2023-12-27 17:04:20 ET
Summary
- SNBR's revenue growth has been driven more by price growth than volume growth, indicating it is not a high-growth company.
- The company has repositioned itself as a wellness technology company, known for its innovative Sleep Number beds.
- Despite some mixed performance metrics, there is a 30% margin of safety when valuing SNBR based on the Earnings Power Value, making it an investment opportunity.
Investment Thesis
Over the past 8 years, Sleep Number Corporation ( SNBR ) revenue grew at 11.1 % CAGR. But this was driven more by price growth than volume growth. In this context, I would not consider SNBR a high-growth company.
From a fundamental perspective, the company is an average performer. There were both plusses and minuses in the performances of the various metrics. But I believe there is more than a 30 % margin of safety even when valuing SNBR based on the Earnings Power Value. This is an investment opportunity.
Business background
SNBR is a bedding company that has repositioned itself as a wellness technology company. It is known for its innovative approach to sleep and mattress technology.
The unique point of the company lies in its Sleep Number beds. These are smart beds that employ innovative technology to respond to individual sleepers' movements to deliver a superior and responsive sleep experience.
The company's products are mainly distributed through its nationwide portfolio of retail stores. In 2022, retail store sales accounted for 86 % of the net sales with the balance of 14 % from online, phone, and other sales channels.
Over the past 12 years, the number of stores has grown with corresponding uptrends in the revenue per store and revenue per mattress. Refer to Chart 1. Comparing the 2022 values with those of 2012, I found that in 2022:
- There are 63 % more stores.
- The revenue per store is about 50% more.
- The revenue per mattress in 2023 is 77 % higher.
You may think that this is a high-growth company and value it as such. However, I will show that there are growth issues.
In assessing whether there is a sufficient margin of safety, it may be more appropriate to view it from an Earnings Power Value perspective.
Chart 1: Operating statistics (Author)
In September 2015, the company acquired BAM Labs, the leading provider of biometric sensors and sleep monitoring for data-driven health and wellness. This strengthened SNBR leadership in sleep innovation, adjustability and individualization.
As such I would analyze SNBR performance from 2016 onwards. Secondly, we are at the end of 2023. thus, I used the Sep 2023 LTM performance to represent the 2023 performance.
Operating performance
I looked at two groups of metrics to get a sense of how the company had performed over the past 8 years.
- Performance Indices for revenue, PAT, and gross profitability (gross profits / total assets). Refer to the left part of Chart 2.
- Operating profits that are broken down into revenue, fixed costs, and variable costs. Refer to the right chart in Chart 2.
Over the past 8 years, revenue grew at 11.1 % CAGR.
Despite the uptrend in revenue, PAT initially grew to a peak in 2021 but declined thereafter. The PAT in 2023 was lower than that in 2016 despite the higher revenue.
The main reason for this PAT pattern was that from 2019 to 2021, both revenue and gross profit margins grew. After that, gross profit margins declined.
- From 2019 to 2020, gross profit margins averaged 62 %.
- From 2022 to 2023, gross profit margins averaged 57 %. Apart from lower revenue, the company attributed the reduced margins to an unfavorable product mix, inflation, and operating inefficiencies due to supply chain issues.
The greater concern was the declining gross profitability since 2016. According to Professor Novy-Marx, this metric has the same power as PBV in predicting cross-section returns of stocks. The declining trend indicates increasing capital inefficiencies.
Chart 2: Operating Trends (Author)
a) Note to Performance Index chart. To plot the various metrics on one chart, I have converted the various metrics into indices. The respective index was created by dividing the various annual values by the respective 2016 values.
b) Note to Operating Profit chart. I broke down the operating profits into fixed costs and variable costs.
- Fixed cost = SGA, R&D and Depreciation & Amortization.
- Variable cost = Cost of Sales – Depreciation & Amortization.
- Contribution = Revenue – Variable Cost.
- Contribution margin = Contribution/Revenue.
In the operating profit profile of Chart 2, the gap between the revenue and the total costs (Fixed cost + Variable cost) represents the operating profit.
- The operating profits for the past 2 years had declined after peaking in 2021.
- The contribution margin has been declining since 2016.
The declining profits and operating metrics are not the signs of a high-growth company.
The other point is that over the past few years, the fixed cost is about 59 % of the total cost. This meant that revenue growth would have a much higher impact on the profits. You should not be surprised to see that when revenue declined in 2023, we saw a sharper drop in profits.
Returns
In its Form 10k, the company reported a return metric known as “adjusted return on invested capital ((ROIC))”. It quantified the return the company earns on its adjusted invested capital.
Based on this metric, the company delivered increasing returns from 12 % in 2016 to a peak of 47 % in 2022. But it dropped sharply to 18 % in 2023. Refer to Chart 3.
However, this metric is “distorted” by the share buyback. The company had an aggressive share buyback so its positive equity of USD 222 million in 2015 turned into a negative equity of USD 421 million by 2023.
Notes to Return chart.
a) ROIC was based on the metric reported in the Form 10k.
b) The Notional return assumed that there was no change in the 2015 Equity. In other words, all the money spent on share buyback was assumed to be paid out as dividends.
To washout this effect, I consider 2 other return metrics
- Return of Assets or ROA.
- Notional return on capital employed. Here I assumed that there was no share buyback. Rather all the monies spent on the buybacks were distributed as dividends. In other words, the equity was assumed to be a constant at the 2015 level. I defined the Notional return as = NOPAT / (Notional equity + Debt)
Chart 3 compares the returns for these 2 metrics with the ROIC. You can see that the ROA in 2023 was lower than that in 2016 although there were improvements for a few years before declining from 2020.
When it comes to the Notional return, it was mostly a declining trend from 2016 to 2022. Both the ROA and Notional return illustrate that there is no improvement in the returns.
I would deduce that the improvement in the ROIC did not reflect improvements in the operations. The improvement was due to financial “measures”. If the company had returned most of the earnings as dividends instead of share buybacks, we would not see improvements in ROIC in my view.
Unit sales
The company provided statistics on the average selling price per mattress. Based on this, I deduced the number of mattresses sold and the cost of sales per mattress. Refer to Chart 4. Over the past 8 years,
- There was hardly any growth in the number of mattresses sold. Revenue grew due to an increase in selling price and not volume growth.
- While the average selling price and average cost of sales grew at different rates, there was growth in the dollar gross profit per mattress.
Chart 4: Mattress statistics (Author)
What are the key takeaways from the above analysis?
- Total assets over the past 8 years grew at 11.2 % CAGR. However gross profits did not grow proportionately, leading to a decline in gross profitability.
- After-tax operating profit did not grow proportionately leading to a decline in ROA.
In valuing SNBR, it may be more appropriate to base it on the Earnings Power Value that ignores growth.
Nevertheless, I would like to applaud the company for delivering the 11.1 % CAGR revenue growth. This is about double the bedding industry growth rate:
“…According to International Sleep Products Association…the industry has grown by approximately 5% annually over the last 20 years, including 5% annually, on average, over the past five years…” 2022 Form 10k.
Reinvestments
Growth needs to be funded and one metric for this is the Reinvestment rate. This is defined as:
Reinvestment = Net CAPEX + Acquisitions – Depreciation & Amortization + Net Changes in Working Capital
Reinvestment rate = Reinvestment / after-tax EBIT.
Over the past 8 years, the company incurred negative USD 66 million on Reinvestment. The negative arose because the amount spent on CAPEX and Acquisitions was less than the Depreciation & Amortization incurred.
One way to interpret the negative Reinvestment is that SNBR has a business model that does not require significant investments (relative to the Depreciation) to grow revenue.
Think of Warren Buffett’s Sees’ Candies. This is an example of a company that required little additional capital to grow the business.
Financial position
I would rate SNBR's financial position as average based on the following:
- It has a 183 % Debt Capital ratio as of the end of Sep 2023. As per the Damodaran Jan 2023 dataset , the Debt Capital ratio for the furniture/home furnishing sector was 36 %. It was only 13% for the household products sector.
- As of the end of Sep 2023, it had USD 1 million in cash. This was about 0.1 % of its total assets.
- It did not have a good capital allocation plan as shown in Table 1. The cash flow from operations was barely sufficient to fund share buybacks. It had to raise additional Debt for its CAPEX and acquisitions.
Table 1: Source and Uses of Funds 2016 to 2023 (Author)
But it had some positive points as well:
- Over the past 8 years, it generated positive cash flow from operations every year. In total, it generated USD 1.36 billion cash flow from operations compared to the total PAT of USD 0.65 billion. This is an excellent cash conversion ratio.
- I had earlier mentioned the Notional return on capital. Over the past 8 years, this averaged 17 % compared to the current cost of capital of 6 %. This indicated that it was able to create shareholders’ value.
Valuation
I considered 3 Scenarios in my valuation.
Scenario 1 . This is the Earnings Power Value case assuming that there is no growth. I assumed that the 2023 revenue represented the future base revenue.
Scenario 2. This is an optimistic scenario. I assumed that the company's growth rate was half of that of its cost of funds. I also assumed that the 2023 revenue represented the future base revenue.
Scenario 3. For this Earnings Power Value case, I assumed that the past 3 years' average revenue represented the future base revenue.
Given the volatile PAT and margins, it may be more appropriate to look at the average margins over the past 8 years when valuing SNBR. This will ensure that we do not have a misleading picture by using the value of a particular year. For all the Scenarios, I assumed the following key parameters:
- The contribution margin was based on the 2016 to 2023 average values.
- Capital turnover (Revenue / TCE) was based on the 2016 to 2023 average ratios
The results of the valuations are shown in Table 2.
Table 2: Summary of valuation (Author)
There is no margin of safety based on Scenario 1. But there is more than a 30% margin of safety each under Scenarios 2 and 3.
The margin of safety depends on your perspective of growth and the base revenue. There are margins of safety under the following combinations:
- 2023 revenue with a low steady growth rate of 3%.
- Average 2021 to 2023 revenue with no growth.
Both combinations seem reasonable. As such I see SNBR as an investment opportunity.
Single-stage valuation model
I valued SNBR using the Free Cash Flow to the Firm (FCFF) model as represented by:
Value of firm = FCFF X (1+g) / (WACC - g).
FCFF = EBIT(1-t) X (1-Reinvestment rate).
My valuation model is based on the operating profit model shown in Chart 2. The formulae and other assumptions used are shown in the sample calculation as per Table 3.
Table 3: Sample calculation (Author)
Notes to Table 3:
- item i. TCE = Equity + Debt - Cash.
- item k. The Reinvestment rate was derived from the fundamental growth equation of growth = Return X Reinvestment rate.
- item q. This is to account for the situation where the current TCE is more than the required under the model.
- item v. Value of equity = Value of the firm + non-operating assets - Minority Interests - Debt
The WACC used in the model was derived based on the first page results of the Google search for the term “SNBR WACC”. Refer to Table 4.
Table 4: WACC (Various)
Risks and limitations
The key valuation risk here is the low WACC of 6.2 %.
We are currently facing some geopolitical tensions with Ukraine and Gaza. We still have a high FED rate. I worry about the low WACC. The main reason for the low WACC is the high Debt.
In my other articles over the past few months, the WACC ranged from about 8 % to 10 %.
If the WACC increases to 10 %, the value under Scenario 3 is reduced from USD 58 per share to USD 24 per share. In mitigation, even at USD 24 per share, there is still more than a 30% margin of safety.
Next, looking at Scenarios 1 and 3, you can deduce that the valuation is very sensitive to the base revenue. The base revenue in Scenario 3 is just about 7 % higher than that of Scenario 1. Yet the intrinsic value increased by more than 4-fold.
A small error in the base revenue will have a big impact on the margin of safety. One way to mitigate this is to seek a higher margin of safety. This higher margin requirement is easily met for Scenario 3.
Conclusion
There were mixed results from the fundamental analysis of SNBR.
- While it managed to achieve 11.1 % CAGR in revenue, this was more price-driven than volume-driven.
- While its ROA and Notional return are trending down, its average returns were greater than the cost of funds. This implies that shareholders’ value was created.
- While the company touted branding and technology innovation, there were not many improvements in the operating efficiencies.
- While it has a high Debt Equity level, it was able to generate positive cash flow from operations yearly. It also had a good cash flow from operations to PAT conversion ratio.
- It requires little additional capital to grow the business.
Given the above, I would rate SNBR as a company with "average fundamentals" rather than a “wonderful” company.
The positive side is that there is a strong margin of safety from both an Earnings Power Value perspective as well as assuming a 3% growth rate.
It is an investment opportunity closer to the “cigar-butt” side than the "wonderful company at fair price” side. However, it is still an investment opportunity for the long-term value investor.
I am a long-term value investor and my analysis and valuation are based on this perspective. This is not an analysis for those hoping to make money over the next quarter or so.
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Sleep Number: Not A High Growth Company, But An Investment Opportunity