Sleeping Easy at Night with Tempur-Pedic International?
C. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Wild changes in sentiment in the stock market are nothing new, but the recent moves in Tempur-Pedic International (NYSE: TPX) have been extraordinary. In mid-April the company was making new highs at $87/share, today we stand at just over $21.50.
The slide began in mid-April after Tempur-Pedic reported a record Q1 but it was the announcement in early June that did most of the damage. The company guided much lower for the full year and reported Q2 would be particularly bad due to "changes in the competitive environment" and "aggressive marketing and promotion."
The company projected Q2 sales to be 3-5% below the same quarter last year and diluted EPS down 50% to around $0.90. For a company that has grown quarterly earnings at a 12% CAGR for the last 12 quarters this was a big surprise. FY12 guidance was equally dramatic. In the first quarter the company guided for $1.60-1.65 billion for sales and $3.80-3.95 for EPS. New guidance is for $1.43 billion for sales and $2.70 for EPS. Relative to last year this a basically flat top line and EPS down around 22%. For a company that bounced back fast from the downturn in '08/'09 -- sales are up 70% since then -- and produced growing margins, this setback has devastated investor confidence.
The question then is: can we exploit this pessimism? At least in the short term I would be wary. Tempur-Pedic was an extremely popular momentum stock bouncing from $4 in early 2009 to the $85 mentioned earlier. Now that a significant portion of the current holders of the stock are underwater, we can expect them to postpone the realization of this loss as long as possible. This may act like a ceiling on the price for quite a long time as ownership changes from momentum to value investors. What is more, the quarter is not over so things could get worse with the "changes in the competitive environment" continuing to obstruct operating performance.
If we take a longer view, we can put the current pessimism in the proper "fundamental" context. The big changes in price can be put in context. Tempur-Pedic achieved massive growth over the past two years. Clearly, people do not need to purchase mattresses regularly so a slow-down at some point was inevitable. Investors and analysts got taken away by the momentum in the sector. Optimism is understandable -- consumers were bringing purchases forward as they switched to "memory-foam type" mattresses. In retrospect, however, it is clear that there was no way Tempur-Pedic could ever meet the constant heightening of investor expectations. Therefore, the recent guidance of the company, whilst surprising, doesn't really suggest that the fundamentals of the business have substantially altered. In other words, people are still going to need mattresses and the recent upset is more due to investors being disappointed and competitors picking up their game.
Tempur-Pedic's performance over the past few years has certainly been outstanding. It has achieved the rare feat of managing to increase both margins and asset turns simultaneously. In particular, the company appears to have totally overhauled its use of working capital resulting in huge growth of ROE and improvement in the cash conversion cycle. Improvement in how assets are used stands alone as an impressive achievement unaffected by what others are doing.
However, investors should be more skeptical of the improvement in margins. Margins grew with the increase in sales after 2009 and Tempur-Pedic's margins have been consistently higher than competitors (defined as Sealy (NYSE: ZZ), Select Comfort (NASDAQ: SCSS), and Leggett & Platt (NYSE: LEG)). This seems to be due to a combination of greater "brand" value and more efficient SGA operations. Competitors are now bringing out rival products and the mere fact that Tempur-Pedic achieved an extraordinary 45% return on net operating assets last year highlights that it is now a target for competitors. The new guidance for the full year should be seen in this context. Competitors are making inroads on Tempur-Pedic's incumbency and it isn't possible to make such extraordinary returns in a persistent fashion in such a competitive industry.
So where does this leave the investor? Tempur-Pedic is currently trading at a significant discount to competitors -- 8x the new FY/12 earnings guidance against forward multiples of 12.7x and 10.9x for Leggett & Platt and Select Comfort, respectively. To me, this seems overly pessimistic. At 8x investors aren't paying anything for growth and it seems Tempur-Pedic will now be the industry laggard.
This doesn't make much sense. First, Tempur-Pedic has some advantage in how it uses assets and in margins. Some of the advantage in margins will prove to be cyclical but some is secular. The advantage in how it uses capital is clearly unaltered. Second, there is presumably potential for further growth in international markets and it seems unlikely that, given the level of sales since 2009 and various assumptions about average selling prices, the US market is totally penetrated (the company highlights it could, and plans to, move into another 1000+ stores in the US) or that people will stop buying mattresses.
The problem for Tempur-Pedic has not been any secular change but a temporary slowdown in the "mattress cycle," but the market appears to have discounted the stock to a level that infers there has been some secular change. These situations are rare but I believe, in this case, we should not forget that the people who bought on the way up were expecting something quite different from what has transpired. This has created a unique opportunity.
Potential investors should certainly take the challenges that Tempur-Pedic will face going forward seriously. It is entering a new environment where competitors are going to press its incumbency harder than ever. The current price will look worse if the company experiences further competitive pressure. However, we should remember that Tempur-Pedic is coming off an extraordinary period of high returns for itself and a period of heightened activity within the industry in general. The current price implies that Tempur-Pedic will now lag, a suggestion which seems unfounded.
The capital requirements for the industry are very low relative to the huge cash flows that Tempur-Pedic is throwing off. The company has returned cash to investors through buybacks (the share count is down 34% since the IPO) and is continuing to do. The combination of these buybacks and the normalization of industry pressures should lead investors to shake off the pessimism surrounding the company. The weight of underwater momentum investors on the share price is significant but the fundamental strength of Tempur-Pedic suggests that this will eventually dissipate.
valuhunteruk has no positions in the stocks mentioned above. The Motley Fool owns shares of Tempur-Pedic International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
