Why you should not buy TPX

Value Investing Case Study 13-3. The original version of this article was published as a guest post in Value Investing Journey under “Should you invest in TPX - A relative fundamental analysis”. For that article, my relative valuation was based on the market price as of 24 May 2021. For this article, I have updated the relative valuation based on the market price as of 22 July 2021.

Tempur-Sealy International Inc (TPX or the Group) is a US bedding group that had experienced a significant rise in its share price since the start of the year.

You could be forgiven for thinking that this is a growth stock. Should you consider investing in TPX? I used relative fundamental analysis to show why you should not buy TPX at the current price.

We are all familiar with relative valuation. You compare the worth of a company (target) relative to a comparable group of companies (benchmark). You then judge whether it is cheap or expensive relative to the group.

You also look at some performance metrics eg ROE to see whether the differences in the relative values can be explained. Most of the time, the performance comparisons are ad-hoc and focused on one or two metrics.

If you are going to use relative valuation, shouldn’t you also take the performance comparisons to the logical conclusion? In other words, shouldn’t relative analysis have 2 related components?

Relative valuation.

Relative fundamental analysis.

Your investment decision should then depend not only on whether the stock is “cheap” relative to its benchmark. You also have to consider its business prospects and other fundamentals relative to the benchmark.

I called this process relative fundamental analysis.

I had earlier carried out a “conventional” fundamental analysis of TPX. I had also determined TPX intrinsic value using a discounted cash flow (DCF) valuation.

I had concluded that while TPX was fundamentally a good company, there was no margin of safety at the current price. It was not a good investment.

This article re-looked at TPX. But this time from the relative valuation and relative fundamental analysis perspectives.

The results of such a relative analysis for TPX based on the market price as of 22 July 2021 are presented below.

Chart 1: Relative Overall Valuation Ranking

Chart 2: Relative Fundamental Ranking

Based on relative valuation, I again concluded that TPX is among the more expensive stocks. But based on relative fundamentals TPX is among the better performers.

TPX would be a buying opportunity if:

It was relatively cheap with relatively good fundamentals.

TPX's relative value was the same as the benchmark, but it had relatively good fundamentals.

TPX was relatively expensive, but the relative fundamentals were outstanding.

Since TPX did not meet any of the above criteria, it is not a buying opportunity. The conclusion is the same as that reached with the conventional fundamental analysis and DCF valuation.

1. Introduction

2. Framework

3. Relative metrics

4. TPX

5. TPX relative valuation

6. TPX relative fundamentals

7. Conclusion

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1. Introduction

If you are a value investor, valuation is key. By comparing price with value, you can determine whether a stock is a good investment. At the same time, if you own the stock, you can assess whether it is time to exit.

There are 3 ways to value a stock - relative valuation, asset-based valuation, and earning-based valuation.

The chart below illustrates the difference between them using purchasing a house as an analogy.

Chart 3: Valuation methods

While relative valuation makes sense when purchasing a house, I seldom use it for valuing stocks. This is because it can present a misleading picture.

For example, if a company has a PE of 15 compared to its benchmark of 30, you may conclude that the company is cheap. But then the benchmark PE could be high because they have been the target of some speculative play. So the stock is actually overpriced.

Having said this, I find that the majority of investors rely on relative valuation.

I favor using both the asset-based and earning-based approaches. In fact, I used both to triangulate the intrinsic value. This is because all valuations are based on assumptions. Using both approaches helps to ensure that I am not somehow biased using one approach.

Any intrinsic valuation should go hand-in-hand with the company analysis. You need the company analysis to ensure that the assumptions you employ in the valuation are grounded in reality.

But more importantly, you want to ensure that the “cheap” company you invested in is not a value trap. Rather, it should be a company with the ability to deliver its intrinsic value.

In other words, I want to ensure that the valuation is consistent with the company’s prospects and other fundamentals.

I now apply the same logic to relative valuation. If you are going to rely on relative valuation, then you have to ensure that you also undertake a relative fundamental analysis.

What is a relative fundamental analysis? It is a comprehensive quantitative comparative analysis of the target with the benchmark.

2. Framework

There are 3 steps in my proposed approach:

Relative valuation.

Relative fundamental analysis.

Investment decision.

2.1 Relative valuation

According to Damodaran, to do a relative valuation, you need to:

Identify comparable companies (benchmark).

Convert the market values into standardized values since absolute prices cannot be used. This creates price multiples.

Compare the multiple for the company being analyzed (target) with the benchmark.

When you compare the multiples, there are 3 possible scenarios. The value of the target company as illustrated below can either be cheap, similar, or expensive.

Chart 4: Relative Valuation Scenarios

Of course, you will have to choose the multiple to use for the comparison. Irrespective of the multiples you use, the scenarios still apply.

2.2 Relative fundamental analysis

The concept of relative fundamental analysis is described in detail in my article “Expanding your company analysis toolbox with relative fundamental analysis”. Refer to it if you want to know more.

The goal of relative fundamental analysis is to determine the relative performance of the target company.

There are of course many metrics that you can use for the comparison. The challenge is how to aggregate the results so that we can have an overall picture.

I have chosen the ranking method to do this. First, I rank all the companies based on the respective metrics with No 1 as the best. Then if there are 5 companies being analyzed, the worst would be ranked Not 5.

Next, I determined the overall rank by computing the simple average of the respective metric ranking. The one with the lowest overall average ranking would be the one with the best relative fundamentals.

Based on the overall ranking, there are 3 possible scenarios as illustrated below.

The target ranked better than the benchmark companies.

The target and the benchmark have the same rank.

The target ranked the worst among the benchmark companies.

Chart 5: Relative Analysis Ranking Scenarios

2.3 Investment criteria

You now have the results from the relative valuation and relative fundamental analysis. Your investment decision should take into account both results.

In this context, I suggest the following investment criteria.

1) If the relative valuation shows that the target is cheap, you invest only if the relative fundamentals are better or the same. This is illustrated below.

Chart 6: Relative Valuation - Target is cheap c/w Relative Fundamental Ranking

2) Do not invest if the company is relatively cheap but the relative fundamentals are worse than the benchmark. The implication is that the company is actually cheap for a reason.

3) What happens if the relative values are the same? I would argue that if the relative fundamentals are much better, you could consider investing. This is because the market has yet to recognize the better fundamentals. This is illustrated below.

Chart 7: Relative Analysis - Target is neutral c/w Relative Fundamental Ranking

3. Relative metrics

The goal of the relative fundamental analysis is to compare the performance of a company relative to its benchmark.

The challenge is then determining what parameters to use. As a first step, I fell back on my conventional fundamental analysis and selected the following.

Chart 8: Factors and metrics

I selected these factors as they will affect the intrinsic value. For each factor, I have identified 3 metrics to represent it to keep the analysis simple. It is possible that you can have more metrics to represent a factor.

The companies making up the benchmark are of different sizes. As such, I scaled the metrics where appropriate rather than look at the absolute numbers. This meant creating indices for certain metrics and using ratios for others.

To help undertake the analysis, I used a platform/app called TIKR.com. It has been described as “The 1 Stop Platform To Do All Your Stock Market Research On”.

To be transparent, TIKR reached out to me some time back to test the app and provide feedback. TIKR has been in its building stages for almost 2 years now and has finally decided to soft launch their site in beta.

4. TPX

To illustrate the relative fundamental analysis approach, I analyzed TPX relative to the following peers (benchmark):

LEG - Leggett & Platt Inc (FYE 31 Dec).

SNBR - Sleep Number Corporation (FYE 2 Jan).

LZB - La-Z-Boy Inc (FYE 25 Apr).

CSPR - Casper Sleep Inc (FYE 31 Dec). Note. Listed in 2020 but financials were available from 2017.

I have a conventional fundamental analysis of TPX in my blog which I summarized below. If you are not familiar with TPX, I suggest that you refer to them.

Is Tempur Sealy a growth trap? (Part 1 of 2)

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

4.1 Recap

TPX was formed when in 2012/13, Tempur-Pedeic International acquired Sealy Corporation. TPX went from being a memory foam mattress manufacturer to one with comprehensive bedding products.

TPX today develops, manufactures, and markets bedding products under a number of products and retail brands.

It has product brands serving all price points eg Tempur, Sealy, and Sterns & Foster.

It has a number of retail brands eg Tempur-Pedic retail stores and Sleep Outfitters.

TPX has 2 business segments - North America and International.

North America accounted for the majority of the Group revenue. The US accounted for the majority of the North American revenue. Note that in 2020, the Mexican operation was reclassified from International to North America.

International revenue came from the manufacturing and distribution subsidiaries and joint ventures. These are located in Europe, Asia-Pacific, and Latin America.

TPX also derived income from royalties by licensing Sealy brands, technology, and trademarks. In 2020, these generated about USD 21.9 million royalties for the Group.

I had valued TPX based on both the asset-based and earning-based approaches with the following results.

Chart 9: TPX Intrinsic value

4.2 Is TPX is a buying opportunity?

I had concluded that:

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 averaged 19 %. This 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 market price far exceeds the Earning Power Value (EPV) and the Earning Value with growth (EV with g)

The market is pricing TPX as if it was a high-growth stock. I had 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 current business economics of TPX 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.

If you want further details, refer to the actual articles.

5. TPX relative valuation

The relative value of TPX compared to its benchmark as of 22 Jul 2021 is tabulated below.

Due to its large share repurchase programme, I would not use the PB multiple. Secondly, due to TPX's high leverage, I would prefer looking at the enterprise multiple rather than the equity multiple.

Chart 10: TPX relative values

On a TEV/EBITDA basis, I would consider TPX as expensive relative to its benchmark.

Case Notes

Unlike market prices, the fundamentals of a company do not change every day.

In practice, as fundamental analysis is based on the company’s financial statements, we only have the opportunity to reassess the fundamentals quarterly in tandem with the reported quarterly results.

For this reason, while I have updated the relative valuation of TPX, I have not updated the relative fundamental analysis.

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.

6. TPX relative fundamentals

The concept of relative fundamentals is like the Rating Agencies concept of rating the credit standing of companies.

The main difference here is that I am looking at those factors that will affect the intrinsic value of the company - returns, growth, risks.

Furthermore, the focus is on comparing the target company with the benchmark only. This is like relative valuation which compared the target company valuation metric with those of the benchmark.

This post is not about how to carry out a relative fundamental analysis so I would not go into details on the review of the various factors and metrics. The goal is also not how the target company performed relative to the benchmark for a particular metric. Rather it is the overall picture that is most important.

If you want the details, refer to my article “Expanding your company analysis toolbox with relative fundamental analysis”.

But to give you a flavour, I present below a part of the discussions on the Sources and Uses of Funds.

6.1 Sources and Uses of Funds

I looked at 3 metrics here - capital structure, % of operating assets, and the % of "float". They provide a picture of how effective the funds have been deployed and the financial strength.

For the capital structure analysis, I consider the lower leverage as the best rather than looked at the optimal ratio. In theory, you could compute the optimal ratio taking into account the company’s Beta and determining the lowest WACC.

In terms of uses of funds, I would like to see that most of the funds were deployed for the net operating assets.

Warren Buffett has attributed Berkshire Hathaway's success to float. You can think of float as a source of interest-free funds. For manufacturing companies, float arises from Deferred Taxes, Pension Liabilities, and Other Unearned Revenue.

Chart 11: Sources and Uses of Funds

Notes

a) Based on latest FY

b) Net OA = Total Assets less Cash, Securities, and Current Liabilities. TCE = SHF, MI, Debt, and Lease.

c) Float = Non-current Deferred tax, Non-current Other Liabilities, Pension liabilities, Unearned Non-current revenue. I did not account for Current Payables as part of the float as I looked at float as a % of the Net Operating Assets (NOA). This is because I have deducted Current Liabilities to arrive at the NOA.

6.2 Overall Fundamentals

To get an overall picture, I used a ranking approach as follows:

I ranked all the companies for each of the metrics. The best performance is ranked No 1 with the next best as No 2 and so on.

If there is a tie, both companies share the same rank. Then I skipped one rank when it comes to the next company.

I assumed all the metrics have equal weights when computing the overall rank. The overall rank for a company is the simple average of all the metrics ranks.

The ranking results are shown in the table below

Chart 12: Fundamental metrics ranking

It is obvious that because of my ranking approach, the lower the average rank, the better the company’s relative performance.

The results show that TPX together with SNBR were the better performers. CSPR had the worst performance.

7. Conclusion

The goal is to compare the relative value with the relative fundamentals.

TPX is relatively expensive based on EV/EBITDA. Note that by virtue of a negative multiple, CSPR would be considered the most expensive.

In terms of relative fundamentals, TPX is ranked among the better ones.

Chart 13: Relative EV/EBITDA

Chart 14: Relative fundamental ranking

Based on relative EV/EBITDA, I concluded that TPX is among the more expensive stocks. But based on relative fundamentals TPX is among the better performers.

TPX would be a buying opportunity if:

It was relatively cheap with relatively good fundamentals.

TPX's relative value was the same as the benchmark, but it had relatively good fundamentals.

TPX was relatively expensive, but the relative fundamentals were outstanding.

Since TPX did not meet any of the above criteria, it is not a buying opportunity. The conclusion is the same as that reached with the conventional fundamental analysis and DCF valuation.

You may argue that I am not being consistent in my approach. If I am ranking the fundamentals to determine the overall positions, shouldn’t I also rank the valuation based on a number of valuation metrics?

I do not want to get into the debate on which is the appropriate metric to use. But just to see whether the argument made sense, I also performed a ranking of TPX and the benchmark based on the valuation metrics in Section 5.

The result of the ranking is shown below.

Chart 15: Relative valuation metrics ranking

Chart 16: Relative Overall Valuation Ranking

As you can see TPX still remains among the expensive group. There is no change to the relative position compared to using the EV/EBITDA multiple.

7.1 Comments

The basis of my approach is that if you are using the relative valuation, you have to also assess the relative fundamentals of the benchmark. Otherwise, you would not be consistent.

The relative fundamental analysis is another way to carry out a fundamental analysis. It is not completely different from the conventional fundamental analysis. This is because in my conventional analysis I also compared metrics between companies.

However, in the conventional fundamental analysis,

I sometimes compare the target with the industry. The industry will cover more companies than the benchmark.

I sometimes compare the target's current performance with its own historical performance.

There are qualitative measures that would be hard to carry out a relative comparison. For example, how would you rate the company's competitive edge, business strategy, and management track record?

I believe that relative fundamental analysis should be part of your assessment toolkit. It will complement the conventional fundamental analysis and should not replace the conventional one.

For mature and cyclical sectors where there is a strong reversion to the mean, the relative fundamental analysis should work well. It is probably not as good for analyzing start-ups and high-growth sectors where the historical performance may not provide much insight into the future.

There is not much literature on relative fundamental analysis from an investment perspective. The closest I could find was the methodology used by the Rating Agencies. But these are more about assessing the credit standing of companies. Rating agencies do not assess stock investment opportunities.

So, in developing the relative analysis framework, I fell back on my experience. I think there is room for improvement.

In this context, if you have found the article interesting, I would like to get your thoughts on the following:

What other factors should I take into account for the relative fundamental analysis?

Should I use more than one metric for each of the factors?

Email your thoughts to i4valueasia@gmail.com.

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This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.

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