000 targeted stores. [retail sales account for about 80% of total sales] Also not surprising is that the company’s healthy profit margins would attract substantial competition (TPX’s competitors typically have less than 5% profit margins for their standard innerspring mattress businesses), not to mention the general trend to premium mattresses causing higher growth in that segment.
With its widely recognized brand and products that are well positioned in a growing global industry (currently estimated at $12 billion by the company), the question is whether TPX has a durable franchise that will allow it to continue to earn high returns on equity and benefit from the growth of the specialty mattress segment of the industry. Although a number of companies offer alternatives to TPX’s mattresses, the key competitors are the three companies that dominate the standard mattress business in the U.S., Sealy, Serta and Simmons. These competitors have entered the market with their own memory foam mattresses to compete directly with TPX.
Attempts by competitors to emulate TPX’s products have failed in the past. Of course, that does not mean they are certain to fail again or that they will not cause some harm to TPX. However, there is no evidence that any competing products match the feel and comfort of TPX’s products. At one store, the salesperson steered me away from the store’s own memory foam mattress in favor of the TPX products which it also sold. Indeed, the store’s product did not seem to me to match the comfort level, look or general feel of the TPX product. At another store that sold both TPX mattresses and a competitor’s product, the salesperson seemed more enthusiastic about the TPX product. Moreover, the prices of the competitor’s product were not significantly less and to me it seemed that the competitor’s product was not as comfortable. Also, there were not as many different models of the competitor’s product.
Unlike TPX, the other major mattress companies do not specialize in memory foam mattresses. That aspect of the competitors’ businesses represents only a small part of their operations. TPX is focused on the premium market, has superior proprietary technology, and is years ahead of the competition in terms of research to refine and perfect its products and build its brand recognition. In particular, TPX has done a wonderful job of differentiating its products and building a brand that is strongly associated with quality foam mattresses and for which customers are willing to pay a premium. It seems that no competitor will be able to feasibly provide a comparable substitute for TPX’s goods or services any time soon. TPX offers a unique product and has high customer loyalty, strong brand recognition, proprietary technology, infrastructure that is not easily replicated, and foreseeable long-term demand for its products. Even under current market conditions, TPX has been able to resist discounting its products. These factors appear to provide TPX with a durable franchise or wide economic moat.
There is little doubt that TPX’s management will have to engage in constant innovation, maintain strong relations with distributors and retailers, and creatively market and build the Tempur-Pedic brand to retain its competitive advantage. Of course, given their success so far, TPX’s management deserves somewhat of the benefit of the doubt. Nonetheless, the strength of TPX’s franchise must be constantly monitored and the nature of the business requires a substantial margin of safety to justify an investment. Fortunately, at current prices, such a margin of safety exists.
TPX currently trades in the low-$9 range. That places the market value of the company at under $700 million. Even using a conservative estimate of intrinsic value assuming only a five year 5% growth rate (a significant departure from its past double digit growth rates) based on the average ‘04-’06 owner earnings of $61 million (and leveling off after five years) and a 7.5% discount rate, intrinsic value would exceed $1 billion.
At its current price, TPX appears poised to create value over time for its owners while offering a reasonable margin of safety to its investors’ capital.
The author owns shares of Tempur-Pedic.
____________
Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm.
With all of today’s gloomy economic prognostications, including warnings about recession, inflation, falling home values, high unemployment, tight credit, rising interest rates, over-extended consumers, etc., a business that sells expensive luxury consumer items for the home might not seem to be a wise investment. As usual, however, the market’s current turbulence presents an opportunity to investors who enjoy accumulating wealth by owning businesses as long-term investments.
Tempur-Pedic (TPX) is the largest manufacturer and distributor of premium mattresses. Unlike conventional mattresses which are made using metal innersprings, TPX’s products are made of proprietary foam formulations. The company’s products are widely in demand for their distinctive feel and comfort, and they command high prices relative to standard innerspring mattresses. As a result, the company possesses strong financial characteristics. TPX’s profit margin last year was over 12% and in the three previous years it was over 11%. Using figures from 2004 to 2006 to be conservative, the company had an annual average of about $61 million in true owner earnings (operating cash flow minus capital expenditures). Based on that figure, the company has enjoyed returns on equity of well over 20% for the past few years. Inventory turnover for 2007 was nearly 7 times.
On the other hand, the company is highly leveraged. That seems largely the result of stock repurchases, but it is a concern nonetheless. Operating income and free cash flow substantially exceed the $30 million interest expense reported for 2007 and at year end the company had about $33 million in cash: this somewhat, if not completely, mitigates that concern. Another concern is the discrepancy between reported net income and true owner earnings in previous years. Thus, it is necessary to closely watch the quality of earnings going forward.
Founded in 1991, TPX enjoyed substantial growth at least from the time it went public in 2002 until the first quarter of this year when sales and profits fell substantially, 7% and 55%, respectively. Sales grew from about 367,000 mattress units in 2003 to about 774,000 units in 2006. TPX’s recent sales and earnings shortfall is not surprising given the current economic climate, particularly with respect to the housing market (new mattress purchases may somewhat correlate to new housing purchases). The company has also largely penetrated its targeted retail channels in the U.S. with a presence in about 6,000 of the about 7,000-8,000 targeted stores out of a total of 10,000 retail stores. International penetration is also high with a presence in about 4,450 stores out of about 7,000 targeted stores. [retail sales account for about 80% of total sales] Also not surprising is that the company’s healthy profit margins would attract substantial competition (TPX’s competitors typically have less than 5% profit margins for their standard innerspring mattress businesses), not to mention the general trend to premium mattresses causing higher growth in that segment.
With its widely recognized brand and products that are well positioned in a growing global industry (currently estimated at $12 billion by the company), the question is whether TPX has a durable franchise that will allow it to continue to earn high returns on equity and benefit from the growth of the specialty mattress segment of the industry. Although a number of companies offer alternatives to TPX’s mattresses, the key competitors are the three companies that dominate the standard mattress business in the U.S., Sealy, Serta and Simmons. These competitors have entered the market with their own memory foam mattresses to compete directly with TPX.
Attempts by competitors to emulate TPX’s products have failed in the past. Of course, that does not mean they are certain to fail again or that they will not cause some harm to TPX. However, there is no evidence that any competing products match the feel and comfort of TPX’s products. At one store, the salesperson steered me away from the store’s own memory foam mattress in favor of the TPX products which it also sold. Indeed, the store’s product did not seem to me to match the comfort level, look or general feel of the TPX product. At another store that sold both TPX mattresses and a competitor’s product, the salesperson seemed more enthusiastic about the TPX product. Moreover, the prices of the competitor’s product were not significantly less and to me it seemed that the competitor’s product was not as comfortable. Also, there were not as many different models of the competitor’s product.
Unlike TPX, the other major mattress companies do not specialize in memory foam mattresses. That aspect of the competitors’ businesses represents only a small part of their operations. TPX is focused on the premium market, has superior proprietary technology, and is years ahead of the competition in terms of research to refine and perfect its products and build its brand recognition. In particular, TPX has done a wonderful job of differentiating its products and building a brand that is strongly associated with quality foam mattresses and for which customers are willing to pay a premium. It seems that no competitor will be able to feasibly provide a comparable substitute for TPX’s goods or services any time soon. TPX offers a unique product and has high customer loyalty, strong brand recognition, proprietary technology, infrastructure that is not easily replicated, and foreseeable long-term demand for its products. Even under current market conditions, TPX has been able to resist discounting its products. These factors appear to provide TPX with a durable franchise or wide economic moat.
There is little doubt that TPX’s management will have to engage in constant innovation, maintain strong relations with distributors and retailers, and creatively market and build the Tempur-Pedic brand to retain its competitive advantage. Of course, given their success so far, TPX’s management deserves somewhat of the benefit of the doubt. Nonetheless, the strength of TPX’s franchise must be constantly monitored and the nature of the business requires a substantial margin of safety to justify an investment. Fortunately, at current prices, such a margin of safety exists.
TPX currently trades in the low-$9 range. That places the market value of the company at under $700 million. Even using a conservative estimate of intrinsic value assuming only a five year 5% growth rate (a significant departure from its past double digit growth rates) based on the average ‘04-’06 owner earnings of $61 million (and leveling off after five years) and a 7.5% discount rate, intrinsic value would exceed $1 billion.
At its current price, TPX appears poised to create value over time for its owners while offering a reasonable margin of safety to its investors’ capital.
The author owns shares of Tempur-Pedic.
____________
Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm.
