The market is not happy with Sleep Number (NASDAQ:SNBR). Despite mostly positive news on the company’s Q1 earnings call, the stock price is in freefall. This tells me that the market has reached peak pessimism towards SNBR and that this might be a good time to add to my position in the company. In this article I will discuss why the situation at SNBR is better than the market thinks and why I remain bullish on the company.
Why Does the Market Hate Sleep Number?
I think the market is bearish towards SNBR for two main reasons. First, the company sells a high-end, discretionary product in an environment where everyone is concerned about a recession. The company is experiencing a drop in units sold and expectations are muted for Q2 and 2023 as a whole. Management spent time on the last conference call talking about consumer sentiment, noting that it dipped by 5 points in March and translated into poor results for the month. Sentiment went on to improve 3 points in April and management was comfortable maintaining their full-year EPS estimates, but it is clear that SNBR is not immune to shifts in consumer sentiment.
Based on comments on my other SNBR articles, I also think investors have a poor opinion of the company’s management team. It is hard to see the decision to add $450mm of debt to the balance sheet to fund buybacks at $40-$100/share as anything but a mistake, given that free cash flow has slowed to a trickle and the stock trades in the low $20s. SNBR’s debt was cheap at first, but interest expense has ballooned to over $9mm per quarter (about 35% of operating income for Q1). The general sentiment is “look how bad management is, they borrowed money at a floating-rate right before a spike in interest rates and a broad-based recession.”
The Good News in the Q1 Earnings Report
I believe the market’s fear of a recession and distrust of management are clouding their collective judgement. While Q1 results weren’t a blowout, there was a lot to like in the numbers. Gross margin is climbing steadily back towards 60%, net income was meaningful despite having to overcome $9mm in interest expense, and operating cash flow was a solid $18.5mm. Even free cash flow was positive, though management guided that Q2 is likely to produce negative free cash flow. The chip shortage that has plagued the company for the last 18 months has finally been resolved. SNBR is once again able to offer its full suite of products (most notably the FlexFit model 2 and 3 adjustable bases) and is on the cusp of launching their next generation of smart bed.
Management has been clear that 2023 will remain a difficult operating year, but they were comfortable enough to maintain their $1.25-$2.00 EPS guidance for full year 2023, as well their $40-$50mm free cash flow estimate ($100mm in operating cash flow minus $50-$60mm in capex). The positive cash flow is particularly important, as the company keeps very little cash on their balance sheet. I expect SNBR to continue to be able to fund operations via operating cash flow, but in a pinch they still have over $300mm remaining on their credit facility and some room to maneuver before they hit the 5x EBITDA leverage ratio imposed by their lenders.
In summary, SNBR’s operating business is stable, the company doesn’t appear to be on the brink of financial distress, and the market is overly concerned about issues that won’t matter over the long term.
Thoughts on valuation
If we assume that SNBR can survive a recession, I think the company is undervalued relative to its long-term potential. At the time of this writing SNBR’s market cap is $500mm and its enterprise value is just under $1.5b. In my opinion the $1.5b number is overstated; this total contains operating lease liabilities, which are obligations of a different sort than financial debt (backing them out gives an enterprise value closer to $1b).
Even using the $1.5b number, I don’t think SNBR is overvalued in relation to its normalized free cash flow. Estimating “normalized” free cash flow can be contentious; who can say what “normal” really is? If you were to look back at the last three years, for example, average FCF is ~$150mm, but SNBR averaged a whopping $247mm in free cash flow between 2020 and 2021. Average free cash flow over the last five years was $130mm. One could argue that 2020 and beyond is anything but “normal”, so one could also look at, say, 2017 through 2019, where the average was $110mm. The further back in time you look, the worse the value gets, but this is because SNBR has been steadily growing revenue and free cash flow for the last decade. I think a trailing five year average free cash flow is an acceptable proxy; looking backwards that includes a difficult 2018 and 2022 and a wildly successful 2020 and 2021. In this case we end up with an EV/FCF ratio of 11.5, which doesn’t look especially cheap but isn’t dramatically overvalued either.
This may be controversial, but I choose to value SNBR based on its market cap rather than its enterprise value. For better or worse, SNBR’s debt is almost 100% discretionary. The company hasn’t needed debt to fund operations or to grow the business; debt has been used to fund share buybacks but not much else. One can argue that it was a management mistake to fund buybacks this way, which is fair, but I think it is important to note that in a “normalized” environment SNBR does not need to carry a debt balance. As such, $130mm in average free cash flow looks much better compared to a market cap of $500mm. For a growing company with a competitive moat I am very comfortable paying 10x normalized free cash flow, which gives me a conservative price target of ~$60/share ($1.3b market cap divided by 22m shares outstanding).
Risks
SNBR faces performance risk if the US falls into a prolonged recession. The bulk of SNBR’s customer base isn’t so wealthy that they are immune to a recession and I expect 2023 to be a tough year for the company. That being said, I don’t think SNBR is likely to face a liquidity problem, despite only having $1.5mm of cash on the balance sheet. The company managed to generate positive free cash flow even in a difficult Q1, and there is still plenty of liquidity provided by SNBR’s credit facility in a pinch. The worst-case scenario is that operations drop off so badly that the company starts to bump up against the 5x EBIDTA leverage ratio, but even in that scenario I suspect that they have some negotiating room with the lender. I say this because they were recently able to increase the limit from 4x EBITDA to 5x.
Conclusion
I expect SNBR to struggle in 2023, but based on the Q1 earnings call I also expect them to stay solvent, survive, and then return to thriving on the other side of a recession. SNBR is trading very cheaply compared to its performance in a more “normal” environment; I think long-term performance supports a share price around $60/share. I am happy for the opportunity to add to my position at a price that I expect will yield ~200% upside in the long run.
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