Will You Sleep Well With This Mattress Retailer?

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Founded in 1986 in Houston, Texas, Mattress Firm (NASDAQ: MFRM) is one of the nation’s leading specialty bedding retailers, offering a broad selection of both traditional and specialty mattresses from leading manufacturers, including Sealy, Serta, Simmons, Stearns & Foster and Tempur-Pedic.

Business Quality

Mattress Firm is the market leader in specialty bedding retailing, operating 1,159 stores (including franchise locations) primarily under the Mattress Firm name, in 78 markets across 28 states, after the acquisition of Mattress Giant acquisition in May 2012. According to an internal study completed by Mattress Firm in October 2012, more than 90% of its company operated stores are located in markets in which it had the number one market share position. Mattress Firm's extensive retail network allowed it to enjoy economies of scale and scope through bulk purchasing discounts, exclusive products and stronger advertising support from vendors.

Mattress Firm also benefits from favorable industry dynamics. According to the International Sleep Products Association's October 2012 forecast, U.S. wholesale bedding sales are expected to grow by approximately 6.3% in 2013. Pent-up demand for mattresses and related products since the last recession will continue to drive future growth, as 2011 wholesale mattress and foundation unit volume at 34.9 million units are still approximately 20% below the 2005 peak at 43.7 million units. In addition, consumers have shown an increasing willingness to spend more money on mattresses and related products of higher quality, with the average unit price for a mattress at wholesale increasing by 50% from $119 in 2000 to $182.0 in 2011.

Notwithstanding the cyclicality of the industry, Mattress Firm's business can be considered as relatively 'resilient' for a couple of reasons. Firstly, approximately 80% of mattress sales are replacement in nature, driven by technological improvements and health & comfort reasons. Secondly, online retailers are unable to gain significant headway in the area of mattress sales, as a mattess is a long term investment with a useful life typically exceeding a decade, where consumers will prefer to 'experience' themselves at brick & mortar stores. Lastly, the bedding industry faces limited competition from imports due to the high shipping costs, and import duties.

Valuation and Financial Analysis

Mattress Firm currently trades at a trailing-12-month P/E of 18.2, and a trailing-12-month EV/EBITDA of 12.6. It achieved a trailing-12-month ROE of 38.3%. Due to the fall in demand for bedding products against the backdrop of a weak housing market, its gross margin fell from 41% in fiscal 2009 to 35% in fiscal 2010.

The housing market has seen a recovery since then, and Mattress Firm achieved gross margins of 39.6% and 39.9% for fiscal 2012 and the trailing-12-month period ended October 2012. Mattress Firm also delivered a 42% year-on-year growth in sales for fiscal 2012, driven by an increasing mix of sales of higher-priced specialty mattresses. It also delivered positive free cash flow for three consecutive years from fiscal 2010 to fiscal 2012, despite a loss in 2010. Mattress Firm is highly geared with a gross debt-to-equity ratio of 90% and a net gearing of 86%.

Competitor/Peer Analysis

According to its 2011 10-K, Mattress Firm's store competitors include regional and local specialty retailers of bedding, national and regional chains of retail furniture stores carrying bedding, department store chains with bedding departments. Mattress Firm is the only multi-brand, public mattress specialty retailer, so listed furniture retailers Haverty Furniture (NYSE: HVT) and Ethan Allen Interiors (NYSE: ETH) are highlighted here for peer comparison. Haverty) is a specialty retailer of residential furniture and accessories and also offers the bedding product lines of Sealy, Serta and Tempur-Pedic. Ethan Allen is a manufacturer and retailer of home furnishings and accessories and operates in both retail and wholesale segments.

All three companies including Mattress Firm are trading at trailing-12-month P/Es of between 15-18, and Mattress Firm is also trading at similar EV/EBITDA levels as Ethan Allen at 11-12 times EV/EBITDA. The market values Haverty Furniture at eight times EV/EBITDA, as its trailing-12-month ROA at 6.4% is inferior to that of Mattress Firm and Ethan Allen; Mattress Firm and Ethan Allen delivered trailing-12-month ROAs of 7.9% and 9.0% respectively.

Haverty Furniture and Ehtan Allen both sport a 1% dividend yield with significantly less leverage than Mattress Firm, with gross debt-to-equity ratios of 5% and 48% respectively. Macy's (NYSE: M), a department store chain with bedding departments, trades at a a trailing twelve months P/E of 12.2 and a trailing twelve months EV/EBITDA of 5.9. Lower valuations are reflective of a lower trailing-12-month ROA of 6.1% and a higher gearing of 124%.

Investment Risks

Mattress Firm plans to grow to 1,450 stores in 2015, through the opening of new stores in existing and surrounding markets, with 40% of growth coming from new markets. It may not be able to execute its store growth plans successfully, as it faces challenges in the following three areas: finding favorable locations for new stores, advertising of stores in a cost-efficient manner and achieving operating results in new stores at the same level as its current stores in the vicinity.

Mattress Firm's sales are heavily dependent on consumer discretionary spending and the strength of the housing market. Same store sales declined by approximately 23% during the housing crisis in 2008.

Mattress Firm faces significant supplier concentration risk. Sealy, Simmons and Tempur-Pedic, the primary suppliers of branded mattresses for Mattress Firm accounted for 73% of its mattress product costs for fiscal 2011; while Corsicana, a primary supplier of its private label mattresses, accounted for 14% of its mattress product costs for fiscal 2011.

Mattress Firm is unlikely to pay dividends or buy back shares in the near term. It currently does not have a share repurchase program in place; and its 2007 Senior Credit Facility alsoplaced restrictions on the payment of dividends.

Conclusion

Mattress Firm's valuations are comparable with furniture retailers like Haverty Furniture and Ehtan Allen, but do not provide a compelling case for investment. Current valuations do not offer a sufficient margin of safety to compensate investors for the financial risks associated with its high gearing and the inherent cyclicality of the industry.


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