Is there money to be made in the sleep of other people? Yes, according to the Sleep Number Corp. SNBR, which delivered a lot of it in 2019. It reported in its 10-K for 2019 that net sales increased by 11%, earnings per diluted share grew by 41% and that cash from operations was up by 44%. This GuruFocus chart shows its earnings per share and free cash flow:
That growth was made possible, in part, because of a dose of short-term debt in 2018 and 2019.
Sleep Number (known as Select Comfort before 2017) is the company that designs, manufactures and sells those heavily-advertised beds that adjust at the touch of a button, along with several related lines of business. And a new generation of even smarter beds is on its way, providing more opportunities for growth.
All of that is currently interrupted by the Covid-19 outbreak and subsequent lockdowns. Sleep Number management has reported that it closed most of its retail and home delivery operations, furloughed about 40% of its staff and another 30% is down to reduced hours. It has taken several other measures to reduce its outgoing cash flow, including cuts to management compensation.
Still, a recession appears imminent and investors have taken their money out of the Sleep Number stock and hidden it under their mattresses (so to speak). That’s driven down the share price from nearly $60 in mid-February to the low $20s now.
It has also put this small cap on the Undervalued Predictable screener list at GuruFocus, meaning its price is below the intrinsic value established by discounted cash flow analysis and providing a margin of safety. It’s also a 4.5 out of five-star predictable stock, meaning it has a solid history of growing its earnings.
Analysis
For a scan of the pros and cons of the business, we employ the Macpherson model, a set of tests used by Thomas Macpherson, the managing director and chief investment officer at Nintai Investments. It has four sections: a moat (competitive advantage), financial strength, profitability and an appropriate valuation. Data comes from the most recent financial statement and GuruFocus.
Moat
To test a company’s competitive strength, we check its return on capital, looking for a median return of at least 15% over the past 10 years. We also use the same criteria for return on tangible equity.
- ROC: GuruFocus provides data for the past eight years and, in that period, the lowest return was 30.22%, allowing it easily pass on this measure (ROC refers to the yield on all capital employed by the company, mainly equity and debt).
- ROTE refers to the relationship between net income that can be attributed to common stockholders and the total shareholder tangible equity. Sleep Number has negative ROTE, in part because it has built up goodwill through numerous acquisitions ($64 million of its $73.2 million of intangible assets are from goodwill).
On the basis of its strong ROC, we give the company a pass on having a competitive advantage.
Financial strength
In this category, the model looks for a financial strength rating of at least 9 out of 10 and a cash-to-debt ratio of 100 (the model is skewed against debt):
- The financial strength rating is only 4 out 10, well below the target of 9.
- The cash-to-debt ratio is 0.00, obviously well below the target of 100. Still, it does have a solid interest coverage ratio of 9.67, meaning it has ample cash on hand to meet its interest obligations.
Debt is the main reason for these shortfalls. As noted above, that debt helped pave the way for strong growth in 2019 and might have produced continued gains this year and beyond if not for the current pandemic.
Also contributing to the company’s success was research and development, which had grown to $35 million for 2019. In addition to research on the design of its beds, the company also researches consumer needs and the science of sleep.
Profitability
Writing about profitability, Macpherson noted that he wanted companies that were “extremely profitable,” so he set the minimum at 9. He added, “This assures the company also has an uptrend in profit margins.”
Sleep Number passes on this criterion, with a 9 out of 10 rating. But among the warnings issued by GuruFocus is a “severe” warning that the firm’s operating margin has declined.
Valuation
The final criterion is that the company be priced at less than its intrinsic value, which it is. GuruFocus recommends that Sleep Number be evaluated on its earnings-based DCF and, according to that, is available at an almost 46% discount. With the market price at $23.38 and the earnings-based DCF at $43.06, there is a wide margin of safety:
Overall, Sleep Number does well when analyzed with the Macpherson model. It has a competitive moat, it is highly profitable and is available at a steep discount. On the question of financial strength, it received a fail, but at the same time, it can easily meet its interest expenses with cash. We should also remember the steep rise in debt also fueled a big jump in earnings, cash flow and net sales. Further, the big boost in last year's cash flow makes available funding for debt reduction, new growth or dividends and buybacks.
Ownership
At the end of 2019, six gurus owned shares in Sleep Number, which is not unreasonable given that this is a small-cap stock. Lee Ainslie of Maverick Capital was the biggest shareholder with more than a quarter-million shares. Joel Greenblatt (Trades, Portfolio) of Gotham Asset Management held some 57,000 shares, while Paul Tudor Jones (Trades, Portfolio), John Hussman (Trades, Portfolio), Philippe Laffont and Chuck Royce (Trades, Portfolio) held lesser amounts.
Of its 27.36 million shares outstanding, institutional investors own nearly 60% and insiders hold almost 12%. The biggest position among the insiders is that of Michael J. Harrison, who’s been a director since 2011. CEO Shelly Ibach held 39,000 shares (plus more than 67,000 in a family trust) at the end of first-quarter 2020.
Conclusion
Sleep Number is a promising small-cap, one that appears to have allocated its capital well. It increased its debt load substantially in 2018 and 2019, but the effect of that new investment began paying off almost immediately. All the key metrics were up substantially last year and it has a new product platform that should contribute to new growth.
It is substantially underpriced, according to its earnings-based DCF, trading for 46% less than its intrinsic value. Given that there were no apparent problems before the price slump earlier this spring, we can assume its plunge was a reflection of a broader market malaise rather than company-specific problems.
It should be suitable for value investors who are prepared to live with a manageable amount of debt, but should be ruled out by stricter investors who want companies with no debt at all.
Disclosure: This article is only an introduction to the company and investors must do their own due diligence. I do not own shares in it and do not expect to buy any in the next 72 hours.
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