Sleep Number: Buying The ‘Mess’ Before The Rest (NASDAQ:SNBR)

I wrote an introductory article about Sleep Number (NASDAQ:SNBR) at the start of the year. SNBR’s share price has been cut in half since that article was published. This article revisits my investment thesis in light of the Q1 earnings report. My long-term thesis on SNBR hasn’t changed; I believe the company will continue to generate ample free cash flow and use that cash to both reward shareholders and invest in profitable growth. That being said, SNBR is facing short-term headwinds of continued supply chain difficulties and inflationary pressures. Piper Sandler downgraded the stock after the Q1 report, citing “messy” results and operating conditions (source). I am looking to take advantage of the disconnect between the short-term price drop and the long-term value of the company. I am buying the “mess” before the rest of the market.

A Look at Q1 Results and Guidance

SNBR’s Q1 results and guidance were underwhelming but not disastrous. SNBR broke even from an earnings and free cash flow perspective in a quarter plagued by supply chain shortages, inflation, and geopolitical difficulties. Net income was just $2mm and free cash flow just $5mm against $527mm in revenue (down 7% YoY). Difficulties sourcing semiconductors pushed nearly $200mm worth of sales into future quarters while inflationary pressure in other raw materials and labor knocked gross margins down to 57%. Management cited a sharp drop in demand when the war in Ukraine began, though it is unclear to me how this event would impact consumer sentiment beyond a vague sense that it would be inflationary. Full year 2022 guidance was meaningfully reduced from earlier estimates; management now projects earnings per share of between $5 and $6, operating cash flow of $200mm, and capital expenditures of about $80mm. These estimates assume revenue growth between 0-3% for the year and a continued drop in revenue in Q2.

SNBR bought back $51mm worth of stock in Q1 while adding $45mm in debt to their credit revolver. The average repurchase price was above $80/share, which isn’t great given that the stock now trades at $40. Management stopped repurchasing shares in March in light of softening demand but suggested on the conference call that they might restart repurchases later in the year. With projected free cash flow of $120mm, it would not surprise me if management makes repurchases again in Q3 or Q4, especially if the company’s share price remains depressed. I would love to see buybacks, even buybacks fueled by a modest debt increase, when shares are trading at or below $40/share.

Looking Further Into the Future

I added to my SNBR position to take advantage of the disconnect between poor short-term performance and what I expect will be strong long-term performance. I think the market is correct to predict that 2022 will be a poor year for SNBR; management has admitted as much themselves. However, I don’t see any indication that their business model is under pressure in the long term. Chip shortages have persisted longer than I would have expected, but there is a clear path to production normalizing in the next two to three years (source) (source). The delays caused by these shortages have thus far only deferred revenue for SNBR; the company’s backlog has ballooned as they try to meet their existing orders. This is causing a poor customer experience for those who expected their beds to be delivered in 1-2 weeks and instead are being asked to wait an additional 6-8 weeks, but this revenue hasn’t been lost.

The health of the retail consumer is also an open question at the moment. Target (TGT) and Walmart (WMT) both got hit hard after their most recent earning reports due to softening demand in their hardline divisions. Inflation remains stubbornly high despite some indicators that the rate of price increases has peaked. I am generally optimistic about inflation over the longer term (I wrote a whole article about that here) and SNBR’s customer base provides some protection against rocky economic conditions. SNBR offers a high-quality product at a premium that is ample but not outrageous. SNBR doesn’t sell basic mattresses; even their most simple product contains their embedded “SleepIQ” technology. Their highest-end product is still within reach for an upper-middleclass customer (though is still clearly in the luxury category). SNBR’s customers have more discretionary income, on average, by virtue of being able to afford a smart bed in the first place. SNBR’s products are differentiated from the bottom-tier mattresses so they compete with fewer companies and products. A recession would hurt SNBR, but not as badly as companies focused on cheap, simple mattresses.

SNBR remains focused on the future while tackling short-term challenges. The company is continuing to invest in research and development; Q1 spending in this area was up over 20% YoY. While controversial, I am comfortable with SNBR using debt to buy back a modest number of shares, especially when the stock price is so low. When earnings become more robust in the future, they will be spread across fewer shares. Management, and CEO Shelly Ibach in particular, have significant holdings in SNBR stock and plenty of skin in the game. Management’s long-term focus will serve the company well through the uncertainties and instabilities of 2022 and 2023.

SNBR’s Valuation is Just Too Cheap

2022 isn’t going to be as strong a year as 2021, but SNBR is still trading too cheaply relative to both 2022 projections and historical performance. Over the next three to five years, I think 2021 performance will be the norm, in which case SNBR is trading at a PE of 6 and a P/FCF of 4. For a growing company, that is too cheap; SNBR should be trading at 3x its current market cap at least.

Looking at projected 2022 performance, SNBR still looks pretty good. Management guided net income of $100mm at the low end and about $120mm in FCF. A number of analysts are skeptical of these numbers (source) (source), but I think management laid out a pretty clear case as to why their estimates are reasonable. There is a lot of higher-margin product in their backlog, there was a pickup of sales activity in April, and management is adjusting their advertisement spend to better reflect the current climate. Revenue for 2022 will almost certainly be below 2021 revenue, but SNBR is still trading at a single-digit PE ratio relative to this depressed performance. I wouldn’t value a company based on one year’s earnings, but $41 a share is still too cheap.

Even if we look at the five-year period prior to 2021’s record performance, SNBR is trading cheaply relative to its average net income and cash flow. From 2016 through 2020 SNBR averaged $81mm in net income and $130mm in FCF. This methodology undersells the company’s performance due to its consistent growth in revenue and earnings, but even in this situation SNBR is only trading at 11 times earnings.

Risks

SNBR will continue to face headwinds and short-term risks throughout 2022. The big three I will be watching are inflation, chip shortages, and consumer weakness. Of the three, I’m really only concerned about a sustained economic slowdown lowering customers’ discretionary income. I see a logical path to inflation and chip shortages improving; I am less confident in my ability to assess the health of the retail consumer. I think SNBR is somewhat insulated, given that they target higher-income customers, but a prolonged recession isn’t going to do them any favors. I am not worried about SNBR’s debt position. The terms of their revolving credit facility are favorable and there is over $300mm in liquidity that could be tapped in a pinch. At worst SNBR might be forced to cut back on share repurchases for longer than expected, but I’m not worried about their solvency or the viability of their business model. I’m confident that SNBR will be around in 5 years, and the upside potential in that time far outweighs the short-term risks.

Conclusion

SNBR is a wonderful company trading at a cheap price relative to the long-term value it will deliver to shareholders. The company is performing well in a difficult environment and finding opportunities to reinvest cash at high rates of return. I expect SNBR to post market-beating returns over the next three to five years despite a difficult 2022 and have added to my position in the company.