TPX: Can Tempur Pedic Investors Rest Easy?
This is a reprint of my December 10, 2007 RealMoney article.
Despite an impressive recent history of earnings surprises and a string of analyst upgrades in the last few months, shares of Tempur Pedic (TPX) have been stuck in a trading range for much of 2007.
The slowdown in the housing market has investors skittish over anything related to homes, including furnishings. But earlier this year Tempur Pedic was selling more mattresses than it could make.
By April the company had caught up with demand and was ready to start driving demand again. And in both the June and September quarters earnings per share came in $0.04 ahead of estimates.
So, with the stock now trading at just 14x the consensus earnings estimate for 2008 (and history suggesting that the consensus estimate is too low), is it time for investors to overcome their skittishness and buy Tempur Pedic? I turned to the latest 10Q to look for answers.
Financial Engineering
So far this year, the company has borrowed $200 million and used those proceeds (plus most of the cash flow it generated) buying back shares. The 8% reduction in share count accounted for a nickel’s worth of the EPS in the third quarter.
The downside to this move is that adding debt to reduce equity has caused some odd consequences. The book value has been virtually wiped out, and there is now $556 million in long-term debt against just $28 million in shareholders’ equity on the books.
Of course, debt financing is not necessarily a bad thing. As long as the company can make payments on the debt, the tax advantages and lower capital costs can make it a favorable alternative to equity. And why let private equity buyers reap the advantages if management and shareholders can do it themselves?
Tempur Pedic generated $130 million in cash from operations in the first nine months of 2007 and spent just $14 million on capital expenditures and acquisitions. The remaining $116 million (remember - that was just nine months worth) would have been enough to repay a quarter of the debt. So for now it doesn’t look like the company is overly stretched.
Cash Flow Concerns?
Prudence, however, dictates a careful examination of that cash flow to see whether it is sustainable. After all, cash flows can be volatile, and debt won’t just disappear if the cash flow starts falling.
That $130 million in cash flow from operations was a decline from $133 million in the first nine months last year, even though net income was $20 million higher. Net income rising while cash flows are falling is a signal that more of the net income is attributable to accruals (estimates) rather than actual cash changing hands. Many consider such relationships to be a warning sign that net income is overstated.
For Tempur Pedic, the culprit is a $33 million swing in inventory investment. Last year the company drew down $18.5 million in inventory, whereas this year it added $14.2 million to inventory.
I’m not too concerned about that, for the reasons mentioned earlier - at the beginning of this year (and much of last year) the company didn’t have enough manufacturing capacity to meet demand. As a result, it drew down inventory. This year the capacity has been increased enough to meet demand and build back some of the inventory. Since the sales are growing, it is also appropriate for the inventory to keep growing (as long as the growth is more or less in line with the growth in sales.)
Valuation
As noted earlier, Tempur Pedic is starting to look attractive on a P/E basis, particularly given the 23% earnings growth expected next year and the 17% five-year consensus growth forecast.
The company still gets two thirds of its sales in the United States, which suggests that some concern is still warranted given the declining housing market and other signs that the economy may be slowing.
Still, with the company on track to generate $100 million in free cash flow this year, the 3.6% FCF/EV yield is at least comparable to the yield on Treasuries. The consensus growth estimate clearly offers investors an enticing risk premium, provided they believe it will materialize.
Note:
If you’re at college then be sure to look into student credit cards to pay off your bills.
