Investors may have slept comfortably after a first glance at the latest earnings release from Sealy (NYSE: ZZ). However, they likely woke up with some back pain after taking a closer look at its results. Although sales and earnings improved over last year, Sealy was forced to reduce prices to maintain its momentum, and it still carries significant debt on its balance sheet.
For its fiscal second quarter, Sealy reported earnings of $16.1 million, or $0.17 per share. That's a vast improvement over last year's $126,000 in earnings, which was knocked down by IPO costs. Sales also improved in the latest quarter, growing 6.7% to $401.8 million. Domestic sales gained 4%, and international growth was an even more impressive 15.8%. So where exactly is the problem?
Well, as you settle in a bit more, you may start to feel uncomfortable pressure in certain areas. In order to maintain its growth, Sealy has reduced its average unit selling price by 10.6% -- a pretty significant discount. The reduced selling prices, combined with increased costs, put a damper on margins, pushing gross margins lower by 180 basis points.
For me, the company's balance sheet is an even bigger concern. Its long-term debt stands at just less than $798 million, while its cash and short-term investments fell by 10.3%. The good news? It showed a marked improvement in its free cash flow, which turned from negative to $5 million in its latest quarter.
Sealy is obviously doing many things right. However, I'm not sure how successful it can be going forward, should recent trends continue. At some point, it will have to stop offering such large discounts on its products. With intense competition from the likes of Select Comfort (Nasdaq: SCSS) and Tempur-Pedic (NYSE: TPX), that won't be easy.
In an effort to set itself apart and offer products for which consumers are willing to pay top dollar, Sealy is focusing on new designs it believes will generate higher margins. If the market remains soft, it may be forced to reduce prices, no matter what it develops. If that's the case, Sealy may be in for a few sleepless nights.
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Fool contributor Mike Cianciolo welcomes feedback and doesn't own any of the companies in this article. The Fool's disclosure policy sleeps like a baby.
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