SNBR - Sleep Number: What's Your Edge?

2023-08-01 10:33:22 ET

Summary

• Sleep Number has a high-quality business model.
• Sleep Number is working through short-term challenges.
• I am willing to look foolish owning Sleep Number to take advantage of its long-term potential.

Sleep Number (SNBR) is a good case study for the way I think about an edge in investing. The company has a 10+ year track record of growing revenue and cash flow, but recent hard times and a poor Q2 earnings report have crushed the company's stock price. It wouldn't surprise me if SNBR continues to do poorly over the next 12-18 months, and I don't see a clear catalyst on the horizon that would cause a positive re-rating of the share price. So, why do I hold SNBR today? It is situations like these where I think the edge of patience comes in. I think a willingness to be early and to look foolish for months or years can be an edge if you are right about the investment but not certain about the timing. In this article, I will revisit my SNBR investment thesis to explain this concept.

SNBR is a Solid Long-Term Investment

I've done five writeups on SNBR already (including this one that best outlines my investment thesis) and each time I look at the company I see the long-term potential. SNBR produces "smart" mattresses and accessories that track and promote healthy sleep. I compare their mattresses to other embedded technology products like smart phones or high-end vehicles. Every 2-3 years SNBR can release a new product with a few new features and charge more as a result. The Climate360 product line is a recent example. The new model includes automatic temperature-adjustment technology and sells for ~35% more than the previous model. Sales of this model have so far exceeded management's expectations and the product is receiving rave reviews ( source ).

Existing SNBR customers have incentives to stay with the company when they look for a new mattress. All SNBR mattresses collect nightly sleep data, which can be reviewed and tracked in the Sleep Number smart phone app. If a customer moves to a competing product, that data is lost. In addition, SNBR products have features that few competitors can offer. All of their mattresses, for example, have dual-sided firmness adjustability so couples can pick the firmness levels on their side of the bed, and they can adjust those firmness levels over time (to account for weight gain or loss, for example). This might seem like a small feature, but once you are used to having that option it feels like a downgrade to lose it. I have seen very few competing products that offer this feature. SNBR has solid margins and a relatively capital-light business model. Gross margin is consistently over 60% (this has dipped recently, more on that later), and free cash flow margin averaged ~6% from 2011 through 2019. SNBR leases all of its retail locations and keeps low product inventory, assembling beds as customer orders come in. SNBR can comfortably fund capital expenditures from operational cash flow; prior to 2017 the company didn't carry any debt and the recent additions have been used purely to repurchase shares. SNBR slowly but consistently grew revenue and cash flow from 2011 through 2019, prior to major fluctuations caused by the pandemic in 2020. Revenue, net income, and free cash flow grew at an annual compound rate of 9%, 4%, and 7% respectively.

I view SNBR as a high-quality consumer-technology company with a semi-defensible moat and good free cash flow generation.

SNBR hit a Rough Patch

SNBR has experienced above-average operational volatility from 2020 through the present day. At first the volatility was positive; lockdowns and stimulus checks led to a large jump in sales and cash flow. 2021 was SNBR's best year ever, with over $2b of revenue and $233mm of free cash flow. Problems began to emerge as global supply chain constraints led to a dearth of semiconductors, which are vital to SNBR's product suite. By 2022 the company didn't have the necessary components to service customer demand, leading to delays and lower margins as the company paid extra to expedite orders for whatever semiconductors they could get their hands on. Free cash flow was negative in full year 2022 as a result.

The situation seemed to be improving by the end of 2022. Supply chain constraints were resolved and the Climate360 model launched at the end of the year. However, it is clear that either a lot of demand was pulled forward in 2020 and 2021 or that the retail consumer isn't doing quite as well as recent headlines might have you believe (or both). Through Q2 of 2023 sales are down double digits from 2022, gross margin is stuck at about 57%, and free cash flow is sitting at negative $11mm. Management's full year guidance has been revised downward as a result, with expected earnings per share of $1.50 and free cash flow between $40-$50mm. While not dire, these projections would suggest that SNBR shares are overvalued, even after the 30% post-earnings selloff.

Why I am Willing to Look Stupid to Own SNBR

If SNBR's short-term prospects look grim and its shares look overvalued relative to short-term performance, why I am long the stock? The answer is that I am confident that SNBR is a quality company, but I am not confident in my ability to correctly time a share price turnaround. If I had a crystal ball or was smart enough to calculate a precise buy-signal, then I could just sit on the sidelines and buy at the right time, but alas I possess neither. Instead, because I want to own SNBR in the long-term, I have to be "early" and willing to hold through some not-so short-term pain. Frankly, I have to be "stupid" to make sure I don't miss SNBR's return to form. I use the word "stupid" because in hindsight it seems obvious that holding SNBR over the last 18 months was a bad choice. "Obviously" demand was being pulled forward, "obviously" we were headed into a recession, and "obviously" borrowing money to buy back shares above $50 was a mistake, and here I am owning shares and even doing a bit of dip-buying.

I continue to be "foolish" and own shares of SNBR, because I believe the upside remains substantial. Using very simple, "back of the envelope" math, I peg SNBR's "normalized" annual free cash flow potential at least at ~$130mm. This was 2019's value and gives no credit for any growth. At a modest free cash flow multiple of 10, that would give SNBR a market cap of $1.3b and a share price of $59. That is more than double the current share price of $28, and that is with a conservative multiple for what I believe is a high-quality company. If 2023 and 2024 go poorly and SNBR doesn't reach $130mm in FCF until the end of 2025, as long as the market is willing to assign an FCF multiple of at least 10 then I would be looking at a compound annual return of 28%. This is substantially above my investment hurdle rate and is compelling in a time when I'm finding it difficult to find investment ideas that really excite me.

As a final note on being early, consider the price action of SNBR over the last two months:

The SNBR narrative and guidance have been equally glum since the beginning of the year, yet starting in June the share price rallied nearly 100% to $39/share on no company-specific news. Granted the share price fell hard after Q2 earnings, but it goes to show that if you wait until the good news arrives, you may have already missed out on a substantial portion of the potential gains. I am willing to accept greater volatility and discomfort in exchange for maximizing my returns.

Risks

There are two major risks to my investment thesis. The first is that SNBR is actually a poor long-term investment. I see the company's product as a differentiated technology platform, but at the end of the day they are selling mattresses, and there is a lot of competition in the mattress space. Dozens of new online mattress companies have sprung up in the last 5-10 years, and the high industry gross margins will likely continue to attract more competition. I think SNBR can stand out from the rest, but if they can't they will face compressing margins and lower sales volumes.

The second risk is that management's historical capital allocation strategy will put the company in dire straits in the short term. It is no secret that management loaded up the company's balance sheet with variable-rate debt to repurchase shares at prices well above $50. Now that debt has gotten a lot more expensive just as the company is seeing a sharp decline in cash flow. I see evidence that SNBR's relationship with their lender is strong enough to avoid a full default, but the company could face less favorable terms in the event of a debt restructuring or potentially even need to do a small equity raise.

Conclusion

The semi-famous investor Tom Russo talks about investing in companies with the " capacity to suffer. " I think this can be an edge for individual investors as well. It is simple, but not at all easy, to look foolish and accept losses in the short term. Professional money managers might get away with under-performing for a short period of time, but it is difficult to lose money over a 12-18 month time period on a "stupid" investment, even if the long-term potential remains intact. I see my edge as the ability to keep my investment theses more simple than the competition and the willingness to look dumb for longer than the competition. I've looked pretty dumb holding SNBR for the last 18 months; in another 18-24 months we will see if the suffering has been worth it.

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