Thursday, December 13, 2007

Select Comfort not getting any better

Select Comfort gave a brief overview of 4th Quarter results and there is very little to like about them. The current advertising isn't working except for specials and sales. When a sale ends, the stores lose significant traffic. Worse, the company will be raising prices in January to cover increased materials prices. The last year and a half has been miserably poor for shareholders.

I'm listening to Winning by Jack Welch and it opened my eyes to where Select Comfort is going wrong. Traditionally, mattresses are a commodity business. According to Mr. Welch, there are only three things a commodity producer can change: a) price, b) quality, and c) service. Like the NASA mantra (cheaper, better, faster), you can only choose two. So, for instance, at Costco, you get price and quality (= value), but no service. At a traditional mattress store, you get more service, but sacrifice either quality or price. Until recently, Select Comfort was able to side-step that game because they had an innovative product that differentiated itself by being a completely separate category—adjustable mattresses.

This past year, other companies began to invade the category. I noticed that advertisers have started using phrases like "select your level of comfort" that are right out of Select Comfort's play book. Costco now sells mattress very similar to the Sleep Number bed. Further, other technologies such as memory foam are becoming mainstream. In other words, the air mattress is now a commodity.

Now there are two choices for the company: shift to a commodity strategy or find some other way to innovate. Now we don't know what direction management will take but I think we have some clues. Last month, Select Comfort hired a new Chief Marketing Office, Catherine Bur-Hall. Before that, Ms. Hall was a Vice President of Marketing at Midas Printing. Printing is even more of a commodity business than mattresses and from what I can tell, the Hong Kong company has focused on quality and service as its strategy. If it's going to be a commodity, those are the areas Select Comfort is likely to have greatest strength.

When I last bought this company, I made a mistake. I thought their product had a sustainable advantage that could be exploited for years to come. I thought they owned enough mind-share to propel the brand forward with a few tweaks to the advertising. I think management made the same mistake. The cost in terms of market value has been substantial and I think the board needs to hold management responsible.

But the market has clearly over-reacted. At $6.63, earnings would need to shrink by 5% or so over the next ten years in order to be justified. Given more reasonable growth rates, the price should be $15 to $18 a share. The market is assuming that not only will Select Comfort become a commodity business, but it will also fail to be competitive. Those are far from certain in my opinion.

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