Putting Select Comfort's 1Q to Bed
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By uffnik
May 17, 2007

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For this analysis, I will refer to the latest numbers of Q1 2007, but maybe will take some input out of the 10K.

Sales and gross margin

Net sales were 216.5M and only 1.8 % higher than last year; where are the times of double digit growth? The top line weakens the latest two quarter with only + 5.4 and +1.8%: The reason why?

We can find the answer in the growth rates the sales channels. The retail channel weakened with + 0 and -1%; very, very bad are the signs of the Same Store Sales, which where beaten with - 9% and -11%. This sales channel represents 76% of total sales :-(. We can find more color on this problem, if we look at the average sales per mattress unit, which declined from over $2.200 to round about $1.700 again in the last two quarters.

And what is the reason for this decline? Well, maybe some problem in the marketing? The Chief Marketing Officer just resigned his position. Maybe it's the deteriorating macro-economic environment, as mentioned in the 10Q? But why is TPX so successful in just the same market (+ 16% growth in Q1 2007 YoY ) ? I think, the problems are house-made.

The gross margin of SCSS is very stable at slightly over 61% TTM. That's a good sign at least :-)


Looking at the cost structure, total operating expenses are very stable in % of sales. (54 % vs. 52% YoY); marketing expenses are a little bit higher at 45 % of sales, G&A at 8% . The same picture for interest and tax expenses.

The higher marketing expenses are the result of "higher number of stores and markets served" (10Q).


Net income was 10,7 mio (-9 %), Net income TTM declined -1,6%; Net margin weakened from 5,5% last year to 4,9% this year;

Cash Flow

Here are the "only positive points" of this quarter.

Operating Cash Flow was + 27,5 mio compared to 9,1 mio last year, resulting from higher depreciation and amortization, higher accounts payable, and higher accrued taxes.
Looking at the investing cash flow (+ 21,4 mio) , there where more than $29 mio proceeds from marketable securities.
And finally in the financing cash flow we find the repurchase of shares for $43,8 mio.

The repurchase of share was founded by both the operating cash flow and the selling of the securities. The management of SCSS bought 2.359.000 shares with an average price paid of $18,14. This amounts to $42,792 mio. ( I cannot find the explanation of the difference to the $43,825 , but in 10Q the data is provided; maybe these are transaction costs ?)
It's a positive sign, that SCSS doesn't increase debt for the repurchase. And it's a positive sign that the board of directors have authorized additional repurchase up to $250 mio without expiration date.

Balance Sheet

The "highlights" of the balance sheet are

* Cash & cash equivalents of $ 15,5 mio; o.k.
* Marketable securities were lower with 20,6 mio due to the repurchase of shares.
* Accounts receivables a little bit higher; no problem.
* The level of inventories is higher (+$2,8 mio / +12,8% YoY). Hmm, I think I will have to look at this number in the next quarters. Maybe it is an indicator for more problems in the top line?
* Property plant and equipment are o.k.

* Accounts payable are much higher; good for cash flow this quarter but it will generate negative cash flow next quarter.
* Other Current liabilities are in normal ranges.
* Long Term liabilities have not changed and are very low. Good!

Some other valuation data:

ROE: 10,5 % could be little bit stronger;
LT Debt / Equity ratio : 0,1 x and better than the last year; very good

Today's price: $ 17,3 per share
Price/Sales ratio : 1,1 means over $1,1 per 1$ of sales; that's in the preferred area of $1 and less: Good
Price /Earnings ratio: 19,4 ; I think SCSS for me is not undervalued;
Price / Free Cash Flow ratio : 19,9 ; shares are very pricey regarding this ratio, too

2007 Guidance
The Company reiterated guidance for net sales and increased guidance for diluted earnings per share for the full year 2007.

* Full year 2007 net sales to range from $900 to $925 million an increase of 11% to 15% over 2006.
* Diluted earnings per share for 2007 to range from $1.02 to $1.09. This guidance reflects an increase of 10% to 16% compared to 2006 EPS of $0,93.

Quote from CC:

* Our outlook anticipates the current business climate will stabilize but not improve for the remainder of the year. This outlook corresponds to the National Association of Realtors' forecast for home sales for 2007

* In addition, our guidance anticipates that our growth initiatives will begin to have a meaningful effect on our results in the third quarter. If the economy deteriorates, or if the benefits from our growth initiatives take longer than expected, then the lower end of our sales and earnings ranges could be pressured.

.. Several factors should be considered, however, in setting expectations for our second quarter earnings.

* First, we expect second quarter gross margin will be approximately 300 basis points below the first quarter rate of 62%, both as a result of normal seasonality in our business, and more significantly, due to the launch of our fire retardant product across our core line.
Costs associated with our FR launch include additional product costs incurred to comply with the new regulations, ramp up costs for production, and cost to support the rollout of this new product for display in the stores.
We expect gross margins will improve quarterly over the balance of the year, and consistent with previous communications, full year 2007 gross margins are expected to be in line with the full year 2006 rate of 60.9%.

* The second factor is the introduction of our new media campaign. With the introduction of this campaign, investment in media will increase by approximately 15% in the second quarter, compared to year ago levels, and up from essentially flat spending levels in each of the past two quarters. Historically, sales ramp up over a number of months when we introduce new creative marketing, which is factored into our outlook for improved sales trend in the back half of 2007.
We do not expect to realize such a lift in the second quarter, which is seasonally our slowest quarter of the year. We expect second quarter sales growth rates will be similar to the first quarter. Overall, we expect second quarter earnings will be below year ago levels, and therefore below current Street estimates.

* In summary, although near-term performance will be challenging, as we expected, we believe we are working on the right things for short and long-term impact. We continue to control costs and adjust to performance [and learning].
We remain very confident in the long-term outlook for our business, as reflected in our share repurchase activity. Our confidence is based on the fundamental advantages of our vertically integrated business model, favorable consumer demographics, a highly differentiated product with clinically proven sleep benefits, and the initial progress we have seen against our 2007 growth initiatives.

So the next quarter will be very tough:

1. Top line growth like the first quarter: this means $192 mio net sales for Q2
2. Gross margin - 300 basis points below 62% = 59%: this means 114 mio gross profit
3. Sales and marketing - about + 15% YoY: $78,6 x 1,15 = 90,4
4. G&A - my estimates : 15 - 16 mio

Net income after calculated taxes should be about $5 mio; so estimated EPS for Q2 should be about 10 cents per share.

For me, the management is very optimistic regarding full year guidance. It is necessary, that many assumptions may turn out to be right.

Some other interesting snippets from the CC

Q. The guidance I think for the comps for the year was 3% to 5%. Is that still applicable, based on first and I guess early second quarter look?
A: I think there's a lot of year to play out, certainly. But there -- we certainly could be short of that a little bit. But it's still to see how it rolls out the rest of the year

Q: And could you share with us your -- you made the comment that you would entertain leverage to buy stock in. Would the stock have to go lower from where it is, or would that be a strategy you'd contemplate at or around this share price?
A: Well, I think our -- the actions we've taken over the last nine months certainly indicate that we've been repurchasing aggressively at current prices. I think the statement about willingness to take on debt really speaks more to the fact that we have been repurchasing against the cash balance and taking cash down. We're not going to -- we won't take an approach that says we stop buying when cash gets to zero...

Q: I was wondering if you could update us sort of on your thoughts regarding international expansion..
A: ..we don't have any expectations of material impact in this year, or near future, and in part because we need some systems capability to get into international in a significant way, and that will not be coming on line until 2008.

Q: You reference the new ad campaign as potentially reaching a broader segment. Why is that? Is it a broader message? Or is the mediums used to convey the message?
A: I think it's both, but the early work here is primarily a lot of the different mediums that we're using. It's less oriented to the direct marketing purchase, and there's some broader reach mediums that we have been testing here.

Q: Can you comment on the -- as it relates to the comp, how much of the negative 11% was unit volume related versus price?
A: There's really not -- once we lapped the price increase from a year ago, there's not a lot of price contribution one way or another that number.

Q: ..could you give us a little color in terms of when you're talking with your people out in the stores, I know you've indicated a lot of the challenges in the current selling environment are housing related. Have any difficulties in terms of converting traffic into actual sales transactions, has that become more challenging than it once was?
And can you give us any color on how you feel -- when people come in looking for a specialty bedding product, competing air versus visco product, has that environment changed in terms of you guys trying to win that transaction instead of a visco sale?
A: The feedback from our stores is that what they're seeing -- this changes by geography around the country, but it's generally more traffic-driven, motivated traffic-driven. I don't think we've necessarily seen a measurable difference in our conversion rates. It's been more of a traffic deal.
In terms of visco, we've been -- we get compared -- our shoppers come in comparing with Tempur and other visco products. But that's been going on for quite a while, and we do very well when we have that kind of customer in the store.


For me, SCSS now has some serious problems. I sold my shares over a year ago and then purchased again at the recent level. I think I should sell them the next days because I believe that there will be again a buying opportunity after the next earnings release. I believe that Mr. Market will overreact although the information of the decline was already clearly given. It is quite astonishing for me, that the share price till this day has not reacted more.

Thank you for reading.

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