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By deadcat2
December 1, 2006

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Today management warned of a rather sizeable shortfall in earnings for this year. Fortunately in my own portfolio I purchased this stock back in August at approx today's price. In the excitement of the moment, I doubled down today. Upon reflection, however, the precipitous decline in earnings - around 20% - suggests that a similar hit to the share price isn't out of line. Management advises that 2007 earnings are still targeted at 20-25% and if that's true, the current price, earnings and growth combine to create a PEG ratio of around 1 which suggests this stock is fairly valued at this price. I usually like a bit more of a buffer than that, but am hoping that management (who has done a good job over the past few years) can do as they say, or better yet, is simply being conservative with their forecast.

Red flags: I worry that management's stated reason for the shortfall (" a closer correlation in our business with housing industry trends") may not be the only explanation. That this trend suddenly catches up with SCSS in one quarter seems unlikely. On the other hand, the double whammy of a consumer-heavy holiday season, with many people having less discretionary income than in past years, may make the statement accurate. The explanation seems too patented and superficial to me, however, and I would look to marketing and distribution as more likely reasons. I would also hope that management is devising plans that extend beyond waiting out the housing slump.

Another cautionary sign is that the CAPS community (including myself) seems to have fallen in love with this stock. Makes me wonder if being a bit of a contrarian is in order. A 20% drop in earnings should cause more reflection rather than the knee jerk "it's a great company so this is an even better price" kind of response.

Additionally, the increased "noise" regarding quality issues with their product has made me hold off purchasing one of these beds myself and I imagine it's had a similar impact on other potential buyers. I am heartened by other Fools' positive experiences with the company, but without a good sense of the percentage of complaints to overall purchases, I'm hesitant to jump into a new purchase. It would be helpful if management made some kind of declaration regarding their product quality and customer service. There's nothing more frustrating to a customer than a bureaucratic response to a problem.

In summary, I'm still (very) long and would expect SCSS to beat the S&P over the next 3-5 years, but in light of the earnings shortfall, I don't perceive this stock to be the bargain that it seemed to be when the pace of growth was not in doubt. I'll be watching closely.

 


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