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Reevaluating SCSS
Board: Select Comfort

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By deadcat2
April 17, 2007

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This weekend I thought it was time to update my own outlook for SCSS, being long on this stock at a price slightly higher than the close last Friday ($17.40). What follows is just one investor's journey to a decision with some of the tools, trail markers and signposts I've used along the way. You may follow the same path but arrive at a completely different decision, which is okay. Everyone should follow the route that makes the most sense to them. As they say, it's not the destination that's important, but the journey. Hope you enjoy the trip!

For starters, let's look at a few selected FY2006 results (8K, http://tinyurl.com/34qggj). Company owned stores increased by about 10% (to 442) in 2006, and retail partners increased to 882 doors, an increase of 132% from the prior year. Good numbers, both. New stores contributed 9% to total sales during 2006, offsetting a same store sales drop of 9% (ouch!). While gross profit as a % of net sales was up 0.7% for 2006, operating income was down a full 5%, mostly as a result of an asset impairment charge (related to SAP implementation by 2008), stock option expenses and an incease in sales and marketing costs.

The sales and marketing expenses don't particularly bother me - it's critical that Select Comfort develops a strong campaign and raises consumer awareness about their product. I am, however, disturbed by the costs of stock based compensation. As indicated in the 8K, "If full year 2005 results had included stock option expense, earnings would have been $0.69 per diluted share in the prior year, and 2006 earnings of $0.85 per diluted share would represent earnings growth of 23 percent." That means that for 2005 when earnings were reported at $0.76, the hit to earnings as a result of stock option expenses was around $0.07, or a little more than 9%! That's just not a percentage I'm comfortable with. On the other hand, an apples to apples earnings increase of 23% is darn good.

Media costs are projected to increase 10% in 2007 - part of the expanded marketing program - which should pay off in time. Another 40 net new stores, an increase of about 9%, are expected for 2007, while retail partner doors are expected to remain flat, probably another good thing for now, considering the rapid expansion last year. The company itself still maintains its long term growth targets of net sales growth at 15% or higher, and earnings growth at 20% or higher. For 2007, company guidance is for $1.02-$1.07/share. And if anyone cares, analysts ratings are almost evenly split between buy and hold (this again from Select Comfort's own web site). If the "pros" are split on whether to buy or hold, it's no wonder that this board might show the same uncertainty.

I understand the consternation of several posters to this board, trying to figure out whether SCSS is a keeper or a throw away. The only real catalyst for a fallen angel is to prove that they're dealing with or have removed the reasons for their earlier stumble, and the ultimate proof generally shows up in increased revenues, earnings and margins. Mr. Market is not likely to bestow an outsized Investor Sentiment Multiple (the ISM, or p/e) on SCSS until they can prove they're worthy of it... again. So, as much as we might pore over the history and the past statistics, there's no way today that we're gonna get our hands on the data that will ultimately remove our uncertainty - next year's earnings ;-). By the time we do get that data, of course it'll be too late to profit from it.

While we can't remove all uncertainty, perhaps we can come up with some measured risk scenarios. Let's look at a few sites for down and dirty valuation from a DCF or discounted earnings basis. Value Pro (http://www.valuepro.net/) suggests the intrinsic value of SCSS is $35.85. Smart Money (http://tinyurl.com/8olda) suggests the estimated value per share is $24.23. You'll notice that Smart Money is using a ttm earnings figure of $0.92. If we plug in actual 2006 results of $0.85, we get a value per share of $22.39. And finally, plugging in an earnings growth rate of 20% for 5 years and 3% thereafter yields a present value of future earnings of $21.56 with the Money Chimp calculator (http://tinyurl.com/54ng4). So, the take away from this exercise is that estimates of value (based on our assumptions of 20% earnings growth) are all higher than today's price and the potential appreciation ranges from 24% - 106%.

I know it's simplistic and a lot of folks wouldn't look at estimated earnings x ISM, but IMO it's another data point worth looking at. The median earnings estimates from First Call (which are the same as those on Select Comfort's web site - http://tinyurl.com/35ar7x) look like this:


Year             Est EPS

2007               $1.03
2008               $1.24
2009               $1.80


Let's consider various Investor Sentiment Multiples and see what the likely effect is on share price. If SCSS disappoints on earnings a second quarter in a row, it's quite possible the ISM could drop to 15, a figure it's not seen since 2003 (check out Big Charts interactive charts, use four years for the time frame and lower indicators for Rolling EPS and P/E Ratio - http://tinyurl.com/2uy5ew). For that matter, the ISM could drop even lower than 15, though I believe that would be unlikely. For a median multiple, we'll use 20, the figure SCSS seems to have averaged since the bad news from last November. And feeling conservatively optimistic, I'll use a multiple of 25 on the high side. Plugging in these values, we get this range of possible share prices:


Year             Est EPS         ISM 15        ISM 20      ISM 25

2007               $1.03          $15.45       $20.60      $25.75
2008               $1.24          $18.60       $24.80      $31.00
2009               $1.80          $27.00       $36.00      $45.00


On the low side, I've assumed a multiple of 15, but the reason it would drop to that figure is because SCSS failed to meet earnings expectations. For a more realistic low price, I'll assume SCSS fails to meet expectations by a large margin, increasing earnings by only 14%. That would give us 2007 earnings of only $0.97. Multiplied by an ISM of 15 would give us what I think would very likely be a possible low price - $14.53. That's a 16% drop from today's price... ouch, that would hurt!

But looking on the bright side, if SCSS merely meets expectations they should be able to maintain their multiple of 20 which would give us an end of year share price of $20.60, an increase of over 18% from today's price. And beating expectations - even by a couple points - could push SCSS into higher multiples (which have been as high as 28 over the past six months) and a possible price of over $25, a very appealing gain of nearly 50% from today's price.

Looking further into the future, only one analyst has estimated earnings for 2009, and that prediction shows a 45% increase over 2008 earnings. I'm not sure why the big bump - perhaps the anticipation of efficiencies gained from the completion of the SAP implementation, or maybe the marketing message reaching critical mass, I don't know. To be conservative, I'll assume there's something to the efficiencies notion, but only to the tune of a more moderate 25% increase that year. That would give us an earnings estimate of $1.55 for 2009. With that kind of growth I'd anticipate the market would easily reward SCSS with a multiple of 25, and a share price therefore of around $39. That would represent a gain over today's price of nearly 125%, or 30% compounded annually over the next three years. Not bad.

What about the competitive landscape? One of my online brokerages, Fidelity, does a pretty good job of allowing me to compare various metrics between competitors. A similar feature can be found at Yahoo Finance (http://finance.yahoo.com/q/co?s=SCSS) although in this case, the site only compares Select Comfort with Sealy. However, if you look up competitors for Sealy, it shows a comparison with Tempur-Pedic... go figure. But toggling between the two can give you a good idea of metrics between the three. Gross margins appear best at SCSS, but when it comes to operating margins, TPX is far and away the leader. P/E is about the same for all three, but the only one with a PEG below 1 is SCSS, implying a greater earnings growth rate. YOY quarterly growth rate is about 4-5 times as high for TPX as for the other two. Over the past year, TPX shares have gained 75%, ZZ has remained flat, and SCSS has dropped 30%. From my Fidelity site, however, SCSS beats TPX handily in Price/Sales, Price/Book and Price/Cash Flow. Cash flow and book value have grown at substantially higher rates for the past five years at SCSS, while past revenue and earnings growth has been much higher at TPX than SCSS. Select Comfort, however, is projected to grow EPS at a much higher rate than TPX in the future. Long term debt is much higher at TPX, as is the current ratio. So, put that in your pot and boil it down for what it's worth. It tells me that for the most part, I like what I see with the future projections for SCSS (although perhaps I should also take a closer look at TPX as an investment opportunity).

Another site I like to use is Google Finance (http://finance.google.com/finance?q=scss). I like the feature of seeing the overlay of news releases with stock price. It gives me a good idea of why a stock may have risen or dropped at a certain point in time. I also like to read analyst opinions which many brokerage firms provide online at no cost. While their recommendations don't usually mean a lot to me, I do like to read their rationale - it gives me more insight into what elements I should be thinking about for a particular company or industry.

One last bit of info that can be helpful and that is whether insiders are buying or selling (http://tinyurl.com/33byw2). For SCSS it's not a particularly pretty picture. For one thing, these guys don't buy anything on the open market (we've already seen how much the stock option expense is for SCSS), so they don't really have that much skin in the game. Yeah, the grants they've been given might lose value, but that's not quite the same as putting up your own money to buy your company's stock. And they're all sellers, although there may have been a few options exercised and held (although most of the exercise prices are below $2.00 - not a big gamble). Unfortunately, this peek at insider trading doesn't offer much comfort, but it's not necessarily a red flag either. Officers and directors may be selling to balance their portfolios, buy a new car or build a guest house on the back forty - who knows?

So back to the question at hand - is SCSS a buy, a sell or a hold? Ultimately, of course, I can only answer the question for myself. And it's really all about trying to predict the future. Looking at the past certainly gives us a clue, but in the end, what's your best guess for tomorrow? That's where the risk resides. Everyone must determine how much risk they're willing to accept and what level of returns they expect to generate for that risk. It's been discussed on this board quite a bit lately - establishing your own investment philosophy. My own goal is at least to double the value of my portfolio every five years with a relatively low level of risk. To attain those returns, I have to generate 15% per year overall. And to accomplish that, I generally look for stocks that I believe have a good chance of appreciating at least 20% per year because some will and some won't, but on average, I should do okay. And I try to pick stocks that I can understand. Beds I can understand.

Since I already hold a large enough position in SCSS, I'm not inclined to add to my position right now. In the absence of any other news, however, the risk/reward ratio looks very compelling to me. It appears that the downside is limited to around 15% or so, but the upside potential could be very high... as much as 125% over the next three years. If it drops another 10%-15% on news that doesn't look that threatening to me, I may average down my cost basis. For me, less than a 10% drop isn't worth averaging down. But if I were already a buyer of SCSS in the $20s, I'd be averaging down after the earnings release. If I were a new investor to SCSS, I'd probably be a buyer at these prices although again, I'd wait until the next earnings release, April 25 (a handy earnings calendar - http://tinyurl.com/38fkpd). If the news is good, the price jump is liable to be followed by a more consistent run up and there should be opportunities to buy before the price shoots too high. If it's not so good, and depending on the severity of the news, I'd buy on the drop.

Whoa, that was a much longer post than I had intended. For those of you who actually read to the end, I hope the thought process has been worthwhile. If you have your own approach, please post. I'm here to learn along with everyone else, and when possible, share something that hopefully might be helpful. If nothing else, perhaps you'll find some bookmarks to add to your own research process. When possible, I find it helpful to establish a consistent way of analyzing all the stocks I'm thinking about selling or buying. While certainly not exhaustive, I find this approach a handy outline of elements to research, making sure I touch bases on what I consider to be some of the most important considerations before buying or selling any stock.

To those posters that got me thinking about my own approach to investing in general and SCSS in particular, thank you. There's nothing better than going through an exercise like this to solidify my analysis and feel comfortable about the reasons I've bought, sold or continue to hold any of my positions.

Thanks,
Derek

 


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