Sleep Number Stock: The Short Term Is A Mess (NASDAQ:SNBR)

Sleep Number (NASDAQ:SNBR) continues to struggle in a messy macroeconomic environment. Q3 net income surprised to the upside, but revenue, margins, and cash flow were all pressured due to slowing consumer demand and a shortage of key semiconductors. Management slashed FY estimates, implying negative net income for Q4 and breakeven cash flow for the year. Management isn’t releasing 2023 estimates until the end of the year, but a stubborn lack of a specific semiconductor and a cautious consumer will cause difficulties for the company in the coming year. Despite the headwinds, I think the long-term thesis remains intact and SNBR’s balance sheet flexibility will enable them to weather the short-term storm.

SNBR Saw Softening Demand for their Products

SNBR’s performance is being hampered by slowing demand for their products. Q3 revenue of $541mm was down 16% year-over-year on “near-record low” consumer sentiment. Management expects softened demand to last through Q4 and beyond into 2023. Digital traffic remained relatively flat, but conversion rates fell as customers were “slow to take additional steps leading to purchase”. Management’s plan is to put extra emphasis on targeting existing customers for repeat sales and to offer significant product discounts. This is a bad situation for SNBR; the company is facing declining unit sales at lower prices while their gross margins are already under pressure from supply chain issues.

SNBR Continues to Face a Chip Shortage

Despite broad improvements in the global supply chain, SNBR is struggling to procure an adequate number of chips that are critical to their smart bed technology. The chip shortage hurts SNBR in two ways. First, it limits the company’s ability to offer their full range of products. SNBR removed entire product lines from their catalog due to the shortage (such as their Flex Fit I and II adjustable bases) and will have trouble servicing their backlog in Q4. Management noted on the Q3 conference call that the lowered Q4 guidance is due in part to a shipment of 15,000 semiconductors that will arrive later than expected.

Secondly, the chip shortage puts pressure on SNBR’s gross margins. Q3’s gross margin was 500 basis points below the previous year’s margin. COGS increased due to “expedited freight (costs) to pull forward chip receipts to the earliest possible dates, brokerage part premiums, unfavorable (sales) mix and inefficient operations from uneven chip flow”. SNBR’s net margins were a paltry 1% in Q3 as a result, with total net income coming in at just $5mm.

An analyst on the Q3 conference call questioned SNBR’s claims of a semiconductor shortage against the backdrop of improving supply chains and headlines declaring the chip shortage to be over (an example). Management responded by stating the flow of the semiconductors was the primary difficulty. Smart bed production is hampered by small delays in semiconductor production that turn into long delays as those chips move through the global supply chain. CEO Shelly Ibach noted that the particular semiconductors needed by SNBR are the same that are used heavily in the auto industry, and there are signs that automakers are still struggling to get the chips they need (source) (source). The pessimistic take is that SNBR is less effective at procuring chips than other companies or that they are using a chip shortage as a flimsy excuse for declining performance. The optimistic take is that the semiconductor shortage is resolving much faster than expected, and this drag will be removed by the start of 2023. I’m willing to give SNBR the benefit of the doubt here, but it will be a red flag if they continue to struggle with semiconductor supply when everyone else is able to get what they need.

A Look at the Bigger Picture

The short-term outlook for SNBR over the next year is poor, but I remain bullish on the company’s long-term prospects. I see the current headwinds as temporary, and I believe the company is in good enough shape to weather a recession and survive to realize its long-term potential. I also think the company is cheap relative to more normalized performance.

I see evidence that both of SNBR’s major problems are temporary. Despite shipment delays and diminished product offerings, SNBR’s customer satisfaction and brand loyalty remain high (according to management). The company’s cancellation rate remained flat in Q3 in the face of longer lead times, and web traffic held steady. SNBR has a long history of robust customer demand and profitable operations; people love their products, they just might have a more difficult time justifying buying them when they are worried about the broader economic outlook. On the semiconductor issue, there is growing consensus that the global chip shortage is resolving faster than expected. The only bright side of slowing consumer demand is that it will also lower the demand for semiconductors across industries, which would help to alleviate supply concerns and allow for a build-up of chip inventory.

I believe SNBR’s financial position is strong enough to weather the current storm. The company’s balance sheet looks weak on the surface, with limited cash and $400mm in revolving credit facility debt, but the situation is not dire. SNBR is generating meaningful cash flow from operations ($80mm worth through Q3) that is on track to cover their capital expenditures for the year. The company has another $400mm available to tap from their credit facility and raised their leverage ratio limits with minimal fuss from their lender. SNBR doesn’t anticipate dipping deeper into their credit facility, given the capital-light nature of their operations and a moratorium on share buybacks, but the available liquidity acts as a safety buffer if economic conditions further deteriorate.

Finally, SNBR is undervalued relative to its normalized performance. At the time of this writing, the company’s market cap is just $640mm. This is in contrast to the trailing 5-year average net income of $95mm (including the low-end estimate for full-year 2022) and free cash flow of $141mm. A conservative 10x multiple on both (which would discount SNBR’s history of slow but steady revenue growth) results in a target market cap somewhere between $950mm and $1.4b (50-120% upside). Even using the 5-year period from 2015 through 2019 (to avoid any boost from pandemic spending) results in normalized net income of $63mm and free cash flow of $88mm. The market is slightly undervaluing SNBR even based on 2019 normalized performance with no credit for growth. I see a future much brighter than that for SNBR; the market is overly focused on the next year, not the next 3-5 years.

Risks

The biggest risk here is that I am wrong about SNBR’s future prospects and that the company is actually a melting ice cube rather than a sustainably profitable business. SNBR has had over 12 years of consecutive years of revenue growth prior to 2022, but history in and of itself doesn’t guarantee future success. I’m not worried about SNBR’s debt burden; the company has enough liquidity on their credit facility to fund another 5 years’ worth of capital expenditures and has demonstrated that they can adjust terms with the lender as needed. Of course, if the business is a melting ice cube this becomes a much bigger problem, but in that case, the business would be doomed anyway even if they were debt free.

Conclusion

SNBR’s short-term problems are painful and will likely continue into 2023. The market is acutely aware of this, and the company’s shares are trading at a depressed valuation relative to normalized performance as a result. I’m content to hold my position through these short-term struggles to take advantage of the long-term rerating higher, but I expect this could take another 2-3 years to achieve.