Select Comfort Corp. (SCSS)

mdjuranovic (< 20) Submitted: 5/16/08 12:06 AM : Start Price: $3.00 SCSS Score: -37.13

I was waiting for SCSS to announce their earnings. In a word, they were awful in the short term – the company is now losing money and may end up being unprofitable over the entire year (on an earnings basis, I still think they’ll have positive cashflows). I hadn’t expected it to get this bad but if you read the earnings announcement you’ll see they’re doing all the right things.

The real risk here is that when mall traffic is bad like it has been in Q1 SCSS will have a horrible quarter. Their business model is driven by people coming into their stores, seeing and trying the product, and then deciding to buy. When the first part doesn’t happen everything suffers. And in economic downturns and housing starts being down, a new-fangled mattress that’s supposed to let you sleep better is the last thing on someone’s mind.

As for Sealy, Sealy doesn’t want to replicate SCSS for two reasons. One, selling a product like that requires completely new production lines and mechanisms and a sales force trained in it. Two, SCSS isn’t doing that well right now so there really isn’t too much reason to copy them. Three, and most important, a product like this would cannibalize their own sales. It would be very bad for Sealy to talk down the rigidness and non-adjustable nature of their innerspring mattresses for this new product when most likely what would happen is that they’d lose the innerspring sale and probably not gain the other sale. Then there’s the ad spending that’s needed for it and the fact that SCSS almost went bankrupt in the last downturn before it realized that it needed its own stores for the concept to be successful.

All you’re seeing here is the response to the economic environment. Granted, that might last a while and might even kill the company (though I don’t think that’s likely). But when the economy does rebound this one’s going to go through the roof. Their sales will double, they’ll easily get to well over a $1 per share in EPS, and then the market will expand the P/E that it gives these shares accordingly to at least 20x b/c it will now be a growth stock. That’s where I see $20 a share at least.

And I don’t think a bankruptcy is very likely even under some dire conditions. First, they’re cutting costs pretty significantly, to the tune of $15M per quarter. That alone should get them back in black. Second, they were actually cashflow positive in the quarter – they only have $44M in debt and their credit facility allows for a lot more than that: it’s a $100M credit facility that can be expanded to $175M. Also, they could also issue more equity, though considering that they bought back stock at levels that are 10x higher than right now that alone should be grounds for being fired.

It strikes me that these guys just had no idea what was coming and who was really buying their product. Apparently, home remodelilngs etc… were a larger part of their business than they thought. And they also didn’t think that mall traffic would go down so much. To top it off, they’re stil searching for a sure-fire way to expand their brand and I’m sure that in this economy it’s hard to know what’s working and what’s not.

I think they’ve finally realized that things are serious and they’re switching to survival mode; cutting staff, slowing store expansion and remodelings, and lowering ad spending. Which is good; I was never convinced that there were THAT many opportunities for their store locations anyway. They’ll probably look to expand brand presence via the wholesale route.

I don’t think the market is pricing in a bankruptcy; I think the market is being somewhat realistic that this is a company with no book value. All its value derives from future profits. And those are in question; the days when the company used to make $50M a year in earnings may very well have been an aberration but I doubt it very much. Even if the most they can ever manage in good economic times is $30M that means you’re getting the company at about 4x earnings now. A true Buffett play! Now, I can understand that for a lot of people this seems like a fad so they’re discounting the earnings heavily but I disagree – this is a legitimate product that is actually priced attractively for what it is and the level of comfort it provides. And it’s something that’s been selling, profitably, from well over a decade now.

I’m more afraid of a private equity shop coming in and buying out the whole thing at $5. If I had $250M around, I’d do it. You could cut out all the costs of being a public company, you could forget quick-fix advertising solutions, scale back on stores, and focus on cash generation and building out the wholesale program.

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