Is Tempur Sealy a growth trap? (Part 2 of 2)

Value Investing Case Study 13-2: This post covers the risk analysis and valuation of Tempur-Sealy, a US-listed group in the bedding sector.

Is Tempur Sealy a growth trap?
Tempur Sealy International Inc (TPX or the Group) is trading at USD 38.14 as of 30 April 2021, equivalent to a Price to Book of 25.2.

Following the convention that a low Price to Book is a value stock and a high Price to Book is a growth stock, you would conclude that TPX is not a value stock. Is it a growth stock then? 

What do you call a growth stock that is expensive based on a number of valuation metrics? Is this a growth trap?

I think the terminology is not important. For a value investor, what is critical is that you compare price with its intrinsic value. There is a buying opportunity if the price is at a significant discount to the intrinsic value.

If the price exceeds the intrinsic value, then it is not a buying opportunity. You may think of shorting it. 

Join me in Part 2 of this series as I showed why TPX is not a buying opportunity. If you want a background, read Part 1 which was published on 9 May 2021.

Should you go and short it? Read my Disclaimer.

Contents

  • How well did Top Management Seize Opportunities?
  • Is there a great Buying Opportunity?
  • Will Shareholders’ Value continue to be created?
  • How to minimize Risks and secure your Investments
  • How to Gain from the Case Study

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Did top management seize opportunities?

Did Top Management Seize Opportunities?

In 2020,
  • The directors and executives of TPX held a 3.8 % share of the company. 
  • One investor, H Partners Management, with a 5.9 % share of the company had one representative on the Board of Directors.
  • There were 2 others institutions (Vanguard and Blackrock) that held 17.3 %. They did not have any Board representatives.

I would not classify TPX as an owner-managed group given the low ownership by the directors and executives. 

But, TPX has an executive compensation programme. According to TPX 2020 Proxy Statement, the Group had in 2015 updated its executive compensation programme. This is to more align it with the successful execution of its growth strategy and the creation of value for the shareholders. 

Over the past 3 years, the incentive components in the form of bonus, cash incentives, and stock-based compensation averaged 7 % of TPX PBT.

In its 2020 Proxy Statement, TPX reported the following profile:
  • 8 members of the Board of Directors with an average age of 63 years. They have served on TPX Board for an average of 9 years.  The President/CEO of TPX also served as the Chairman of the Board since 2015.
  • 7 Executive Officers (including the President/CEO) with an average age of 56 years and 13 years average tenure with the Group. 

How did the leadership team perform given the long tenure?

Operations

In its Proxy Statement and Annual Reports, TPX listed a number of peers from a number of industries.

I think that when assessing management, it would be more appropriate to focus on the bedding industry. 

However, many of the larger bedding peers are not listed on any stock exchange and hence there is no available financial data. 

I could only find 3 listed companies with mattress operations to enable a comparison. These were Leggett & Platt, Sleep Number, and La-Z-Boy.

TPX Peer revenue index
Chart 1: Peer Revenue Index

In terms of revenue, both TXP and Sleep Number had revenues in 2020 which are more than 3 times larger than those in 2010.  Of course, in dollar terms, TXP revenue is doubled that of Sleep Number.

But peer comparison over the past decade does not present the full picture due to the Sealy acquisition.  If we look at growth post-Sealy from 2014 to 2020, TPX revenue only grew at a CAGR of 3.5 % compared to:
  • 4.5 % for the industry.
  • 2.1 % for Leggett & Platt.
  • 8.2 % for Sleep Number.
  • 3.9 % for La-Z-Boy

When it comes to returns, because of the capital structure of TPX, it is more meaningful to look at Return on Assets rather than ROE.  Based on this metric, and considering the post-Sealy acquisition period, TPX performed the worst among the peers, except for 2020. Refer to the chart below. 

TPX Peer ROA
Chart 2: Peer Return on Assets

Capital Allocation

From 2010 to 2020, the Group generated USD 2.78 billion in cash from operations. Of this, TPX incurred USD 1.74 billion for its share buyback programme, equivalent to 63 % of the cash flow from operations. There was no dividend paid.

From 2010 to 2020, TPX did not raise any additional capital from its shareholders. Instead, it funded the various capital programmes from internally generated funds and borrowings. 
  • Its borrowings increased by USD 1.24 billion during this period. Note that USD 0.28 billion of this was for lease following the change in accounting standards.
  • It spent USD 0.65 billion for its CAPEX (excluding acquisitions) and an additional USD 1.22 billion for acquisitions.

The chart below shows how the cash from operations and loans were deployed. 

TPX deployment of cash flow from ops
Chart 3: Deployment of cash from operations and loan

How would I rate management?
  • Post Sealy, TPX only had a 3.5 % CAGR in revenue which is lower than the industry. Secondly, for most of the period, it delivered the lowest returns compared to the listed peers. I would not rate the performance as good.
  • In terms of capital allocation, a share buyback is a form of distribution of value to shareholders.  But this is only clearly excellent if it was funded from its free cash flow.  However, the amount involved in the buyback exceeded the free cash flow. I think this buyback rate needs to be scaled back. 

Case Notes

The free cash flow can be estimated as cash flow from operations less capital expenditure.

Over the 11 years period, TPX had the normal capital expenditure and acquisitions. Thus, the total capital expenditure = USD (0.65 + 1.22) billion = USD 1.87 billion.

If so, then the free cash flow = USD (2.78 - 1.87) billon = USD 0.91 billion.  

Compare this free cash flow with the USD 1.74 billion spent on the share buyback. 

You may argue that TPX has a debt-equity ratio of 3.3 (based on 2020). So a significant part of the total capital expenditure should be funded by debt assuming that the debt-equity ratio is maintained.  

Instead of deducting 1.87 billion, we should deduct only the equity part. The amount to be deducted = 1.87X 1 / (3.3 + 1) billion = USD 0.43 billion for the equity part. 

Thus, the free cash flow should be = USD (2.78 - 0.43) billion = USD 2.35 billion. 

But, I would argue that TXP has a very high debt to equity ratio compared to the industry, and part of the free cash flow should be to reduce the debt.

As you can see, fundamental analysis is more than just using some formula. There are choices to be made in terms of which approach to use and what to assume. 

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.  

There are several financial advisers who provide such analyses. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.




Is there a great Buying Opportunity?

I generally use two approaches in assessing the intrinsic value ie Asset-based and Earnings-based.

However, in the case of TPX, the share buyback has reduced shareholders' equity.  So the Asset Value does not reflect the cost of the assets incurred over the years. 

Secondly, due to the reduced equity, a more appropriate valuation model is to first value the firm based on the free cash flow to the firm.   The value of equity is then derived by deducting the market value of debt from the value of the firm.

For the Earnings-based valuations, I computed 2 values:
  • The Earning Power Value (EPV) assuming zero growth.
  • The Earnings Value with growth (EV with g) using a 2-stage growth model.

I have derived the EPV for TPX based on the average revenue of TPX from 2014 to 2020.  This is using the post-Sealy acquisition revenue as the expected revenue.

TPX valuation
Chart 4: Valuation

As can be seen from the chart,
  • The Earning Power Value is significantly larger than the Asset Value. This reflects the situation that the Book Value does not capture the historical investments in the various assets.
  • The current market price is higher than the Earnings Value with growth. 

TPX valuation table
Table 1: Valuation table
Note
a) Further details on the valuation methodology and assumptions are listed in Note 1.
b) Based on the number of shares outstanding as of Mac 2021.

Valuation with growth

I adopt a 2-stage valuation model with the following additional assumptions. 

Items

Notes

Value

Starting revenue

a

USD 3,073 m

High growth duration

 

10 years

Growth at high growth stage 

b

8.9 %

Reinvestment rate                 

c

70 %

Terminal growth rate             

d

1.9 %

Table 2: Parameters for the 2-stage valuation model
Notes
(a) 2014 to 2020 average revenue
(b) Based on the past 11 years Housing Starts growth rate
(c) Based on the fundamentals ie Reinvestment rate = growth/return.
(d) Assumed to be the risk-free rate.  Note TPX past 7 years organic growth rate was 2.3 % CAGR (excluding 2020 acquisitions)


Can TPX achieve the 10 years revenue growth at 8.9 % per annum? There are two potential sources of growth for TPX.
  • Housing starts.
  • Anti-dumping.

However, these are not long-term growth trends as once the “gap” is filled, the bedding industry will revert to the long-term growth rate. 

Reverse engineering TPX market price

As can be seen, the market price far exceeded the EV with g.  To try to understand what is driving the market price, I reversed engineered the market price using the 2 stage valuation model. 

One way to achieve a value in excess of the USD 38 market price was to change two of the assumptions in Table 2.
  • Instead of the post-Sealy average revenue, I assumed the 2020 revenue of USD 3,677 million.
  • Instead of using the fundamental re-investment rate, I used the actual reinvestment rate of 10% computed as follows: 


TPX reinvestment computation
Table 3: Computation of reinvestment rate

With these inputs, the EV with g then became USD 44 per share. 

Based on the above, the market is suggesting the following fundamental characteristics for TPX:

Firstly, TPX can continue to achieve 8.9 % annual growth rates for the next 10 years.  As I do not expect the US bedding industry to grow at this rate, this must mean that TPX will gain a very significant market share.
  • If the US bedding industry continues to grow 4.5 % ie historical growth, TPX market share will increase from less than 18 % to 27 % in 10 years’ time.
  • This TPX growth would be very challenging as the competitors are not going to sit by.  For example, in 2019 Leggett & Platt spent USD 1.24 billion to acquire a specialty foam company that is intended to help it expand its bedding business. At the same time, given the growth of the online mattress business, TPX would have to take on Amazon.

Secondly, TPX can continue to maintain a low reinvestment rate of 10% compared to its fundamental reinvestment rate of 70 %.  The fundamental investment rate is the one derived from the following fundamental equation.  Return X Reinvestment rate = growth rate.
  • The 10 % rate was derived based on TPX's actual post-Sealy’s CAPEX. In other words, it did not include the USD 1.2 billion spent on the Sealy acquisition.
  • From 2014 to 2020, the US Furniture/Furnishing sector had an average Net CAPEX/EBIT(1-t) of 69 %.  The Net CAPEX is defined as the sum of capital expenditures on the statement of cash flows minus the sum of depreciation. Source: Damodaran. In contrast, during the same period, the TPX average was -19 %.  The negative here meant that the amount spent on CAPEX was smaller than the depreciation. It suggests that the 10 % reinvestment rate is not realistic. 

How do we reconcile the market price with the reversed engineering results? 
  • Either the fundamental analysis and the 2-stage growth valuation model is wrong, 
  • Or the market is being irrational.

I lean towards the irrational market. Given the reversed engineering results, it suggests that there is no margin of safety at the current market price. 

P:BV history

Due to the share buyback, TPX's Price Book multiples have been high as well as volatile.  Refer to the chart below.

In practice, the Price to Book Value multiple is not the appropriate multiple to value TPX. The free cash flow to the firm model is more appropriate given the high debt level. 

In this context, the Acquirer’s Multiple is a better metric. But even based on this metric, TPX 15.1 Acquirer’s Multiple is high as the conventional wisdom is to look for companies where this multiple is less than 6.

TPX Price Book Value multiple
Chart 5: Price to Book multiple.   Source: Macrotrends.com

Will Shareholders’ Value continue to be created?

There are several perspectives to gauge whether TPX has been able to grow shareholders' value.  Based on these metrics, TPX has grown shareholders' value. 
  • For the period 2014 to 2020, TPX had an average after-tax return on total capital employed of 13.1 %. Comparing this to its WACC of 6.1 %, I would conclude that any growth will create shareholders' value. Note that this is return is based on EBIT(1-t) / TCE where t = tax rate and TCE = total capital employed comprising shareholder’ funds plus total debt. 
  • From the end of 2013 to 2020, the Book value of TPX has grown by 21.3 % CAGR.   Apart from those due to stock compensation and/or options, there was no new infusion of capital.  Thus this growth has been due to retained earnings. Of course, this is also after reduction due to the share buyback programme.
  • A long-term investor of TPX would be have achieved a capital gain equal to a CAGR of about 10 %.  The actual gain would depend on when he bought the share. The gain for two periods - pre-Sealy and post-Sealy acquisition - is shown in the table below.  Considering that cost of equity of 6.7 %, the returns look good.

TPX shareholders' gain
Table 4: Shareholders' gain
Note: The share price is based on the post 4:1 share split.  The share split should not affect the CAGR. 


What are the negatives?
  • TPX has not paid any dividends over the past 11 years.  However, it has announced plans to pay dividends from 2021 onwards. 
  • Most of the share buyback exercises did not add to shareholders' value as they were purchased at prices higher than intrinsic value as presented below. 

Share repurchases

The table below summarized the average cost for purchasing the treasury shares for the various years.  These were extracted from the relevant Consolidated Statement of Stockholders’ Equity. In certain years, the amount purchased was not substantial.  For these, there were no data presented in the relevant Consolidated Statement of Stockholders’ Equity.

I would conclude that only the share buybacks for 2010 and 2012 were likely to add value to the shareholders.  Even on a volume-weighted basis, the share buybacks were carried out at prices that did not add value to shareholders.

TPX share re-purchases
Table 5: Share repurchases
Notes
(a) This is the EPV before the acquisition of Sealy.  It is based on the valuation as at end of 2011 using the same model as that for the current year. I assumed that the value was the same for the various years as the model is based on the long-term prospects. 
(b) Assumed that the current value of TPX applies to all the years' post-Sealy acquisition.

Sealy

In 2013, the Group entered into an agreement to acquire Sealy for a total consideration of about USD 1.3 billion.  To fund the acquisition, the Group entered into a credit agreement with a syndicate of banks for a total loan of about USD 1.77 billion.

I estimated that for the period 2013 to 2019, 
  • The Operating income and royalties from Sealy amounted to about USD 0.85 billion or USD 121 million per annum. Based on the USD 1.3 billion costs of acquisition, this is equivalent to an EBIT return of 9.3 % per annum. 
  • TPX incurred about USD 0.54 billion additional interest expenses.   This is equal to about USD 77 million per annum or 5.9 % of the USD 1.3 billion acquisition fund. This is on top of the interests incurred for its Tempur operations.

Sealy was a debt-funded acquisition.  The above back-of-envelope analysis showed that it was a value-added acquisition. 

Another perspective is to value Sealy based on free cash flow to the firm basis. I valued Sealy at USD 1.5 billion (refer to Note 2) giving it a 15 % margin of safety compared to its USD 1.3 billion price tag.

Again, I would conclude that it was a value-added acquisition. Kudos to management. 

Risk

How to minimize Risks and secure your Investments

In its 2020 SEC filings, TPX listed 28 risk factors. Of these, I think the following two are key when you consider investing in TPX - Leverage and digital disruption.

Leverage

TPX currently has a book debt to book equity ratio of 6.7. This partly due to the reduction in equity following its share buyback plan as well as the debt incurred to fund the acquisition of Sealy.

Over the past 11 years, the Group has undertaken a number of re-financing plans eg 
  • The 2019 Credit Agreement to refinance the outstanding borrowings under the 2016 Credit Agreement.
  • The 2016 Credit Agreement to refinance the outstanding borrowings under the 2012 Credit Agreement.

From 2013 to 2020, the average debt of the Group amounted to USD 1.7 billion with a standard deviation of USD 139 million. Unless there is a change in the share buyback plan, I expect this level of debt to be maintained. This assumes that there is no other major acquisition.

Thus, interests will continue to be significant.  From 2013 to 2020, the Group incurred an average of USD 91 million of interest per annum. 

The Group profits will be affected if there is any rise in the interest rates in the future. 

Secondly, any loss in revenue will have a significant impact on the net income.  This was what the Group experienced in 2017 when a 12 % drop in revenue following the loss of a major customer, led to a 28 % drop in net income.

Digital disruption 

There has been news about how online start-ups have disrupted the traditional mattresses business.  Companies like Casper and Tuft& Needle have been mentioned.

But it was Amazon who has taken the lead with the online sales with USD 1.9 billion sales in 2019, up from USD 900 million a year ago. (Source: Statista ).   

This is a significant share considering:
  • The USD 16 billion 2019 US bedding industry.
  • TPX total direct sales (call centres and online) to be USD 573 million in 2019.

This is a growing channel. 

According to Research and Market, the online mattress market was already following a growth trajectory.  It registered a +30% growth in 2019, with different performances across the world. The United States was by far the largest market.  In Europe, the increase in the online mattress market in Germany was remarkable.  In the Asia-Pacific, the booming Chinese market drove growth.

TPX had recognized this trend, with its direct sales growing from the end of 2013 to 2019 at a CAGR of 33.7 % for North America. 

But the dollar amount achieved paled in comparison with that of Amazon.


How to Gain from the Case Study

This case study seems to have some anomalies:
  • Its two business segments - North America and International - still have organic growth prospects. But TPX's lower growth rates suggest that it has not been able to enjoy this.
  • In the past 3 years, EBIT/TCE employed averaged 19 %. This is commendable at it is above the cost of funds. But TPX Return on Assets is the worst among the peers.
  • While it has created shareholders value, the share buyback plan was carried out at prices that were greater than the intrinsic value.
  • The current market price far exceeds the EPV. The market is pricing TPX as if it was a high-growth stock. 
  • The key risks do not look insurmountable. 

The market is pricing TPX as if it was a high-growth stock. I have shown that it has short-term revenue boosters ie from Housing Starts and anti-dumping.  But the long-term outlook is likely to be growth at the US long-term GDP rates.

The following quotes from Warren Buffett may explain the anomalies.

“Good jockeys will do well on good horses but not on broken-down nags.”

“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” 

The current business economics of the Group is good.  In the short run, it can even overshadow some of the non-value-adding decisions. But if management does not take advantage of this to make the necessary changes, TPX may not have a bright future in the long run.

At the current price, TPX is a growth trap.

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Notes
1) Valuation methodology
The valuation is based on Free cash flow to the firm model as per Damodaran.
  • Free cash flow = EBIT X (1 - tax rate) X Reinvestment rate
  • EBIT was derived as follows
    • Gross Profit = Revenue X Gross Profit Margin
    • SGA = Revenue X SGA cost per $ revenue
    • EBIT = Gross Profit - SGA - Incentive
    • The Incentive was based on historical Incentive as % of EBIT before incentive
  • Gross Profit Margins, SGA, Incentive were based on 2014 to 2020 averages. 
  • The cost of capital data was derived from Damodaran (Jan 2021) dataset.

Items

Value

Risk-free rate

1.9 %

Risk premium

5.2 %

Cash adjusted unlevered Beta

       0.78

Cost of equity

6.7 %

WACC

6.1 %

Tax rate (average of US and others)

28 %


2) Valuation of Sealy

  • Based on the financials for the Sealy operations for 2013 and 2014 as provided in TPX SEC filings, I projected the revenue, gross profit, SGA, and operating income from 2015 to 2019.
  • I then computed the average EBIT (equivalent to operating income) from 2013 to 2109 and used this as the expected earnings for the EPV assessment. 
  • I assumed the same cost of capital data as for TPX.
  • The EPV was derived based on the free cash flow to firm model valuing the “firm” at USD 1.48 billion.


End of Part 2 of 2

Coming Next on 13 Jun 2021 - Leggett & Platt 




Reading guide
If you are a first-time visitor to this blog, you may not be familiar with some of the concepts that I have used in my analysis and valuation.  I suggest that you check up the Foundations series - Fundamentals 01,  Fundamentals 02, and Fundamentals 03.   I also have a Definitions page in case you are not familiar with the terms I have used. 




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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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