When Tempur-Pedic (TPX) announced last month that its earnings would be below expectations, I noted that the company generated $130 million in free cash flow to the firm last year. Tempur-Pedic’s enterprise value was $1.4 billion, including $600 million in debt. I said “April $10.00 put options are trading for $0.60, offering a 6% six-week premium and/or a $9.40 entry price to anyone daring enough to write the options ahead of the new financial guidance.”

Too bad I didn’t have the capacity to take that dare. Shares traded much higher on the announcement, so I would have been able to pocket that premium.

The Company reported net income of $13.5 million for the first quarter of 2008 as compared to $29.8 million in the first quarter of 2007 and revised full year 2008 guidance for net sales and earnings per share. It currently expects net sales for 2008 to range from $1.01 billion to $1.07 billion, a decrease of 9% to 3% as compared to 2007. It currently expects EPS for 2008 to range from $1.20 to $1.45 per diluted share. This guidance reflects a decrease of 31% to 17% compared to 2007 EPS of $1.74 per diluted share. The Company noted its expectations are based on information available at the time of this release, and are subject to changing conditions, many of which are outside the Company’s control.

Even after the rally, the shares are trading at less than 10 times the low end of that guidance range. Cash flow from operations for the quarter was down $4 million from the year-ago period, so on a trailing 12 month basis the free cash flow is closer to $125 million. That’s good for a 14.2% yield on the current market capitalization.

I think there could still be some downside risk to those estimates. As I have said before, four thousand dollar mattresses aren’t likely to be high on cash strapped consumer’s shopping lists.

That said, however, the valuation could still look cheap even after further cuts. I’ll be interested to see whether the support it was getting at $10 stays firm.

Disclosure: At time of publication, William Trent has no financial position in the stocks mentioned.

A few weeks ago, Tempur-Pedic (TPX) lowered its earnings guidance for 2008, and I said even though the current consensus estimates are at the low end of management’s new guidance, I wouldn’t be at all surprised to see additional cuts to future estimates.

To me, the most telling sign in the press release was management’s excitement over new product launches. “Next week, we will introduce a new mattress model in the U.S…. This model… will have a suggested retail price point of $3,999 for a queen size mattress.” Four thousand dollar mattresses aren’t likely to be high on cash strapped consumer’s shopping lists.

Today Tempur-Pedic noted that first quarter sales to date in the U.S. have been significantly below the Company’s plan as a result of economic factors affecting consumer spending. The Company’s first quarter operating expense structure was planned and incurred to support a higher sales level. Therefore, the Company currently expects first quarter earnings per share to be approximately half the amount for the first quarter of 2007.

That means less than $0.20 per share in earnings, compared with analyst estimates of $0.44.  So much for the apparently-low P/E multiple.  The Company currently expects to amend financial guidance when it reports first quarter results in April, and its previously announced financial guidance for full year 2008 should no longer be relied upon. The question is whether the amended financial guidance should be relied upon.

That said, the company generated $130 million in free cash flow to the firm last year. At today’s share price, the enterprise value is $1.4 billion, including $600 million in debt. The Company said today it will be using that cash flow to reduce the debt load, which I view as appropriate.

April $10.00 put options are trading for $0.60, offering a 6% six-week premium and/or a $9.40 entry price to anyone daring enough to write the options ahead of the new financial guidance.  I don’t have the capacity for it right now, but it’s something I’ll consider in a few days.

Disclosure: William Trent has no financial position in the companies mentioned.

The following is a reprint of my January 28, 2008 RealMoney column.

When I wrote about Tempur Pedic (TPX) in December, I said “some concern is still warranted given the declining housing market and other signs that the economy may be slowing.” Although the shares appeared attractive based on the then-expected 23% earnings growth in 2008 and 17% five-year consensus growth forecast, that attractiveness depended heavily on the forecasts.

On Friday, those estimates were taken down a few notches after the company reported earnings. The company’s new guidance was “net sales for 2008 to range from $1.195 billion to $1.250 billion, an increase of 8% to 13% over 2007…. EPS for 2008 to range from $2.03 to $2.20 per diluted share…. an increase of 17% to 26%.” The consensus estimate is now $2.06, well below the mid-point of management’s guidance.

That doesn’t mean I think the estimates are now too low, however. None of the issues the company was facing then have gone away.

To me, the most telling sign in the press release was management’s excitement over new product launches. “Next week, we will introduce a new mattress model in the U.S…. This model… will have a suggested retail price point of $3,999 for a queen size mattress.” Four thousand dollar mattresses aren’t likely to be high on cash strapped consumer’s shopping lists.

So even though the current consensus estimates are at the low end of management’s new guidance, I wouldn’t be at all surprised to see additional cuts to future estimates. However, the valuation is low enough that I wouldn’t want to risk being short the name, either.

The shares are trading at barely 8x the current-year consensus EPS estimate. Free cash flow to the firm (operating cash flow, plus after-tax interest, less capital expenditures) over the last 12 months was $130 million, and that number was lower than would otherwise be sustainable because the company had to make up for an inventory shortfall due to high demand and production problems early last year.

Even at the potentially conservative cash flow number, the current free cash flow yield of 6.6% is nearly 500 basis points higher than the 5-year Treasury. And even with the now-lowered numbers Wall Street is expecting 13% earnings growth on average over the next five years. Hardly what I would consider an ideal short.

There is one way to play Tempur Pedic that I think may prove profitable, though. Selling put options would allow you to keep the insurance premium if the shares don’t drop further, and would reduce the effective purchase price if they do have further to fall.

For example, the February $17.50 puts closed at $0.65 on Friday. By writing the puts, an investor could keep that $0.65 (a 3.7% one-month return on the money at risk) as long as the shares didn’t fall more than 7.75% from Friday’s close in the next month. The trade would still be profitable up to an 11.2% decline in the stock from the Friday close.

Alternatively, the longer-term options may also work. The midpoint of the spread for January 2009 $17.50 puts was $3.15. At this premium, the one-year return is potentially 18% on the money risked provided the shares remain above the strike price. As long as the shares stay above $14.35 (nearly a 25% drop from Friday’s close) the trade would be profitable.

So rather than buy the shares or short the shares today, I’d rather wait… or get paid to wait.

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.

In a recent RealMoney column, I wrote that Tempur-Pedic (TPX) 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. However, 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.

The stock is down today after competitor Select Comfort (SCSS) lowered guidance. But I also saw two positive bits of news on the company.

First, the judge dismissed an anti-trust case against Tempur Pedic.

Second, Zacks ranked it highly and wrote a detailed analysis on their site.

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The market has been very rough on my Small Cap Watch List (Track at Marketocracy) this quarter. Obviously including Impac Mortgage (IMH - Annual report) on the list was not a good start, but the housing market isn’t the cause for all the woes – at least not directly. Pretty much everything is down and homebuilder NVR’s (NVR - Annual report)10% decline puts it among the top performers while furniture maker Tempur-Pedic (TPX) has turned in the best performance on the list.

In the bottom camp, however, has been another construction related stock – namely US Concrete (RMIX). Down nearly 20% since the end of June on the heels of a lowered outlook, it is starting to look ugly. The Zacks rank, which tracks earnings momentum, is the second-lowest possible rating. Free cash flow in 2006 was a big goose egg thanks to unusually high capital expenditures and the debt load now exceeds the market capitalization.

Still, the stock is also now trading with a single-digit P/E multiple and 7.6x EV/EBITDA multiple, both of which are reasonable. The market price is barely above book value and the price/sales is a measly 0.35x. The company also has more than $75 million in working capital, which is a double-edged sword. In a slowdown working capital could be reduced and boost cash flow – provided the customers to whom they sell the inventory and from whom they are owed receivables are able to stay in business too. Combining this with the fact that capital expenditures were abnormally high in 2006 suggests that the “normal” free cash flow is closer to the $25 million they realized in both 2004 and 2005.

My spirits rose a bit when I saw the 8-K they filed yesterday, saying:

On July 31, 2007, we entered into new Executive Severance Agreements with several of our officers, including the following “named executive officers” identified in our proxy statement relating to our 2007 annual meeting of stockholders: Michael W. Harlan, Robert D. Hardy and Thomas J. Albanese. The new agreements generally replace other agreements or term sheets previously agreed to between us and the applicable officers. Each Executive Severance Agreement provides for severance payments and other benefits following termination of the applicable officer’s employment under various scenarios, as described below. Each such agreement also contains a confidentiality agreement, requiring the applicable officer to maintain the confidentiality of confidential information we provide him, as well as a non-competition agreement that generally extends for one year after the officer’s employment terminates (subject to extension in the event of a change of control, so that the non-competition agreement will extend to cover the number of months used to determine the severance benefits payable to him (as described below)).

Could all the focus on a potential change in control signal that one may be in the works? It is possible. I think the odds of a private equity buyout are relatively low due to the fact that there is little room for additional leverage and the valuation already appears reasonable rather than cheap. Then again, the low market capitalization would make it an easy bite.

Still, I think that if there is to be a buyout it would probably come from a competitor who would have greater opportunity to cut costs through economies of scale. Yahoo! Finance lists six cement makers with market capitalizations of $2 billion or more -  all of whom would also find US Concrete to be a bite-size addition to their current business.

Here’s hoping.

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Small Cap Watch List (Track at Marketocracy) and Mid Cap Watch List (Track at Marketocracy) member Tempur-Pedic (TPX) announced that earnings per share (EPS) increased 30% to $0.39 per diluted share in the second quarter of 2007 as compared to $0.30 per diluted share in the second quarter of 2006. Net sales rose 18% to $257.6 million in the second quarter of 2007 from $219.0 million in the second quarter of 2006. Retail sales increased 22% worldwide. Domestic retail sales increased 23% and international retail sales increased 18%.

Analysts had been expecting just $0.35 on $244 million in sales, and the stock soared in after-hours trading, finally validating one of my earnings previews this week (I said estimates have been rising but they will probably still beat them.)

Having blown through the prior $100 million share repurchase since January, the board authorized an additional $200 million. They will have to pay more for these shares, though, since the company raised guidance:

Given the Company’s strong performance through the first half of 2007 and its continued positive outlook for the year, the Company is increasing 2007 full year financial guidance. The Company now expects net sales for 2007 to range from $1.065 billion to $1.085 billion, rather than $1.040 billion to $1.070 billion. This guidance reflects an increase of 13% to 15% compared to 2006 net sales of $945.0 million. The Company currently expects diluted earnings per share for 2007 to range from $1.63 to $1.66 compared to its previous guidance of $1.54 to $1.58. This guidance reflects an increase of 27% to 30% compared to 2006 EPS of $1.28. This guidance reflects incremental earnings resulting from increased sales expectations, shares repurchased through June 30, 2007, interest on associated borrowings and a lower full year tax rate. This guidance does not take into account the anticipated effect of any additional share repurchases.

I am going to nit-pick here, and point out that most of the guidance increase appears to be due to the lower tax rate (and is thus non-operational.) Still, even accounting for this the midpoint of the new guidance is above the high end of the old guidance. Analysts right in the middle of the guidance range, so they will have some raising to do.

Cash from operations declined year/year, mostly due to rising inventories. Normally I would be more concerned about this, but the company had to make up for recent shortages (nice problem to have.) All in all, it was a good report from a company that is on a roll.

According to Reuters:

Shares tumbled 5.5 percent in extended trade after Google (GOOG - Annual Report) said net income rose to $925 million, or $2.93 a diluted share, compared with the year-ago quarter’s $721.1 million, or $2.33 per share. Excluding one-time items and stock option expenses, Google posted a profit of $1.12 billion or $3.56 per share, which was 3 cents per share short of Wall Street targets.

That three-cent miss led to a $40 selloff in after-hours trading, reducing the trailing P/E multiple from 42x to 38x. Bulls will no doubt argue that the stock is still a high-profitability high growth wonder trading at a market multiple on a P/E/G basis. But I think that misses some important points.

First of all, the company has beaten estimates by approximately 10% in each of the prior four quarters. Given that track record, it is likely investors were really expecting the company to beat by 10% or about $0.30. So in reality this was more like a $0.33 miss than $0.03.  Seen from that perspective the multiple has barely budged despite what is arguably a significant slowdown in the growth rate.

Secondly, with GAAP earnings growth of 25% Google suddenly doesn’t look nearly as special as it used to. Heck, Tempur-Pedic (TPX) gave us 30% EPS growth at half the multiple. So much for exciting tech stocks when geriatric mattresses can top them.

In Google’s favor is the fact that they don’t play any guidance games (though the Street tries to do it for them.) So next quarter things could quite suddenly look wonderful again. But this report should give everyone a wake-up call saying they shouldn’t count “forward earnings” before they hatch.

The Economic Calendar is fairly active this week.

• PPI (Tuesday) – Look for my usual breakdown of the industries with pricing power
• Industrial Production (Tuesday) – Let’s see if businesses really are picking up steam
• CPI (Wednesday) – We know food costs more. What else does?
• Housing Starts (Wednesday) – Preview: They will be bad, and if not it will be bad news.
• Leading Indicators (Thursday)

The Earnings Calendar is going into overdrive this week. Some names I’ll be watching:

• Tata Consultancy Services (TCS)  – What will they say on Monday about rising wages and currencies?
• Intel (INTC - Annual Report) – (Tuesday) – Estimates seem low enough. Margins will improve ex Flash.
• Yahoo! (YHOO) – (Tuesday) – Low expectations likely justified but perhaps rewarded.
• American Standard (ASD) – (Wednesday) – They are on my Large Cap Watch List (Track at Marketocracy) and they are on the move. They’re picking up momentum and I suspect they will top estimates.
• Silgan Holdings (SLGN - Annual Report) – (Wednesday) – They are on my Small Cap Watch List (Track at Marketocracy) and have been blowing estimates out of the water. This one seems like another beater to me.
• Advanced Micro Devices (AMD - Annual Report) – (Thursday) – Hard to see how it could get any worse, but if anyone can pull it off…
• Landstar System (LSTR - Annual Report) – (Thursday) – This is one of my favorite companies and is on both the Small Cap Watch List (Track at Marketocracy) and the Mid Cap Watch List (Track at Marketocracy). They are trading a touch higher than I would like, though.
• Google (GOOG - Annual Report) – (Thursday) – Numbers are set up for them to beat them. If they don’t beat by enough, however, the stock could still suffer.
• Sandisk (SNDK - Annual Report) – (Thursday) – Who knows?
• SAP (SAP - Annual Report) – (Thursday) – Shouldn’t be much to trade on, but they might say something nasty about Oracle (ORCL - Annual Report) to make listening to their call worthwhile.
• Tempur-Pedic (TPX) – (Thursday) This one also graces both the Small Cap Watch List (Track at Marketocracy) and the Mid Cap Watch List (Track at Marketocracy). Estimates have been rising but they will probably still beat them.

Keep on your toes!

With the end of the first quarter approaching, it is time to adjust the names in my Watch Lists. I will price all the new lists as of the close on Friday, June 29.

Today I present my planned updates to the Small Cap Watch List. There was a fairly high level of turnover to the list. 12 of the 24 names from the previous run made it to the current list, which was also 24 names. Performance-wise, the list created in March has returned an unweighted average return of 2.6% through June 28, with 80% of the stocks in positive territory. All of the money-losers from the previous list fell out of consideration.
So without further ado, the names on the chopping block from the previous list are: PW Eagle (PWEI), Insteel Industries (IIIN), Allied Defense (ADG - Annual Report), Hartmarx (HMX), Parlux (PARL), Hansen Natural (HANS), FirstFed Financial (FED), Young Innovations (YDNT), ITT Educational (ESI), Rent-a-Center (RCII), Valassis (VCI), and Travelzoo (TZOO). The castaways include four of the five money losers from the previous portfolio (HMX, PARL, YDNT and TZOO) as well as the biggest gainer (ESI).
The new list is:

I will continue to track both lists on StockPickr.