Today, disagreements are the norm. Yet even one world leader agrees – and that is sleep. Sleep count (NASDAQ: SNBR), a leading supplier of “smart” mattresses, has been rapidly growing its revenue and profits, while rewarding shareholders through the efficient deployment of capital. In turn, shareholders benefit from buybacks and growing earnings per share. The stock fell sharply, presenting an opportunity for those who dared to venture into the mattress market.
Sleep Number sells a variety of products, but one product stands out among its champions. That’s the 360 Series mattress with proprietary technology Sleep IQ. The technology tracks variables such as nighttime heart rate variability, provides insights into the user’s sleep circadian rhythm, and generates reports presenting overall health data.
The 360 Series mattress itself is differentiated by the features it adds. One that stands out in particular is Climate360, a mattress that uses advanced temperature control to create a microclimate in the user’s environment. Climate360 is so innovative that it has won the prestigious CES2020 “Best of Innovation” award.
Now, cool products and innovative designs are good, but if the operation is incomplete, the company may be worthless. So, what’s the story here?
Sleep Number operates as a fully integrated DTC (direct-to-consumer) mattress company. They do this by acting as designers, manufacturers, marketers, retailers and servicers of sleep digital beds. Through this, the company believes it has a strong competitive advantage through its integrated supply chain network. This includes two component manufacturing plants and six assembly distribution centers. This all means that Sleep Number controls how its products are produced and distributed to customers. Many competitors outsource many of these intermediate steps, and Sleep Number uses its strengths to maintain consistency, product quality, and customer satisfaction. How this operational setup translates into operational efficiency and profitability is remarkable.
The company is primarily involved in the sleep wellness market. While the main product is mattresses around this overall theme, the growth in sleep health will have a positive impact on the number of mattresses sold by Sleep Number. According to a report by Aritzon Group, the sleep wellness market is expected to grow at a CAGR of 6.1% during 2020-2026. Of this growth, $13 billion is expected to come from smart bedding, underscoring Sleep Number’s focus. North America accounts for about 32% of the entire industry. The group reported that revenue from smart bedding exceeded $32 billion in 2020. With a market share of about 8%, Sleep Number has plenty of room to capture the overall market growth and projected growth that has yet to happen.
The numbers in Sleep Number show the positive story being created by a company that is growing its revenue and reinvesting at a substantial rate to generate excess returns well above its cost of capital, making for a rare operational masterpiece in the making made a contribution.
Sleep Number’s revenue grew from $1.5 billion in 2018 to $2.1 billion by the end of 2021. Annual revenue growth during that period was about 10%. However, revenue rose 18% from 2020 to 2021. Now, it’s illogical to conclude that the 18% increase reflects more than just a COVID-19 lockdown rebound, so it’s important to dig deeper. The company actually reported comparable sales growth of 29% compared to 2019, suggesting that some of this 18% increase in sales was actually attributable to growth unaffected by the pandemic rebound.
Likewise, gross profit increased to 60.4% of net sales, or $1.32 billion. This represents a 14% increase in gross profit compared to 2020. However, gross profit increased by 25% compared to 2019.
As a result, revenue has been growing fairly consistently and predictably. However, we have another way to verify that revenue growth is organic. This is derived from a comparable basis analysis of store sales. 87.1% of its revenue in 2021 comes from its retail channel, so the data is fairly accurate.
Overall trends into 2020 show an increase in both average sales per store and average sales per square foot. The former reflects growing consumer/market demand for specialty mattresses. The latter reflects improvements in the company’s operational efficiency. In 2021, the company will further improve on these key metrics. Average sales per store grew to $3,600, while average sales per square foot were $1,212, the largest increase to date. Additionally, the company reported that the average unit price per mattress increased to $5,309, indicating that consumers’ maximum willingness to pay is increasing. During the year, the company opened 22 new stores. Often, new job openings lower these averages if operations are inefficient. However, this suggests the opposite. As an investor grows, the company becomes more efficient, which should be exciting as an investor.
Operating income in 2021 will increase 5% to 8.9%, or $194 million, a 73% increase over 2019. This resulted in a net profit of 7%, or $153 million. On the EPS front, the company reported diluted EPS of $6.16, a record high for the company, up 26% from 2020 and 128% in 2019. Now, it’s important to note that share buybacks can increase earnings per share for any company, and this one has a recent history of aggressive buybacks.
ROI and cash flow
I think ROIC should be one of the most important metrics to look at as an investor because it shows how well a company is managing its capital deployment. After all, the only way for a company to grow is through reinvestment. Reinvestment can only be positive if it produces a return greater than the cost of capital.
Sleep Number has hit the mark in this regard. Take a look at the historical ROIC from 2016 to 2020 below.
Only one of Sleep Number’s competitors is showing signs of competing for ROIC, Purple Innovation, which has an ROIC of about 20%. Others, like Casper sleep, are unprofitable. However, this trend is still growing. In 2021, Sleep Number reported the highest ROI ever at 27.6%. Furthermore, the figure is reportedly four times higher than the company’s cost of capital.
These returns are mainly from the growth of its retail business and investment in research and development. As mentioned, the former comes from store growth, where scale shows added value in the form of new stores and increased revenue from existing stores. This can both add new assets and maximize revenue from existing assets. The second reward comes from product innovation. Sleep Number invests heavily in R&D to support the former point. Last year alone, the company spent about $58.5 million on research and development. Many of these innovations have been developed by analyzing the data it collects from billions of sleep-hour records. I see data collection and subsequent analysis as a strong competitive advantage for Sleep Number. Investments in research and corresponding end products allow it to continue to expand its reach and differentiate itself by delivering accurate, science-backed solutions to improve sleep.
All told, the record $300 million in cash generated by operations in 2021 is not surprising, given the outsized returns the company has generated. With about $50 million in R&D and a slew of new store openings, it’s no surprise that the company wants to give back in the form of stock buybacks. In 2021 alone, the company raised $382 million in short-term borrowings to buy back 25% of its outstanding shares. Whether this is the best use of their cash is debatable, but our previous view was not.
Risk: Supply Chain
For every good, there is a bad. This company is no exception. Let’s not forget that Sleep Number operates in a business that relies heavily on the supply of inputs such as bubbles and semiconductors, which are currently being hit hard by shortages in global supply chains. In October alone, an Insider report stated:
Consumer demand for foam products such as sofas and mattresses remains so high that the foam industry is struggling to keep up. Shortages, combined with a shipping backlog of stranded raw materials and a shortage of truckers with delayed deliveries, means some furniture ordered now won’t even ship until 2022.
Basically, the overall report says demand has reached pre-pandemic levels, but the supply of the bubble is limited by external factors such as shipping backlogs. These issues create a trickle-down effect that further affects the backlog. Semiconductors are another issue. Sleep Number’s fourth-quarter 2021 sales loss is estimated at $125 million due to semiconductor supply constraints.
I believe that with the outbreak of the Russian-Ukrainian war, the situation may get worse and will continue for several months. However, I am bullish on the long-term outlook for supply chain issues as countries begin to ramp up production to meet growing demand.
In the short term, prices for existing components will continue to rise, and companies should strive for as much cash on hand as possible to meet their supply constraints. Sleep Number has historically left little cash on its balance sheet, and it relies on meeting its working capital needs to be critical to its long-term sustainability during these stressful times.
On a strict EPS basis, the company expects diluted EPS growth of 10%-15% in 2022. The current price-to-earnings ratio is 10, which means the share price is around $67-70 per share. However, the company’s historical P/E ratio is much higher, averaging between 15-20. This implies a share price between $100 and $105.
Now, valuations based on average and historical P/E ratios have some serious flaws. Therefore, valuing on this basis alone is dangerous. However, combined with the above points about the company’s valuation, a stock value of around $65 would be sufficient. All in all, at the current price of $63, the market appears to be pricing in a 10%-15% increase. If you’re long-term, this shouldn’t matter because this is a very well-run company that will create alpha for generations of shareholders.
Sleep Number is a cash cow that generates growing revenue and reinvests its earnings at impressive rates of return. In turn, the company is following a strong strategy of deploying its capital into a model to improve its existing assets and generate new assets that are growing at such a high rate. It’s a viable long-term strategy that could quickly turn this small-cap company into a mega-giant.
With a market cap of just $1.4 billion and a projected market share of 8% in 2019, the company has plenty of room to grow in the sleep wellness industry, which the company reported to be worth more than $30 billion in 2020. With this ongoing strategy, the company can quickly become a market leader and contribute to the continued growth of the industry, resulting in long-term profitability and shareholder returns for future generations.