January 16, 2008
Research Associate: Archana Sultania, M.Com, PGDFM
Editor: Deepa Agarwal, M. Fin., M. Com.
Sr. Ed: Ian Madsen, CFA, , Tel: 1-800-767-3771,x9417
www.zackspro.com 111 N. Canal Street, Suite 1101 l Chicago, IL 60606
Select Comfort Corporation (SCSS-NSDQ) / $6.53Note: All new or revised material since the last report is highlighted.
Reason for Report: Minor Change in Estimates (1/14 brkrs w. cvrg.)
Prev. Ed.: December 18, 2007; Lowers Sales Outlook for 4Q07 and FY07
Brokers’Recommendations: Neutral: 93.0% (13); Positive: 7 %( 1); Negative: 0% Prev: 12, 2, 0
Brokers’ Target Price: $8.00 (↔ with the last report; 6 firms) Brokers’ Avg. Expected Return: 22.5%
Recent Events - Summary
November 12, 2007: SCSS announced that it expects weak sales outlook for 4Q07 and FY07.
October 24, 2007: SCSS announced its 3Q07 results. On the same date, SCSS declared its plan for expansion in Australia.
Details are provided below.
Overview
Analysts have identified the following issues as critical in evaluating the investment merits of SCSS:
Key Positive Arguments / Key Negative Arguments· SCSS continues to generate strong FCF.
· Growth rate is above the industry average.
· SCSS continues to buy back shares, thereby increasing shareholder value.
· SCSS has a strong and well-reputed management team.
· Favorable demographic trends continue to favor SCSS.
· New product innovations are expected to come by late 2007. / · Competition remains intense.
· Management is focused on increasing marketing expenses, which could have an adverse effect on margins.
· Rising commodity costs remain a cause of concern.
· Supply disruptions.
Headquartered in Minneapolis, Minnesota, Select Comfort Corporation (SCSS) engages in the development, manufacture, and marketing of adjustable-firmness beds primarily in the United States and Canada. Its products include mattresses, foundations, sofa sleepers, and accessory bedding products, including pillows, mattress pads, comforters, sheets, bed frames, and leg options. The company also offers delivery and assembly services. Select Comfort sells its products through home furnishings stores, specialty mattress stores, department stores, call centers, websites, mass merchants, wholesale clubs, telemarketing programs, television infomercials, and catalogs. The company has a strategic alliance with Sleep Country Canada and a strategic relationship with Radisson Hotels and Resorts. More information on the company is available at its website: www.selectcomfort.com.
The company’s fiscal year ends on December 31. November 29, 2007
Recent Events - Details
On November 12, 2007, SCSS announced that it expects weak fourth quarter and FY07 sales and added it has planned certain cost cuts. The company further announced that it expects the trend to continue in 2008.
On October 24, 2007: SCSS announced the launch of the Sleep Number bed and accessories in Australia through a strategic alliance with Harvey Norman Holdings Limited and A.H. Beard.
On October 24, 2007, SCSS announced its 3Q07 results. Highlights are as follows:
· SCSS reported revenue of $213.1 million, up 2.4% y-o-y.
· Pro forma EPS was $0.26, down from $0.25 in 3Q06.
Revenue
As per the company, in 3Q07, net sales increased 3.0% to $213.1 million from $207.7 million reported in 3Q06. According to the Zacks Digest report, sales increased 2.4% to $213.1 million from $208.1 million in 3Q06.
In 3Q07, Retail Stores increased 3.1% to $163.2 million from $158.3 million in 3Q06. Direct call center sales fell 15.0% to $15.3 million. E-commerce sales increased 30.0% to $14.3 million. Wholesale sales decreased 2.4% y-o-y to $20.2 million. Sales growth from new company-owned stores totaled 46 net new stores in the past 12 months, including 11 net new stores in 3Q07.
Select Comfort has not provided any guidance for 4Q07 and 2008 given the current uncertainties, including the ongoing impact of the challenging macro environment, unknown customer response to the company’s 2008 marketing campaign, and the lack of visibility on new product introductions.
The company plans to reduce costs where it can, although it may not be particularly flexible on a short-term basis as the company is spending on its most significant projects (logistics systems, retail store openings and remodels, advertising development and up-front work on its ERP system). The company stated it also plans to raise prices on certain items in January in response to rising costs. As such, one firm (Hilliard, Lyons) expects the lower revenue to be accompanied by a de-leveraging of margins, with a preponderance of that pressure continuing through 2Q08.
One firm (Wedbush) believes that 4Q results will not meet previous guidance for sales of $211 million to $221 million. One analyst (KeyBanc) forecasts comps growth of 3% for FY08.
Analysts believe the weak sales trends would continue into 2008.
Provided below is a summary of revenue as compiled by Zacks Digest:
Total Revenue ($M) / 3Q06A / 3Q07A / 4Q07E / 2007E / 1Q08E / 2008E / 2009ERetail Stores / $158.3 / $163.2 / $142.7 / $603.1 / $165.3 / $627.4 / $674.7
Direct Call Centre / $18.0 / $15.3 / $14.9 / $64.3 / $17.0 / $58.9 / $44.5
E-commerce / $11.0 / $14.3 / $15.2 / $56.5 / $15.7 / $65.6 / $74.7
Wholesale / $20.8 / $20.4 / $20.5 / $77.4 / $18.2 / $75.2 / $94.1
Total Revenue / $208.1 / $213.1 / $195.0 / $802.7 / $213.7 / $830.9 / $904.4
Digest High / $208.3 / $213.1 / $212.0 / $820.0 / $216.6 / $890.0 / $980.0
Digest Low / $207.7 / $213.0 / $186.4 / $794.7 / $212.0 / $802.0 / $855.0
Digest YoY growth / 2.4% / -1.5% / -0.5% / -1.3% / 3.5% / 8.8%
Digest sequential growth / 10.4% / 19.0% / -8.5% / 9.6%
Highlights include:
· For FY07, the estimated revenue range is $794.7 million to $820.0 million with an average of $802.7 million (↔ with the previous estimate).
· For FY08, the range is $802.0 million to $890.0 million with an average of $830.9 million (↔ with the previous estimate).
· For FY09, the range is $855.0 million to $980.0 million, with an average of $904.4 million (↔ with the previous estimate).
Following is a graphical chart analysis of the revenue segments:
Please refer to the Zacks Research Digest spreadsheet of SCSS for more details on revenue estimates.
Margins
In 3Q07, gross margin improved to 61.6% from 62.0% in 3Q06. This improvement reflects the full burden of costs for compliance with mandatory national fire retardant (FR) requirements, which took effect from July 1, 2007. Till date, the company has improved the gross profit percentage through ongoing cost and quality control initiatives, despite the high FR-related manufacturing costs.
Operating profit was $19.1 million versus $21.9 million in 3Q06. In 3Q07, operating margin was 9.0%, compared to 10.5% in 3Q06. This decrease was attributable to the higher fixed costs associated with the increasing number of stores. This was partially offset by lower media spending, which totaled $26.8 million, and reduced general and administrative expenses, which totaled $14.9 million, reflecting lower incentive compensation.
Outlook
Management expects 4Q07 media spending to increase nearly 15% as compared to 4Q06.
One analyst (Piper Jaffray) expects the operating margin to decline by 230 basis points for FY07, attributable to higher expenses related to marketing programs.
In the mid-quarter update, SCSS forecast margin pressure from raw materials cost increases and the enhanced promotional activity designed to help drive traffic. As a result most of the analysts believe that the company is going for an ill-timed price increase in January to offset margin erosion.
As per Zacks Digest, COGS would decrease by 1.6% in FY07, and then increase by 3.4% y/y in FY08 and 8.0% y/y in FY09, as against revenue decrease of 0.5% y/y in FY07, followed by an increase of 3.5% y/y in FY08 and 8.8% y/y in FY09. Hence, the gross margin is expected to remain flat in the future.
Sales and marketing expense is expected to increase by 8.7% in FY07, 3.2% y/y in FY08, and 5.5% y/y in FY09. G&A expense is expected to increase by 0.6% in FY07, 10.5% y/y in FY08, and 4.0% y/y in FY09. Hence, the operating margin is expected to increase to 6.3% in FY07, and then decrease to
5.7% in FY08 and then increase to 7.4% in FY09.
Provided below is a summary of margins as compiled by Zacks Digest:
Margins / 3Q06A / 3Q07A / 4Q07E / 2007E / 1Q08E / 2008E / 2009EGross / 62.0% / 61.6% / 60.0% / 61.3% / 61.4% / 61.0% / 60.3%
Operating Income / 10.5% / 9.0% / 4.6% / 6.3% / 5.7% / 5.7% / 7.4%
Pre-Tax Income / 10.8% / 8.8% / 4.6% / 6.2% / 5.7% / 5.4% / 6.6%
Net Income / 6.7% / 5.6% / 2.8% / 4.0% / 3.6% / 3.5% / 4.6%
Please refer to the Zacks Research Digest spreadsheet of SCSS for more details on margin estimates.
Earnings per Share
In 3Q07, net income totaled $11.9 million versus $13.9 million in 3Q06. In 3Q07, pro forma EPS was $0.26 versus $0.25 in 3Q06. These results were in line with the Zacks Digest report.
The company has withdrawn its FY07 and 4Q07 diluted EPS guidance ranges of $0.75-$0.81 and $0.22-$0.28, respectively, due to the weaker traffic, erratic demand, and rising costs. The company has also not provided any guidance for FY08.
Following the 3Q07 results, one analyst (Zacks Investment Research) reduced the FY07 and FY08 EPS from $0.83 and $0.98 to $0.78 and $0.94, respectively, based on the weaker than expected sales trends. Another analyst (Piper Jaffray) reduced the FY07 and FY08 earnings estimates from $0.82 and $1.00 to $0.76 and $0.95, respectively, in order to reflect the ongoing weakness at retail, uncertain marketing initiatives, and undefined solutions to structural concerns.
Provided below is a summary of EPS as compiled by Zacks Digest:
EPS / 3Q06A / 3Q07A / 4Q07E / 2007E / 1Q08E / 2008E / 2009EDigest High / $0.25 / $0.26 / $0.23 / $0.76 / $0.20 / $0.90 / $1.15
Digest Low / $0.25 / $0.25 / $0.05 / $0.57 / $0.13 / $0.45 / $0.59
Digest Avg. / $0.25 / $0.26 / $0.13 / $0.65 / $0.16 / $0.61 / $0.85
Digest YoY growth / 3.7% / -48.1% / -27.6% / -25.2% / -5.9% / 39.3%
Digest sequential growth / 31.6% / 332.1% / -50.4% / 22.2%
Zacks Consensus / $0.15 / $0.68 / $0.15 / $0.67
Management Guidance After FAS123
Highlights from the above EPS chart are:
· 2007 forecasts (14 analysts) range from $0.57 to $0.76; the average is $0.65 (↔ with the previous estimate).
· 2008 forecasts (14 analysts) range from $0.45 to $0.90; the average is $0.61 (↔ with the previous estimate ).
· 2009 forecasts (4 analysts) range from $0.59 to $1.15; the average is $0.85 (↔ with the previous estimate).
Please refer to the Zacks Research Digest spreadsheet of SCSS for more details on EPS estimates.
Target Price/Valuation
Of the 14 analysts covering SCSS, 1 gave a positive rating and 13 gave neutral ratings. None of the analysts gave negative ratings on the stock.
Target prices for SCSS range from $6.00 (Sidoti) to $10.00 (Thomas Weisel), with an average of $8.00 (↔ with the previous report). One analyst (Thomas Weisel) at the high end has used 2008 P/E and 5 year DCF analysis. The analyst (Sidoti) at the low end used 11x the FY2009 EPS estimate to compute the valuation. Most analysts have used FY07 EPS estimates to compute their respective target prices.
Rating DistributionPositive / 7%
Neutral / 93%
Negative / 0%
Digest High / $10.00
Digest Low / $6.00
Median / $8.00
Avg. Target Price / $8.00
Analysts with Target Price/Total No. / 6/14
Metrics detailing current management effectiveness are as follows:
Metric (TTM) / Value / Industry / S&PReturn on Assets (ROA) / 17.2% / 7.3% / 8.8%
Return on Equity (ROE) / 48.3% / 22.9% / 21.6%
Return on Invested Capital (ROIC) / 39.9% / 10.4% / 12.8%
SCSS’s ROE, ROIC, and ROA of 48.3%, 39.9%, and 17.2% are higher than the overall market averages (measured by S&P 500) of 21.6%, 12.8%, and 8.8%, respectively.
Please refer to the Zacks Research Digest spreadsheet of SCSS for further details on valuation.
Capital Structure/Solvency/Cash Flow/Governance/Other
In 3Q07, cash and investments totaled $8.5 million and outstanding debt totaled $21.9 million. As on September 30, 2007, the company has returned $132 million to shareholders through the repurchase of 7.6 million shares of common stock, including $37.6 million to repurchase 2.3 million shares in 3Q07. The company’s remaining stock repurchase authorization stood at $207.0 million.
Management views 2008 capital expenditures, particularly store remodels and the transition to Sleep Number signage, as high-return investments. Also, Select Comfort is pausing share repurchases in the current environment. The company remains committed to share repurchases over the long term, but management believes a debt-free balance sheet is the most prudent course of action, given the credit environment.
One analyst (William Blair) expects SCSS to invest $40 million to $45 million in capital expenditures in FY07 and in 2008. The analyst remains encouraged that 2007 capital expenditures will likely be less than the previous $50 million estimate. However, the analyst expects 2008 capital expenditures to decline.
November 29, 2007
Potentially Severe Problems
There are none other than those discussed in other sections of the report.