Select Comfort: New Mattresses Could Provide a Boost to Sales

Select Comfort has been a rollercoaster of a ride. The stock has had several huge swings, both up and down, that have probably had shareholders ready to throw up. The ups have been driven by a combination of a recovering consumer, a strong "specialty" mattress backdrop (specialty is essentially any non-innerspring mattress - memory foam, adjustable, etc), and Select Comfort's ongoing innovation. The downs have been driven by the competitive environment, execution issues, and volatility within the consumer environment. In the end, you get a stock that is up 25% over the last 5 years but is trying to find some stability in the midst of a major new product launch.

Source: Google Finance

Source: Google Finance

New 360 Beds Could Provide Upside to Guidance and Investor Expectations

For those who are unfamiliar with Select Comfort, their main product is an adjustable air mattress. While this might conjure up images of cheap, tacky mattresses, Select Comfort's beds are actually sophisticated and can adjust its firmness to each user's preferences. If you go into a store, the company will have you lie down on a mattress, show you a heat map of your pressure points, and adjust the mattress accordingly. The company has carved out its own ~$1.4 billion area in the mattress industry selling these beds, and its success has drawn competitors into adjustable air mattresses as well (with perhaps the most notable being Tempur-Pedic's TEMPUR-Ergo mattress).

With a background in data-driven, complex mattresses, the company has been on the forefront of mattress innovation. The culmination of their efforts is their new product, the 360 Smart Bed. Some of the key features of this mattress include:

- Automatic adjustments in firmness based on your sleeping position

- Heats your feet until you fall asleep

- Will lightly lift your head by 7 degrees if the mattress detects snoring

- Smart alarm that will wake you up when you are in the lightest stage of sleep

- Provides data on your quality of sleep in an app on your phone

This is essentially a smart mattress for a more connected world, and it's a fairly significant shift from traditional mattresses.

The company has already rolled out two models of this bed, the i7 and i10, to all of its stores nationwide. These models are higher priced (starting at $3,499 for the i7 and $4,999 for the i10) and lower-volume, allowing the company to gradually gauge consumer interest and ensure that the roll out occurs as planned. The company will be rolling out the other models through the remainder of the year and into early 2018. 

Management's sales guidance is for a low-single digit comp for the full year. This is essentially the same growth rate as in the beginning of the year and does not appear to consider any upside from the new product launch. Investor expectations, measured by consensus estimates, appear to be similar. Adjusting for the decline in 2Q and the bump in 3Q (which is due to about $25 million of sales that were shifted from 2Q to 3Q, explained later in this article), the expected underlying growth rate each quarter this year is about 1-3%.

Source: Visible Alpha

Investors are excited that the rollout of the mattress can potentially boost sales above expectations in the back half of this year. Already, the initial customer response from the mattress has been strong. Management noted that reviews have been positive and that the product has driven ARU (average revenue per mattress unit) and traffic higher. Demand has been above expectations, suggesting that growth could potentially be higher in the back half of the year as more models (that are less expensive) become available.

 

Improving Profitability With More Efficient Operations

Select Comfort is also driving improvements in operations that are expected to increase their profitability by at least 50 basis points this year, and 300 basis points longer-term. The company is doing this through a number of changes, including designing products with value in mind, reducing the number of components in each mattress (from 37 to ~20-25), assembling the bed prior to shipment  (vs. currently assembling the product in the customer's home), reducing bed SKU counts (to 7 from 8), and streamlining other operations. The improvements to profitability should drive significant earnings growth, but note that investors only expect the company to achieve about 20 basis points of improvement  in 2017 (vs. the >50 basis point guidance).

Source: Visible Alpha

The Concerns: Execution Issues, Competition, and Choppy Consumer

The company has had several executional missteps. In 2015, the company mishandled a change in systems that led to a significant disruption in operations and a subsequent drop in stock price. The system change was an ERP upgrade that led to shipment delays, customer cancellations, and increased expenses to fix the issues.

Source: Company filings Note that you can see the importance of comparisons as the 4Q16 growth rate jumped up 34% on a strongly negative comparison from 4Q15

Source: Company filings

Note that you can see the importance of comparisons as the 4Q16 growth rate jumped up 34% on a strongly negative comparison from 4Q15

Just as the company was beginning to put this behind them, they again ran into issues in 2Q17. The company recently switched to new suppliers, and ran into issues with one specific supplier that was not able to meet its quota. This shortage then cascaded across the supply chain, leading to shipment delays. 

There are several takeaways from this most recent mishap.

First, while the supply issue hurt 2Q results, management noted that the issue has now been fixed, and that the lost sales from 2Q (about $25 million, or a 9% negative impact in 2Q) will shift into 3Q (and thereby provide about a 7% boost to 3Q sales). Management's full year guidance of low-single digit comps and high-single digit sales growth remains the same.  As a result, this issue is largely an optical issue. Underlying comps, adjusting for the lost sales, would have been largely similar to 1Q17 trends (when the company reported a 3% company-controlled comp). 

Second, one might wonder just how stable Select Comfort is as an investment. The company has had several executional issues, and is still in the midst of a significant product rollout. Should valuation really trade at a premium given the operational risk?

In addition to operational issues, the mattress industry faces significant competition from the online channel. Bed-in-a-box companies such as Casper and Tuft and Needle have made significant share gains in the industry (estimated in the single digits), and Purple recently was bought out for $1.1 billion. Investors wonder about the more traditional mattress companies' ability to stay ahead of these emerging competitors. 

Finally, the nature of mattress purchases (high ticket, discretionary) has led to choppy trends within the industry. Investors have wondered about management's ability to predict sales trends in such an environment.

 

Conclusion

In the end, we are left with a company launching a promising new product that could offer upside to management's guidance and investor expectations, but with execution and competition representing risks to the downside.