Sleep Number: Not A High Growth Stock, But An Investment Opportunity

News

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.

Over the past 8 years, Sleep Number Corporation (NASDAQ: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.

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:

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.

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.

I looked at two groups of metrics to get a sense of how the company had performed over the past 8 years.

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.

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.

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.

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 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.

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.

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

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.

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,

What are the key takeaways from the above analysis?

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.

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.

I would rate SNBR’s financial position as average based on the following:

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:

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:

Both combinations seem reasonable. As such I see SNBR as an investment opportunity.

I valued SNBR using the Free Cash Flow to the Firm (FCFF) model as represented by:

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.

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.

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.

There were mixed results from the fundamental analysis of SNBR.

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.

Leave a Reply