How Feshbach Nailed a 3-Bagger

Awhile back, I spoke with Joe Feshbach, who manages a hedge fund at Joe Feshbach Partners, LLC. During the interview, we talked briefly about Tempur-Pedic (NYSE: TPX  ) , a high-end mattress maker -- and one of Feshbach's biggest, most successful investments. Here's a more detailed look at how he spotted this opportunity.

Emil Lee: Can you describe your thought process leading up to your purchase of Tempur-Pedic?

Joe Feshbach: I got involved in September 2005, after Tempur issued a disappointing forecast for the third quarter of that year. The bears were convinced that Tempur had a business with low barriers to entry that [competitors] Sealy (NYSE: ZZ  ) and Simmons would be able to threaten.

My thesis, in contrast to the bear case, was that Tempur was the leader in specialty bedding, that it was already a leading global brand, and that displacing it would be a lot harder than conventional wisdom [believed at the time].

Our lowest cost basis on the stock was $9.70. Our core position was built around an average of $11.

Lee: Can you describe the research process you used to "debunk" the bearish view?

Feshbach: I developed a network of retailers around the country that gave me a pretty good look at sales momentum, and my forecasts built on those have been very accurate. I spent a lot of time studying the industry and talking to a lot of the bedding retailers and concluded they were really in the sweet spot of a major demographic change that combined "better-for-you" products with the tendency toward new luxury.

I really believe in this "new luxury" concept, where people will take savings from shopping at Costco (Nasdaq: COST  ) or Wal-Mart (NYSE: WMT  ) and use it for really important items -- with sleep being one of the most important items on the "better for you" survey. This will be an enduring trend for decades.

Lee: From your average cost basis of around $11 per share, Tempur now trades at almost $30. How do you feel about the stock now that it has moved up?

Feshbach: I think Tempur could easily double in the next 12-18 months. Oddly enough, the multiple expanded a little, but not much over the last two years. From a valuation point of view, [the company] has suffered from significant headwinds. The entire furniture and bedding sector is down hard over the last 12 months. For example, if you look at Ethan Allen (NYSE: ETH  ) , Select Comfort (Nasdaq: SCSS  ) , or Furniture Brands (NYSE: FBN  ) , their stocks are all somewhere between wounded and massacred.

I believe that Wall Street estimates, which are moving up for 2008, are still dramatically too low, because of the potential for revenue and margin expansion in 2008.

Lee: Tempur currently has a market share of about 2% of the U.S. mattress industry, in terms of units sold, and around 8% in terms of dollar value. How much incremental market share do you think Tempur can capture?

Fesbach: I'm a believer that innerspring mattress technology is antiquated and will lose market share for many years. I also believe there is no viable competitor to Tempur in the specialty space. I think they can certainly, in terms of mattress sales, go to 5% unit share and 15% dollar share over the next three to four years.

Lee: When looking at Tempur's economic moat, to what extent does the company's competitive advantage come from simply being able to produce a better product, and how much comes from having a well-known brand?

Feshbach: Sealy has 26 manufacturing plants in the U.S. They do about 30% more volume than Tempur right now. Tempur's two domestic manufacturing plants have the capacity to do the same volume [as all 26 of Sealy's plants]. Labor makes up less than 5% of Tempur's cost of goods, effectively insulating them from cheap knockoffs produced in low-labor-cost geographies like China.

When I talk to retailers across the country, they consistently tell me that customers ask for Tempur, and that it is very difficult to switch [the customer] to a competitive product that may be cheaper -- even if the salesperson has an economic incentive to sell a non-Tempur product.

Lee: Is there anything else you think should be mentioned about Tempur?

Feshbach: One thing we haven't talked about is that going forward, most analysts are underestimating Tempur's potential revenue growth and margin expansion. The other thing that's significantly underestimated is [Tempur's] ability to generate free cash flow, which the company will likely use for continued strong buyback activity.

Tempur has said they don't have to build capacity for the next four years. So we believe the company could generate well in excess of $200 million in free cash flow next year. By 2010, that number could grow to approach $300 million annually.


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