Shares of Lovesac (LOVE 2.04%) recently dropped more than 15% after the company announced results from its fiscal first quarter. Jittery investors heard management mention "supply chain headwinds" and hit the sell button before thinking it through.
Shares of the modular sofa manufacturer may be under pressure, but the underlying business is stronger than ever. After already thinking about adding Lovesac stock to my portfolio, the post-earnings dip created a bargain opportunity that was just too tempting to pass up.
Why Lovesac slid lower
During its fiscal first quarter ended May 1, 2022, Lovesac reported a 56% year-over-year surge in sales. The stock fell despite blazing fast top-line growth because its gross margin contracted 4.5% compared to the previous year period. The company cited shipping expenses that soared 6.4% over the same time frame.
Improving product margins went a long way to offset soaring shipping costs. The important thing to remember here is that soaring shipping costs should eventually return to normal. Once oil prices come back down to Earth, the economies of scale that improved Lovesac's product margins will most likely remain.
Lovesac has reported year-over-year sales growth of at least 25% for 16 consecutive quarters. This streak has to end sometime, and it looks like the company is preparing us for the disappointment.
Lovesac also disturbed investors by commenting on moderation in demand over the past few weeks. Management later explained it was referring to tough comparisons up ahead. The company's fiscal second quarter is traditionally its strongest, and the year-ago period was a record-breaker because many of us could barely leave our homes.
A screaming buy right now
Shares of this high-growth business are trading for just 11.3 times earnings expectations. This is a fair price for a stodgy old furniture manufacturer that's grinding forward at a snail's pace. Lovesac's sales have grown at a compound annual rate of 48.7% over the past four years.
At its current valuation, Lovesac shareholders will come out ahead even if its growth rate over the next four years falls all the way down to a single-digit percentage. With a strong competitive advantage, double-digit growth for at least five more years seems far more likely.
Lovesac isn't the only company mass-producing modular furniture. That said, it launched its reconfigurable Sactionals about 16 years ago and they are still in a league of their own. Sactionals come with interlocking seats and sides that their owners can easily add or remove. With different grades of replaceable cushioning, hidden speakers, and hundreds of upholstery options, adding to an existing Sactional will almost always be the preferred option for existing customers.
What to look out for
Lovesac been growing by leaps and bounds for years, and it probably still has plenty of room to grow. Its share of the fragmented couch and home audio markets isn't more than 2% of a pie worth $46 billion annually.
As the company grows, its economies of scale grow as well. This means high-end modular furniture manufacturers will find it harder and harder to threaten Lovesac's increasing share of the market.
Lovesac has dozens of patents to keep copycats off the market, and some expire this year. The company believes its patent portfolio and innovative approach will deter competitors from trying to undercut its healthy profit margins. I agree, but I'm keeping my Lovesac shares in a well-diversified portfolio just in case we're mistaken.
