Tempur Sealy: Long-Term Compounder Trading At A 9% FCF Yield (NYSE:TPX)

Investment thesis

Our current investment thesis is:

• TPX is a high-attractive company with continued success ahead in our view. The company’s growth is extremely good for a mature business, as are its margins, significantly outperforming its directly comparable peers. This is attributable to its market-leading brands and global presence, with a compelling value proposition.
• The company is attempting to acquire Mattress Firm, which is accretive on a valuation and NIM basis. We believe TPX is a far superior owner strategically than its current one, suggesting the scope for synergies and strategic improvements is high.
• TPX is facing near-term headwinds that will be painful, but we see this as a patient pick with the opportunity to pop if the acquisition is completed. We are not for attempting to “pick the bottom” and at an FCF yield of 9%, investors are winning today.

Company description

Tempur Sealy International, Inc. (NYSE:TPX) is a leading manufacturer and distributor of bedding products worldwide. The company provides mattresses, adjustable bases, pillows, and other sleep-related accessories under renowned brands such as Tempur, Tempur-Pedic, Sealy, and Stearns & Foster.

Share price

TPX’s share price performance has been exceptional, returning over 290% to shareholders and significantly outperforming the wider market. This has been driven by strong financial development and improving shareholder returns.

Financial analysis

Presented above are TPX’s financial results.

Revenue & Commercial Factors

TPX’s revenue has grown well for a mature business, with a CAGR of 8% during the last decade.

Business Model

TPX offers a wide range of products catering to various customer needs and price points. From memory foam mattresses to hybrid designs, it covers a spectrum of preferences. This diversity allows it to appeal to a broader customer base, enhancing its market reach and brand strength.

TPX invests heavily in R&D. Its focus on innovative sleep technologies, such as memory foam and hybrid constructions, ensures that its products are at the forefront of the industry. TPX’s products are renowned for their quality and durability. Customers appreciate the long lifespan of their mattresses and thus consider it an investment, which is an important psychological differentiation from many of its peers.

TPX’s brands, including Tempur-Pedic, Sealy, and Stearns & Foster, are well-established and easily considered global leaders. Strong brand recognition has built customer trust, both from existing and potential individuals.

TPX has a robust retail presence, including company-owned stores, third-party retailers, and an online platform. This omnichannel approach, with the flexibility/reach of third-party retailers, allows customers to experience its products in physical stores globally while providing the convenience of online shopping and a luxury experience. The carefully curated nature of its go-to-market strategy has been critical to the development of its brands and is a major reason for its success.

TPX has strategically expanded its presence globally in a careful manner, entering new markets, such as emerging nations, and also regions with a strong existing presence (but with a new brand/approach), seeking to sequentially increase its scope for growth. This has allowed the business to maintain healthy organic growth while limiting its risk of failure by rushing into a market without sufficient strategic planning.

Management has not been hesitant to conduct M&A where an opportunity is identified. During the last decade, the company has spent over $1.5b in cash, strategically enhancing the company’s competitive positioning. An example of this would be “Dreams” in the UK. The company is a leading retailer in the UK and was a major reason for TPX’s success in the country, which is a highly important region. Dreams struggled in the post-GFC period, initially entering administration and then being up for sale in 2017. Management was able to understand the strategic importance of the company and acquired it in 2021. Importantly, Management has been selective. Investments have been accretive or neutral on both a margin and ROE basis, ensuring shareholder funds are not inefficiently allocated. We have good faith that Management is operating this business extremely well.

Most recently, TPX has announced it is seeking to acquire Mattress Firm, the largest mattress specialty retailer in the US, for $4b in cash and stock. Management believes this acquisition provides six key benefits as follows:

We like the deal, although a caveat is that the financial results of the combination have yet to be wholly ironed out. According to Steinhoff International’s financials, Mattress Firm posted revenues of ~$4b in FY22 and a profit of ~0.4b. This implies a 1x revenue and 10x p/e valuation, which based on TPX’s current valuation is accretive. We think the business will also fare far better under the expert leadership of TPX.

Importantly, Management believes the solvency position will be broadly similar and will initiate a short period of deleveraging.

Margins

TPX’s margins have consistently improved during the last decade, with EBITDA-M increasing from 14% to 16% (+2ppts). We attribute this to economies of scale, with GPM improving by 1ppt and S&A spending as a % of revenue declining by (2) ppts.

Given the scale to which revenue has improved and the company’s global manufacturing nature, we would have expected greater improvement than this (noting the business only exceeded this level in the post-pandemic period). This likely reflects the level of price competition in the market during this macro weakness, with better normalized margins hidden beneath.

This said, given the market conditions that have impacted FY22 and the LTM, it is likely TPX can achieve some immediate gains as demand returns to a sustainable level (~17/18%), particularly following the acquisition of Mattress Firm.

Quarterly results

TPX’s recent performance has materially slowed from the strong growth achieved in the last few years, with top-line revenue growth of +3.6%, (12.7)%, (2.5)%, and +4.8% in its last four quarters. Alongside this, margins have declined, although appear to have stabilized at the 14-15% level (EBITDA-M).

The slowdown in revenue growth is a reflection of the current macroeconomic conditions. With elevated interest rates and inflation, consumers are experiencing rising living costs, contributing to financial pressures as wages fail to keep pace. This is leading to reduced spending where possible, as well as a reduction in large-ticket purchases.

The nature of TPX’s products makes it highly exposed, as consumers generally purchase mattresses with new homes or renovations. In the current environment, consumers are dissuaded from moving home or making such purchases. For those who are in desperate need, they are incentivized to trade down.

Looking ahead, we expect macroeconomic conditions to remain difficult. Inflation appears extremely stubborn and the downside risk of a recession does not appear to be receding. The compounding impact will likely lead to some form of downturn, or slow recovery. We consider the following data points to be TPX-specific, implying downside risk:

• US Fixed Housing Affordability: Housing affordability in the US has reached a new low, importantly declining below the “breakeven” level of 100. This means individuals with median incomes are unable to afford homes priced at the median level. Consequently, major capital spending on home renovations or moving to new homes is more unlikely.
• US Housing Starts: Despite the ongoing housing shortage in the US, there has been a noticeable decline in new housing construction since 2022. This reduction implies that home builders anticipate prolonged challenges in the housing market, reducing their stock build-up due to unattractive profitability expectations.
• US Median Price for Existing Family Homes: Individuals feel comfortable investing in home renovations or considering moving when they have accrued equity in their existing homes. Following a drop in the price of homes sold, this indicates a decrease in property valuations and, subsequently, homeowners’ equity.

Key takeaways from its most recent quarter are:

• The most recent return to growth was driven by 5.3% in North America and an increase of 3.9% in the International business segment. Although we are skeptical, this could imply the “bottom” has been reached, with scope for sideways trading.
• In addition to regions, All three of its U.S. brands – Tempur, Sealy, and Stearns & Foster – performed well in the quarter. Interestingly, Management believes they are “significantly ahead of” where the U.S. industry is trending. If this is true, we attribute the company’s strong brand value to this success.
• The Tempur brand has launched internationally, with strong share gains worldwide.
• The company is currently pending the acquisition of Mattress Firm, with Management currently responding to the Federal Trade Commission’s second request.

Balance sheet & Cash Flows

Management is aggressive with its capital allocation. Debt has been periodically laddered up to fund distributions, with an ND/EBITDA ratio of 3.4x. With interest coverage of 8x and interest representing 3% of revenue, we consider the current balance a healthy maximum.

Although this has allowed investors to enjoy buybacks, we are slightly nervous as to how aggressive it is. Should an attractive M&A proposition arise, or profitability decline, the business could quickly find itself in a difficult position. Nevertheless, thus far, the company has managed to successfully operate with elevated debt.

This has been allowed due to its consistent FCF generation, although the recent demand slowdown has impacted conversion. Inventory turnover has declined from ~7x to 5.6x in FY22 and 5x in the LTM. We believe management is losing grasp of the basics of working capital management and now potentially faces margin pressure if discounting begins.

Broadly, however, the company’s strategy has been good for shareholders. ROE has consistently improved over the historical period and it is currently at an attractive level.

Outlook

Presented above is Wall Street’s consensus view on the coming years (excl. Mattress Firm currently).

Analysts are forecasting a step-down in growth, with a CAGR of 4% into FY27F. In conjunction with this, margins are expected to sequentially improve.

These assumptions appear reasonable in our view. Excluding the potential impact of M&A, TPX is positioned to achieve growth, with the optionality to exceed this with targeted growth strategies such as the expansion of Tempur.

Further, the business has shown some ability to generate margin improvement, with reasonable scope from the current level given the pressures on inventory.

Industry analysis

Presented above is a comparison of TPX’s growth and profitability to the average of its industry, as defined by Seeking Alpha (10 companies).

TPX performs well relative to its peers. The company has seen strong revenue growth, with comparable profitability gains. This is an impressive achievement given the company’s maturity and scale. This is illustrative of its strong competitive position and ability to identify and acquire targets.

Further, the company’s margins are significantly above its peers, which is a level that will likely be close to its 5Y low. Interestingly, TPX’s FCF-M is below its peers, suggesting working capital is being better managed by its peers.

Valuation

TPX is currently trading at 13x LTM EBITDA and 10x NTM EBITDA. This is broadly in line with its historical average.

We think there is sufficient evidence to imply a premium to its historical average is justifiable, owing to the company’s improved margins, greater scale, and below-average leverage. Based on this, we see an upside at the current share price.

Further, TPX is trading at a ~28% premium to its peers on an LTM EBITDA basis and ~23% on an NTM FCF basis. A premium is justifiable in our view, owing to the company’s strong margins and superior growth. TPX is significantly superior to the average of its peers in almost every way, with reasonable scope to continue this.

As the following illustrates, TPX’s valuation has trended down during the last decade while its FCF yield has improved, currently sitting 1.6ppts above its average. At ~9%, we consider this to be highly attractive for its risk profile, particularly as investors should see returns through distributions.

Key risks with our thesis

The risks to our current thesis are:

• Economic recessions impacting consumer spending.
• Failure to penetrate emerging markets (scope for improving growth runway).
• Increased price competition given the macro environment.

Final thoughts

TPX is a highly attractive company in our view. The business has developed exceptionally well during the last decade, with good growth and margins. We expect a continuation of this trajectory, owing to its strong brand and impressive execution by Management. Despite its size, TPX is growing better than its peers with far superior margins. The acquisition of Mattress Firm will combine well with TPX in our view.

The business is facing near-term headwinds, with pain remaining. However, we see this as an opportunity to build a position in this stock incrementally, with its FCF yield already at a highly attractive position.