Pricewaterhouse Coopers’ Transaction Services practice published a report in February about the U.S. IPO market in 2011. One of its key comments noted the diversity of industries going public last year.
One of the most successful was Mattress Firm (NASDAQ:MFRM), a Houston-based retailer of mattresses and related products. Up 139% since its IPO on November 17, 2011, the stock will inevitably experience a letdown in the future. I’ll explain why.
According to Renaissance Capital, there were a total of 129 IPOs in the past 12 months, with total proceeds of $27.5 million. Consumer-related IPOs numbered 12, Mattress Firm among them. Although technology IPOs were the most popular this past year, with 46 deals consummated, consumer IPOs have done the best in terms of total return — averaging 53.4%. Mattress Firm produced the highest 12-month return of any U.S. IPO — higher than LinkedIn (NASDAQ:LNKD) or Annie’s (NASDAQ:BNNY).
What makes it so special?
Mattress Firm operates in a fragmented industry, with no single retailer holding over 7% market share. This means the industry is ripe for consolidation.
On April 10, the same day Mattress Firm announced its fourth-quarter earnings, it also announced that it’s buying 180 stores from Mattress Giant for $47 million. The deal, along with a previous one for 55 stores, increased Mattress Firm’s store count by 35%, making it the largest specialty sleep retailer in the U.S. That’s all very exciting until you realize that if Mattress Firm wants to maintain that position, it needs to keep feeding the expansion machine, which is one expensive endeavor.
Recently, CEO Stephen Sanger appeared on CNBC’s Squawk Box, suggesting the company will add 100 stores per year until it reaches its goal of 2,500 stores. At a rate of 100 store openings per year, it will take the company 15 years to reach its goal. Therefore, it’s safe to assume that acquisitions will play a big part in its future growth, and every time Mattress Firm does a deal, the price per store gets ratcheted up.
This will get expensive fast. It costs the company $170,000 to open a new store, and it paid $234,000 each for Mattress Giant’s locations. If the company grows organically, the cost will be $255 million, not including inflation. If the company gets impatient, which I believe it will, the cost will be closer to a billion dollars.
It’s one thing to have 2,500 stores selling blue jeans; it’s another to be selling $1,000 beds. This is a bankruptcy waiting to happen.
According to Mattress Firm’s IPO, its average store generates $1.15 million. The average Mattress Giant store generates 75% of that, or $864,000. Therefore, Mattress Firm paid approximately $0.27 for every $1 of sales Mattress Giant generates. That’s a great deal if these stores are able to match Mattress Firm’s own level of sales. But that’s a big “if.”
In 2008, Birch Hill Equity Partners and Westerkirk Capital paid $335 million for Sleep Country Canada, Canada’s largest mattress retailer, with 206 stores at the time of the deal and annualized sales of $325 million. That’s 1.03 times sales. Either they severely overpaid for Sleep Country or Mattress Giant’s assets aren’t nearly as sparkling as Sanger would have us believe. I suspect it’s the latter.
Forget the consolidation play for a moment and instead consider the alternatives. Mattress Firm’s current enterprise value is $1.91 billion, or 26 times EBITDA. Its CEO sleeps on a Tempur-Pedic (NYSE:TPX) mattress.
A darling of the markets in recent years, Tempur-Pedic’s enterprise value is just 16 times EBITDA. Yet operating margins are three times those of Mattress Firm. A second, albeit less attractive, alternative is Select Comfort (NASDAQ:SCSS), maker of the Sleep Number beds. Its margins aren’t as good as Tempur-Pedic’s, but they’re certainly better than Mattress Firm’s. Investors who got in on the IPO and can sell their shares should do so.
Mattress retail is all about the numbers, and eventually they always turn south. Just look at its history. Sun Capital Partners acquired Mattress Firm in October 2002 for $4.5 million in equity and $30 million in debt. Four years and a serious overhaul later, it sold the business to J.W. Childs and their investment partners for $450 million. Childs & Co. invested about $145 million, with the rest in debt.
Today those shares are worth a little more than $1 billion. It’s not the same return as Sun Capital’s, but it’s plenty. Expect Childs & Co. to start selling off shares through a secondary offering in the summer once the May 15 lockup has passed.
Mattress Firm’s history is like the movie Groundhog Day, repeating the same thing over and over. Down the road, its expansion plan will falter, its debt will increase exponentially and its share price will crater. Then, facing potential bankruptcy, it will sell itself to another private equity firm, which will repeat the process.
The only winners in this IPO are J.W. Childs and partners.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.