Investors in the mattress manufacturers have had a tough time lately, despite favorable tailwinds from rising home sales and discretionary spending. The lower-priced, inner spring segment has been losing sales to the specialty mattress segment, led by Select Comfort Corp. (NASDAQ:SCSS) and Tempur-Pedic International Inc. (NYSE:TPX), as customers have been willing to pay higher prices in order to gain the health benefits of high-tech bedding products. Meanwhile, the specialty manufacturers have been trying to outspend each other in the ad market so that they can mark their product as the world’s best mattress. The question is, can investors earn good returns in the sector? Let’s look at the pros and cons.
Long term growth: Sales of mattresses generally rise in line with overall growth in the population. According to the International Sleep Products Association (ISPA), U.S. wholesale sales of mattresses reached $6.3 billion in 2011 and have grown at a 5.2% compound rate since 1990. Aging customers have also been opting for more expensive models in order to get a “good night’s sleep.”
Limited competition: The industry continues to consolidate, with a better pricing environment for the surviving companies. The ISPA estimates that three companies, Sealy Corporation (NYSE:ZZ), Serta, and Simmons, control over 50% of the inner spring segment, while Select Comfort and Tempur-Pedic control roughly 19% of the specialty market. Continuing the trend, Tempur-Pedic agreed to buy Sealy in December 2012 for roughly $229.5 million to gain exposure to the lower-priced market segment. Meanwhile, Select Comfort bought competitor Comfortaire in January 2013 to increase its market share in the adjustable, air bed segment.
Decent Profitability: Despite weakness during the financial crisis, the manufacturing of mattresses is a profitable business that is enhanced by customers’ increased desire for more expensive, high-tech products. In FY2012, Select Comfort reported increases in revenues and operating income of 25.8% and 32.4%, respectively, versus the prior year. The company benefited from double-digit increases in units sold, as well as higher average prices for its mattresses. In addition, the company’s focus on direct sales, through its 400 stores, has led to an improved operating margin.
Tempur-Pedic also remained solidly profitable in FY2012, although its results were below the prior year. The company reported decreases in revenues and operating income of 1.1% and 27.1%, respectively, during the period. Despite economic pressure in certain of its 80 international markets, Tempur-Pedic’s domestic segment performed relatively poorly, with a 4.0% decline in sales in FY2012.
The company has undertaken a different sales strategy than Select Comfort, by choosing to focus on the wholesale market. Despite a small direct retail and online segment, Tempur-Pedic generates almost 90% of its sales from its 14,000 retail partners. Its lack of control over the entire sales process requires a more diversified product mix, which the company is likely trying to achieve through its acquisition of Sealy.
Cyclical business: While a subset of customers are always upgrading their mattresses, recessions lead to reductions in discretionary spending and delayed purchases. In 2008, Select Comfort and Sealy ran their businesses at a loss, while Tempur-Pedic earned lower profits. Given this business dynamic, large scale operations are necessary for industry competitors to make the necessary investments throughout the business cycle.
Low leverage: Like most cyclical businesses, the mattress industry is not a good business to run with high debt levels. Sealy has never recovered from its leveraged buyout by a private equity group and is still hobbled by over $600 million in funded debt. The company barely covers its fixed charges, paying a portion of its interest charges with non-cash, PIK payments.