Friday, October 05, 2007

The case for Select Comfort

I think the crowd is wrong about Select Comfort because market participants are focusing on short-term, rather than long-term prospects. It seems to be the usual reason the market undervalues companies. In this case, Select Comfort has swung from a hot, growth stock to a company with troubles on several fronts. They had to take a big one-time expense because of an abandoned computer system. New fire-retardant regulations reduced company earnings to an extent. But the big news is the housing slump that slowed mattress sales. Also, Select Comfort's new ad campaign failed to bring in costumers. As a result, EPS for the last quarter was down 69.41% YoY and for the last 12-months EPS is down 19.48%. Sales last quarter were down 4.84% and for the last 12-months, sales are only up 5.06%—a far cry from management's 15% goal.

But the further back you go, the harder it is to see a problem. Over the last 5 years, sales have grown 25.23% and EPS has gone from -66¢ in 2001 to 85¢ last year. Gross and operating margins have improved dramatically. Management has predicted more margin improvements this year too. The company has a negative cash conversion cycle and new stores pay for themselves within a few months. The Four Factors are moving in the right direction, so earnings yield is higher than a year ago. So the question comes down to has Select Comfort's business changed so that the next five years will be much slower than the last five.

To be certain, growth in the last five years came on the back of fixing a broken sales and marketing system, expanding into new markets and controlling costs. Those low-hanging fruit are long gone. But the market is pricing in about 8.4% growth, which is nowhere close to the 14% projected by the most pessimistic analyst. I think the disconnect is that the market is looking out only one or two years. Because of the current macro-economy, the next two quarters look like they will be flat earnings-wise. But over the next five to ten years, Select Comfort has tremendous operational advantages.

Consider they way mattresses are traditionally bought and sold. Since people rarely buy more than once every decade or so, they don't have any reason to spend a lot of time thinking about how to do it. Unlike buying a car, mattress shopping seems boring and unimportant. Consumers look for things like brand, an in-home trial, manufacturer's warranty, and price. These are shortcuts that people use so that they can get a mattress they are comfortable with and get on with their lives. It's relatively easy to manipulate people using these shortcuts. For instance, there's a mattress store here in Southern California that advertises very heavily with the slogan, "We’ll beat any advertised price, or your mattress is FREEEE!" At first glance, one would assume the store is losing money (which is the way the commercials spin it) or is working on razor thin margins to avoid giving away the store. But the fact is each chain carries slightly different models with different names so that each store can claim to offer the lowest price. The low price message must be drilled into the consumer's consciousness because you never know when they might in the market for a mattress.

Since Select Comfort offers a unique style of mattress and controls the retail experience for the most part, it can differentiate itself without resorting to product name shenanigans. The key will be a long-term, consistent focus on the unique attributes of the product. Just having a storefront in the mall that people walk past year after year improves the odds that they will buy a Sleep Number bed. When combined with advertising (especially on the radio), it should be possible to encourage most people in a market to at least consider it. Management hasn't moved into non-US markets so far because they see plenty of potential in US markets they haven't tapped so far.

Sealy cut prices in the face of slow sales, but ended with a bad quarter in terms of earnings. Tempur-Pedic, on the other hand, recently raised prices yet sales increased. The purchase cycle is very long for mattresses, so its hard to read too much into a few quarters, but it seems foam has become a legitimate substitute for traditional innerspring models. Select Comfort might benefit since newer models come with improved foam toppers.

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