One of the most significant events in a public company's life is its graduation from being a high-growth company to a slower-growth one with an established competitive position. To celebrate this happy occasion, Wall Street does just what you'd expect: It takes the company out behind the barn and shoots it.
First, the hyperactive growthies pile out, looking for the next opportunity. Then the momentum investors clue in that the stock isn't rising anymore, and they flee the sinking ship. The stock's valuation plunges. Shareholders get killed.
It happens again and again. To Dell (NASDAQ:DELL), back in 2000. To TASER (NASDAQ:TASR) early last year. And I believe it will happen to Apple (NASDAQ:AAPL) in the next few years. The only surprising thing about these sell-offs is that investors always seem to be surprised.
But in these situations, people are so busy panicking that they sometimes lose all sense of perspective, pushing stock prices down beyond all reasonable expectations. That's when value investors can step in and make some serious coin. I'm thinking here about Netflix (NASDAQ:NFLX) early last year, below $10 a share. Investors got a 150% to 200% return within a year. Not to mention Amazon.com (NASDAQ:AMZN) at single-digit prices in 2001 -- investors had a five-bagger in a couple years. More importantly, I think Tempur-Pedic (NYSE:TPX) is just such an opportunity right now.
The business
Tempur-Pedic manufactures foam mattresses, pillows, and beds, which it sells through retail stores, direct marketing, and chiropractic and health care stores, both nationally and internationally. The foam in its mattresses was originally used by NASA to cushion astronauts against high G-forces during liftoff. The mattress molds itself to the curves of your body, then bounces back into place when you get up.
Tempur-Pedic claims its products are both more comfortable than spring mattresses and more effective in reducing neck and back pain. Historically, most of its mattresses have been premium products priced in the $1000-$3500 range. Tempur-Pedic has been extremely successful in its niche thus far, developing a strong, well-known brand while growing at a compound annual rate of 33% over the past five years.
The competitive landscape
Worldwide, more than $13 billion worth of mattresses and pillows are sold each year. Traditional innerspring mattresses compose about 80% of mattress sales, dominated by Sealy, Serta, and Simmons. The remainder of the market is foam mattresses, waterbeds, and air mattresses, such as those manufactured by Select Comfort (NASDAQ:SCSS), the only other publicly traded mattress company.
Tempur-Pedic, with sales of about $837 million, has about 6.5% of the overall market. However, it's a dominant player in its premium niche, which is about 20% of the total mattress market. Mattresses provide about 63% of Tempur-Pedic's sales; the rest come from pillows and beds.
Risks
Tempur-Pedic's primary risk is competition. Over the last few years, the big three manufacturers, recognizing Tempur-Pedic's competitive threat, have introduced their own foam mattresses at lower price points. Tempur-Pedic has responded by introducing a sub-$1000 mattress of its own. Tempur-Pedic is a leader with a great brand, but Sealy, Serta, and Simmons are strong, large competitors. Should a price war develop, everyone in the market will suffer.
Even if a price war is averted, Tempur-Pedic's own lower-priced offerings could cannibalize its premium sales. That said, these lower-priced models have also expanded the company's potential customer base to the 80% of the market that doesn't have $1,000 or more to spend on a mattress.
Tempur-Pedic has almost $350 million in debt, mostly at a variable rate. This debt would give it less flexibility in a price war, but given the company's earnings of about $100 million per year, the debt should be manageable in most scenarios.
Finally, over the short term, a downturn in the economy could hurt Tempur-Pedic's results. People don't buy premium mattresses when they're struggling to make ends meet. Still, such an event should not seriously impact the company's long-term competitive position.
Valuation
Tempur-Pedic is unlikely to continue its torrid growth; it's grown too big and has too much competition. At this point, analysts expect the company to grow at an annual average of 20% for the next five years -- not bad for a company trading at a forward P/E of about 8.5.
A discounted cash flow calculator such as the Inside Value calculator can be used as a starting point to see what Tempur-Pedic is actually worth. Start with analysts' projections that the company will grow at 20% for five years, 8% for the next five, and then 3% indefinitely. With a discount rate of 13%, the company would be worth about $19 per share.
However, I think these growth rates are optimistic. In light of the competitive threats, I'd prefer a more conservative model, with short-, medium-, and long-term growth projections of 15%, 8%, and 3%, respectively. Even in this case, the company would be worth $16, and I see relatively limited downside. At the current price of $11.50, the business is being valued as though it will only grow about 7% annually over the next five years.
In addition, I think Tempur-Pedic has a chance to outperform these estimates. The company has a solid brand and historically high growth rates, and for the first time, it's selling a product targeting the low-end market. In addition, the company announced a buyback in October, and it followed through with share repurchases that reduced its outstanding shares by nearly 6% year over year. Continued share repurchases are a great use of cash. When the company's trading at such a low multiple, buybacks will significantly boost earnings per share.
The upshot
While Tempur-Pedic faces some risk because of increased competition, it looks quite cheap to me. At these levels, the potential reward seems to outweigh the risk by a large margin. As a value investor, it's the sort of opportunity that I'm constantly looking for.
Now, for a confession: I didn't identify this stock entirely through my own research. I heard about Tempur-Pedic back when it was added as an Inside Value Watch List company in the October issue. The watch list is comprised of stocks that are attractive, but are not yet cheap enough to be full Inside Value picks. Since that time, the company's shares have fallen further.
If you're considering buying Tempur-Pedic, you might want to sign up for a free trial of Inside Value to read Philip Durell's brief comments about the business when he added it to his watch list. Want more? Take advantage of our best Inside Value deal ever, and subscribe at a 25% discount to the regular price. In addition to the newsletter, all new subscribers will receive two free books: Stocks 2006 and Benjamin Graham's value investing classic The Intelligent Investor. To find out more, click here.
Fool contributor Richard Gibbons' mother advised him to get a bed if he wanted to get married. It worked. He does not own any of the securities discussed in this article. Select Comfort is a Motley Fool Hidden Gems recommendation. Dell is aMotley Fool Stock Advisorand Inside Value recommendation. Amazon.com and Netflix are also Stock Advisor picks, and TASER is a Motley Fool Rule Breakers recommendation. The Fool has adisclosure policy.
