Going short SNBR. Consensus straight lining peak COVID margins which should start to revert within 6-9 months. 35% downside risk.
What is Sleepnumber? Well you have probably seen the commercials for it, it is an adjustable mattress that through a remote control can inflate or deflate air pockets in the core of the bed to match a user's firmness preferences. Some models can also adjust individual sides for couples with different preferences. While the company does sell other sleep items such as pillows and bedding products, the bulk of sales are from their mattresses. Is it a gimmick? Maybe. Is the stock headed lower? More likely. The air mattress wave was started by a company called Comfortaire in 1980 who employed a man named Bob Walker. Bob Walker left Comfortaire in 1987 to form his own adjustable airbed business with his wife JoAnn which they incorporated as Select Comfort. Select Comfort originally went public in 1999, but in 2013 the company acquired Comfortaire and after a few years changed its name to Sleep Number in November 2017. The company has no wholesale distribution channel, selling only through their 600+ owned retail stores and their online store. The DTC only strategy is rare in mattresses, but has worked for SNBR so far. The company has already announced 50 net new openings for this year with the expectation that unit growth will continue to be a top strategy for management. Gross margins for the company are at the top end of the mattresses retailers, clocking in between 60-62% nearly every year for the past 10 years due to the DTC strategy and its product being an air bed consisting of fewer materials. Operating margins have been between 6-7% every year since 2015 until the Covid demand ramp. After the initial Covid panic selloff, the stock took off like a rocket reaching a peak near $140 and currently settling right now at about $110. In 2020 the gross margins of the company stayed consistent coming in at 62.3%, however the company saw significant SG&A leverage, leading to a 336 bps expansion on the operating margin line to a new high of 10% creating record EPS of $4.90. We think that in late 2021 and into early 2022 we will see essential SG&A costs return, demand normalize, and competition intensify driving margins down and EPS well below consensus.
Why we think things will change:
Revenue Slowdown. In 2017 Tempur Sealy and Mattress Firm had their channel dispute where Tempur Sealy thought Mattress Firm was trying to go under their nose and sell their products under the brand name "Therapedic" so they sued Mattress Firm and cancelled the contract. This likely presented some near term share opportunity for SNBR as the company continued its store openings and comp growth. However, in summer 2019 Mattress Firm and TPX were able to put this spat behind them and sign a new deal, a risk for SNBR share. Then we had COVID in 2020 and the home furnishings boom. The industry growth rate roughly tripled and SNBR went from a mid to high single digit growth rate, to LTM growth in the area of 30% vs 2019 levels. Great, but clearly outsized near term demand so what's next? While the average replacement cycle for mattress has fallen from about 10 years to about 8 years, the fact is that it still takes 8 years on average for a consumer to replace a mattress. In addition to the replacement cycle pressures, SNBR is starting to face increased competition aside from just TPX. Throughout the past 5 or so years there has been an increase in "polarization" within the mattress industry to either lower end mattresses or premium offerings. Mid-price point mattresses of $1,000 are losing unit volume and revenues while the cheap sub-$500 dollar Amazon mattresses are increasing in units sold and the higher level mattresses of $2,000 and above are gaining a larger share of units sold and revenue. As this separation continues competition is intensifying in the premium category (from companies like PRPL) where SNBR positions itself. We think that following this demand ramp in a long replacement cycle industry we will hit a demand air pocket over the next 12 months coupled with increased competition leading to in FY2022 and beyond SNBR revenues will fall back into growth around or below the industry growth at about 3-4% per year.
Source: PRPL Company Presentation
SG&A Returns. Since 2015 SNBR has consistently grown total SG&A dollars between HSD and LDD every year EXCEPT 2020. As a percentage of revenue SNBR has clocked in an SG&A margin every year between 51-53%, except this year when it came in at 48.9% of revenue. The SNBR story is the same as every other retailer for why the SG&A dollars came out: closed stores and furloughed employees coupled with lower digital ad rates. The home furnishings (and SNBR) category benefitted from elevated demand despite the lack of demand creation spending industry wide. The problem now is ad rates have returned to normal levels and the stores are opening again. As people shop in stores again, SNBR has to bring back those employees to staff its stores, as its retail channel is its main sales channel. In addition we are seeing wage inflation all across the country which SNBR will inevitably observe on the labor line. SNBR has an online business which has grown in COVID but growing this channel will mean spending in marketing and continuing to invest in the tech infrastructure for the platform as competitors will spend up as well. No matter what way you slice it, SNBR will have to see SG&A deleverage to try to preserve share which ultimately will degrade operating margins.
Consensus has decided SNBR margins are permanently elevated, so it is modeling levels near peak into perpetuity. Street revenue estimates are roughly in line with what we are modeling, between 3-4% per year, but we think given how the industry will normalize in the coming year+, it’s ambitious to get that top line growth without margin reversion. We see TAIL margins trending about 300bps below the street. The timing of that decline may not be instant and linear, as we think the company and the industry still has a couple quarters to report of elevated revenue and margins riding the covid demand wave. So perhaps we are a bit early on the short call. However, we think the multi-quarter and multi-year setup warrants adding this idea at these levels. This year the company has guided to at least $6.50 in earnings, the street is at $6.75 and we are slightly ahead at $6.84. We think Q4 of this year is when these issues will start to present themselves and we expect FY2022 and FY2023 to materially underperform relative to consensus. We are modeling EPS about 25% below the street for the next couple years, with FY2022 of 5.37 vs the street at $7.09 and in FY2023 EPS of 5.81 vs the street at $7.74. With numbers disappointing we think the multiple trends down towards the low teens, which would mean a stock down in the low to mid 70s, or about 35% downside from the current levels.
We’re moving MUDS (Topps SPAC Ticker) higher on our Long Bias list. We added this name a couple months ago (Link: CLICK HERE) noting we liked the TAIL bull case, but several elements of the TREND setup (like no quarterly fundamentals) kept this lower on the long bias list. A few things have now changed. First is the stock price, it’s about 25% below the highs from back around the peak of NFT mania, presenting a much better value on the long-term optionality here. The stock is still well above the $10 SPAC price at $12.36 so the market seems to still be in support of the Topps merger, which currently looks expected for August. NFT marketplaces are still seeing solid growth, despite the dropoff in buzz around the space. A second change is that Topps reported 1Q results a couple weeks back. It was our first look at quarterly data, and unsurprisingly results were strong. Sales were up 55%, and EBITDA was up nearly 180%. Management also upwardly revised guidance for 2021 to sales of $740mm to $760mm and EBITDA of $130mm to $140mm, both ahead of our expectations. Near term trends are solid, and 2021 is tracking well in management’s view. The last notable change is the NCAA NIL (Name, Image, Likeness) decision, where college athletes can now monetize themselves in certain content and promotional channels. It’s a massive untapped segment of athletes, so the rule change is bullish for Topps’ Tail business opportunities in both physical and digital collectibles. We’ve already seen some NFTs drop for NCAA football players. Topps has yet to announce anything, but it has to be one of the leading brands to partner with players on collectible content. Topps could be making some of the first cards/NFTs for the respective athlete, which should they become stars would have huge secondary market value, a secondary market that Topps can actually participate in with new digital content and blockchain technology. We still need some more data to fully assess the Topps trend setup, but recent data points get us more bullish on the long term opportunity and have reduced the near term downside risk.
