Danger Zone: Mattress Firm Holding Corp (NASDAQ:MFRM)
Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

Mattress Firm
Photo Credit: Social Woodlands (Flickr)

A beaten down company will always find its suitors, those wanting to “pick up the pieces” or buy the bottom. This week’s Danger Zone pick is down 32% year to date, but it is not a good value and carries high downside risk. Unsustainable revenue growth, destructive acquisitions, and declining profits land Mattress Firm (MFRM: $31/share) in the Danger Zone.

Revenue Growth Masks Soaring Losses

Mattress Firm’s economic earnings, the true cash flows of the business, have declined from -$14 million in fiscal 2012 to -$111 million over the trailing twelve months. These losses come despite revenue growing from $704 million in fiscal 2012 to $2.5 billion in fiscal 2015, or 38% compounded annually. Revenues have continued to grow to $2.8 billion over the last twelve months. Figure 1 highlights the disconnect between revenue and cash flow. See the reconciliation of Mattress Firm’s GAAP net income to economic earnings here.

Figure 1: MFRM’s Losses Grow Despite Revenue Growth

NewConstructs_MFRM_RevVsEconEarnings_2016-07-25

Sources: New Constructs, LLC and company filings

In its quest be the leading mattress retailer, since 2013, MFRM has made over 15 separate acquisitions for upwards of $1.4 billion. Most recently, the firm paid $795 million for the acquisition of HMK Mattress Holdings in February 2016. While these acquisitions are superficially “accretive” to EPS, they are highly dilutive to cash flows and MFRM’s balance sheet. From 2013-2016, Mattress Firm’s debt grew 42% compounded annually to $2.1 billion. Over the last twelve months, debt has ballooned to nearly $2.9 billion, more than double the current market cap.

The telltale sign that these acquisitions have been a raw deal for investors is the steady deterioration of MFRM’s return on invested capital (ROIC). Since earning a 10% ROIC in 2012, Mattress Firm’s ROIC has more than halved to a bottom-quintile 4% over the last twelve months. Similarly, MFRM has burned $1.6 billion in free cash flow from 2013-2016, and over the last twelve months, FCF sits at -$603 million.

Executive Compensation Rewards Destroying Shareholder Value

Apart from base salaries, executives at Mattress Firm receive annual cash bonuses and long-term stock-based awards. The cash bonuses are granted solely for meeting adjusted EBITDA targets. As seen in Figure 2 below, adjusted EBITDA presents MFRM in a much more positive light than the true profits of the business, which misalign executives incentives with those of investors. By removing costs such as compensation expense or acquisition costs, executives can grow the top line and adjusted metrics with little or no attention paid to the economics of their actions. Additionally, we’ve seen the damaging effects that incentivizing executives with stock price targets can have, particularly at Valeant Pharmaceuticals. The best way to create shareholder value, and align executives with the best interest of shareholders, is to tie performance bonuses to ROIC because there is a clear correlation between ROIC and shareholder value.

Adjusted EBITDA Rises While Profits Decline

Investors analyzing non-GAAP metrics would believe Mattress Firm’s business is achieving great success. Mattress Firm is a prime example of how companies remove normal operating costs to create a more positive picture of the business. Here are expenses MFRM has removed when calculating its non-GAAP metrics, including adjusted EBITDA, adjusted EPS, and adjusted cash EPS:

  1. Loss on store closing & impairment of store assets
  2. Loss from debt extinguishment
  3. Stock based compensation
  4. Secondary offering costs
  5. Acquisition related costs
  6. ERP system implementation costs

These costs have a material impact on results, particularly acquisition related costs. In 2016, MFRM removed $23 million (35% of GAAP net income) in acquisition related costs to calculate its adjusted EBITDA. After removing these costs, MFRM is able to report non-GAAP results that are not only much improved from economic earnings, but rapidly rising when cash flows are declining. Adjusted EBITDA grew from $87 million in 2012 to $255 million in 2016, or 31% compounded annually. Over this same time, GAAP net income grew 17% compounded annually while economic earnings declined from -$14 million to -$55 million, or -41% compounded annually, per Figure 2.

Figure 2: Misleading Non-GAAP Metrics

NewConstructs_MFRM_MisleadingNonGAAP_2016-07-25

Sources: New Constructs, LLC and company filings

Low Profitability In A High Margin Industry

The retail mattress market is well known to have exorbitantly high markup on its products. Such markup provides excellent opportunity for profits, which ultimately breeds competition. The mattress market is highly fragmented, and MFRM faces competition from regional and local stores such as America’s Mattress, retail furniture stores like Ashley Furniture, Haverty’s (HVT), and Rooms-to-Go, department stores like Macy’s (M) and J.C. Penney (JCP), and large retailers like Wal-Mart (WMT), Costco (COST), and Amazon (AMZN). This list doesn’t even mention the new start-up online mattress retailers such as Casper, Tuft & Needle, Saatva, and Leesa. Unfortunately for investors, MFRM has not been able to translate these high markup prices to high margins or a high ROIC. As seen in Figure 3, MFRM’s ROIC ranks well below most competitors and its margins hardly surpass big box retailers better known for selling products with razor-thin margins.

Figure 3: MFRM’s “Retail-Like” Profitability

NewConstructs_MFRM_ROICcomparison_2016-07-25

Sources: New Constructs, LLC and company filings 

Bull Hopes Rest On Happy Ending to Roll-Up

First, we’ve seen this movie before. In my experience on Wall Street (going on 20 years), there have been precious few roll-ups that have a happy ending. Most of them end with investors realizing the emperor has no clothes, or the consolidator has no cash flows.

Roll-ups make the insiders (corporate executives and Wall street bankers) lots of money, and investors should not be surprised to see these folks touting the roll-up plan. Remember that these insiders’ interests are not aligned with yours. As we detail below, Mattress Firm’s roll-up pitch fits the description of a roll-up scheme very well.

Prior to the HMK Mattress Holdings acquisition, the mattress market was highly fragmented. Post acquisition, MFRM stated the combined firm would have a 21% share of the mattress market. As market share climbs, roll-up strategies become harder to execute, because the impact of acquisitions becomes ever smaller. As such, those betting on the future growth of Mattress Firm are betting on the inevitable end of the roll-up and successful, more importantly profitable, integration of all the acquired firms.

However, without the constant acquisitions to grow the top line and poor organic growth, the bull case appears rather weak. Since 2012, total sales have grown on average 38% each year. Excluding new stores, comparable-store sales have grown only 4% on average each year since 2012. Even the revenue growth numbers are misleading. Once the roll-up strategy comes to an end, revenue growth will follow the negative trend that profits have been setting for years.

Investors have taken note of the lack of organic growth at MFRM, but as we’ll show below, even after falling 32% YTD, MFRM is still priced for significant profit growth. Such profit growth is unlikely to be achieved with such low comparable-store sales.

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