deteetarkan/iStock via Getty Images

deteetarkan/iStock via Getty Images

Sleep Number (NASDAQ:SNBR ) is a well-managed, quality company. The recent price correction offers investors a 200-300% potential return in a two/three years' time frame with limited downside risks.

Mattress making has a long history. A few companies had been in existence for hundreds of years - e.g., both Simmons and Sealy were founded in the late 1800s and continue to make and market their mattresses under the same brand names today.

The US mattress market is a $30-$40bn market in retail, growing at 5-6% annually. Sleep Number is the third-largest company with an 8% market share. The top players are Tempur Sealy International, Inc. (TPX) and Serta-Simmons - each has a 20-30% market share.

Market Shares (Purple Investor Presentation)

Market Shares (Purple Investor Presentation)

Innovation in mattresses is slow. The first-generation mattress appeared in the late 1800s, made with innersprings, which later evolved into pocket coils. Coil mattresses are still widely in use today, estimated at 40% as of 2020. After almost 200 years, in the early 1990s, Tempur-Pedic introduced the memory form mattress, a technology originally created for NASA in the 70s. In today's market, these two materials are still the majority of mattresses are made of. This means that the industry is quite stable and unlikely to be disrupted by some revolutionary technologies, like in many other industries.

Mattress Type (Purple Investor Presentation)

Mattress Type (Purple Investor Presentation)

The memory foam material spurred further innovation. In 2010, Casper Sleep (privatized in 2021) introduced the bed-in-a-box. The invention greatly reduced warehousing and delivery costs and made possible a low-cost, e-commerce business model. A bed-in-a-box company can run without much asset investments. It outsources manufacturing to overseas or domestic mattress plants and focuses on online marketing. It's estimated that close to 200 such e-commerce mattress companies were in operation at one time in the low-end segment. The intensified competition has greatly pushed up operating expenses, particularly the online ad costs. Making money becomes more and more difficult. Casper, the pioneer of this business model and the largest in scale, was acquired last year by a private equity firm. Until the time it was acquired, it has not made any profit.

The high-end mattress segment accounts for 20-30% of unit sales in the US, but over 50% in value. This segment has a much better business environment as barriers to entry are much higher. One of the key barriers is simply the fact that consumers are unlikely to spend thousands of dollars on a mattress without a chance to try it out or talk to the salesperson about its premium features. Most e-commerce companies can't afford retail stores. Their low price tags also prevent them from selling through third-party retailers (e.g., furniture stores or specialty mattress stores). Over the past five years, we are seeing the premium segment grow faster than the low-ends. We expect this trend to continue.

Mattress Market Share (Purple Investor Presentation)

Mattress Market Share (Purple Investor Presentation)

As physical stores are needed to sell premium products, a manufacturer, in general, has two go-to-market strategies: 1) wholesale to retailers, which includes department stores, furniture stores, and mattress specialty stores like Mattress Firm (the wholesale model), or 2) sell directly to consumers through company-owned stores (the DTC model). The wholesale model can scale up quickly, as long as manufacturing capacity can catch up. But due to a third party in between, it won't be able to establish a direct connection with its customers.

The DTC and wholesale models also have different margin profiles. In the wholesale business, the manufacturer makes about 30-40% profit and gives 30-40% to the retailers. They, however, can save on marketing expenses, as that would be a joint effort between the manufacturer and retailers. The retailers can generally spread marketing expenses across a much wider range of products, and therefore are more efficient in terms of the use of marketing dollars. While DTC model gives the manufacturer a higher gross margin (~60%), but it also needs to spend significant marketing dollars on customer acquisitions. This is a prohibitive barrier for companies at smaller scales. Therefore, most high-end mattress firms would not go this route until it has achieved a larger scale.

SNBR is unique in that it's a pure play of DTC model. Almost all revenues are generated through its retail network of 648 stores as of today. It's the largest in terms of manufacturer-owned retail stores in the US. Digital sales only increased recently due to COVID, accounting for about 13%. SNBR greatly benefits from having its own retailer store network, in my opinion.

First, there is the direct relationship with customers: The DTC model enables the company to establish a direct relationship with its customers. Its Smart Sleeper community has 2.1 million members today and its award-winning InnerCircle Rewards program drives acquisition of new customers through referral and greater retention with repeat purchases.

Second, there is better cash management: Being close to the customers has enabled the company to better manage its working capital. Sleep Number is the only mattress firm that manufactures after an order is received (the lead time is about 1-2 weeks). This greatly reduced its working capital tied in inventory.

Third, it's better positioned in the value chain: Operating a large retail network gives the company great negotiation power with its upstream suppliers. As a result, the company can pay raw materials on terms. Other the other end, SNBR gets paid by its customers right away. This allows the company to run on negative working capital, meaning that as the company expands, it not only does not need to invest in working capital, it can actually generate more cash out of the business.

Fourth is the long-term margin leverage from SG&A expenses: As the company's store network expands, it will benefit from leverage on SG&A expense, the largest portion of its expenses, ~50% of sales. This is because the general administration expenses and corporate marketing expenses could grow slower than the revenue growth. Over the past four years, SG&A expense declined from 55.7% to 51.5%, about a 1% improvement per year.

SNBR not only operates just-in-time manufacturing and inventory, its retail stores are also highly efficient. On a sales/square foot basis, SNBR is ranked the fourth top retailer in the US - right after Apple (AAPL), Tiffany, and Lululemon (LULU).

Average sales per store (000's)

Average square footage per store open

Return on equity or invested capital (ROE or ROIC) is probably the better measures of a company's operational efficiency. On an ROIC basis, the company has improved continuously, at 27.6% in 2021. ROE is not applicable due to the company's negative equity. The negative equity, however, is not a bad thing in the SNBR case. It simply resulted from too many shares being bought back by the company.

Some investors have commented that the company's low cash balance, high bank loan, and negative equity look scary. But if you understand the reasons behind them, those are actually signs of a rarely found, great-run company.

As explained earlier, the company's negative working capital indicates that it does not require much cash in daily operations. And dealing directly with mass retail customers gives the company a better feel for market dynamics. SNBR can generally project its cash requirement ahead of the time. Keeping a minimum cash on the balance sheet can maximize the utilization of every dollar and generate the maximum value for shareholders. To be safe, the company does have a revolving credit line of $825mn up to $1.2bn in case of emergency. For the last two years, interest rates on its bank loan are merely 1.5-1.6%. Using such low-cost financial leverage further increases shareholder value.

Each year, the company deployed the maximum amount of cash for share repurchases. As shown in the following table, SNBR spent more than twice its earnings and more than 100% of its cash from operations in share buybacks over the past five years, resulting a negative book value starting in 2018.

Like many home goods businesses, SNBR benefited from COVID as sales grew 17.7% to $2,184.9mn in 2021 from 2020, and grew 28.6% from 2019. Net income increased 10.5% to $153.7mn from 2020, and grew 87.9% from 2019. However, the share price peaked in March 2021 and has declined more than 67% over the past year to ~$50 today, the lowest it's been in 18 months. Such a deep correction is due to the following reasons:

The mattress business is defensive. The company grew sales in 18 of the last 20 years and only declined 9% during the financial crisis in 2008 and 2009. With the failing of low-end players, this premium mattress company is expected to perform better than the industry's 5-6% over the next 3-5 years. Despite a temporary slowdown, SNBR should continue to grow in the near and mid-long term. The company has guided low double-digit growth for 2022.

SNBR is well managed, with a differentiated DTC business model. The company is able to leverage financially with low risk (by using suppliers and banks' money) to improve investment returns (27% ROIC). It also committed to significant and impactful share buybacks, the most efficient way to reward shareholders.

Over the last five years, SNBR's revenue increased a modest 11% per year. However, its EPS grew 41% CAGR (implying its stock could increase that much if there's no change in the P/E ratio). How is that possible? Besides some margin expansion, this was achieved mainly through the company's massive share repurchase program. And the good news is that with the share count and share price both at very low levels now, the impact on EPS growth is even greater than before.

Mathematically, EPS growth is the change in net income multiplied by the change in share counts, as depicted in the following formula:

EPS growth = (Net Income1/Share Count1)/ (Net Income0/Share Count0)-1

= (Net Income1/Net Income0)*(Share Count0)/(Share Count1)-1

Because both share count and price are very low, the percentage change from share count will be much more significant than it had been. Specifically, outstanding shares today were 22mn, with the 2021 average count at about 24mn. The company has a $400mn unused quota for share repurchase; if it buys at the current level, $400mn can reduce the share count by 8mn. The growth from share count change is 50% (24/16 - 1). In two years, 16mn can be removed from the market, and growth from this alone is 200% (24/8 - 1).

Obviously, this hypothetical exercise won't be realized since the share price won't stay at $50 for two years. But it shows that the longer it stays at low levels, the stronger it will be for the company's fundamentals. I'm sure the company is very busy buying shares from the market right now.

More realistically, in two years' time, assuming the company spent $800mn for buybacks (operating cash flow of $300-400mn a year plus some borrowing) and purchased share at $80/sh (implying a share price range from $50 to $120/sh), that would cancel 10mn shares from the current 24mn, giving EPS a boost of 70% (24/14-1) growth. In two years' time, supply chain issue should have been resolved and if no other disruptive events are happening, the company should have grown the top line by at least 20%. The bottom line in normal business conditions should have grown by 40-50% due to margin improvement. Along with the 70% growth from share buybacks, EPS growth should be at least doubled from the 2021 level.

As shown above, the current P/E ratio at 8.4x is almost its historical low, except for a brief period in March 2020. The shares had been generally trading at 15-20x in normal times and close to 30x in optimistic times. Therefore, it's reasonable to expect that if in two years the business condition returns to normal, its valuation could also recover to 15-20x. That's another double from the current level.

Sleep Number, a high-quality company, has offered investors a great opportunity thanks to industry-wide, but temporary, distress. In two years' time, when such distress is over and business conditions return to normal, the shares could potentially increase to $200, quadrupling from the current ~$50 level. Even if another unforeseeable risk happened in two years, SNBR's defensive business, close-to-customers business model, strong cash generation, excellent management team, and, more importantly, deep valuation provide investors with an ample margin of safety. I'm a strong buyer at this level.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of SNBR either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.