Sleep Well at Night With Select Comfort in Your Portfolio

As one who spent his primary career as an improvement specialist, I always have had an affinity for products that provide an innovative twist and improvement on a product everyone needs.

Select Comfort Corporation (SCSS, Financial), together with its subsidiaries, provides sleep solutions and services in the United States. It designs, manufactures, markets, and retails in beds and bedding accessories, such as mattresses, adjustable bases, pillows, sheets, and other bedding products under the Sleep Number brand name. The company sells its products through retail, direct marketing, and e-commerce channels. As of January 3, 2015, it operated 463 retail stores in the United States. Select Comfort was founded in 1987 by Robert "Bob" Walker and his wife JoAnn Walker and is headquartered in Minneapolis, Minnesota. The current CEO is Shelly Ibach and it now also has manufacturing and distribution facilities in South Carolina and Utah. As of 2015, the company reported a total of 3,098 employees.

Select Comfort holds 23 issued or pending U.S. patents and 40 issued or pending foreign patents for its products. Select Comfort products are sold through 466 company-owned stores located across the United States; direct marketing operations; and online at sleepnumber.com.

The company's signature product, the Sleep Number bed, is an adjustable air mattress that allows the consumer to adjust the firmness of the mattress to suit their personal preference and needs. The "sleep number" is a setting that adjusts the firmness of the mattress, adjusted by air pressure, with higher numbers (up to 100) denoting higher pressure and more firmness. In addition, each side of full size and larger beds has its own chamber to allow for separate adjustment. There are different models of Sleep Number beds with various features, and Select Comfort has also introduced a memory foam version of the Sleep Number mattress as well.

In the past, the company's TV commercials have featured actress Lindsay Wagner. The company has also advertised with and been endorsed by radio talk show hosts such as Glenn Beck, Paul Harvey, Laura Ingraham and Rush Limbaugh; all of whom professed that their own troublesome back problems were improved by using the Sleep Number mattress.

A Good Product is Fine, What About the Business?

All of the celebrity endorsements in the world mean nothing if they don’t bring sales dollars through the front door. A quick review of the sales figures from the company’s financial statements reveals that, between the end of 2010 and the end of 2014, the revenue of the business has increased from $606 million to $1.157 billion; an annualized increase in sales of 17.55%. In addition, the most recent quarterly filing from the company shows sales for the first six months of 2015 have equaled $625 million for an increase of 22.3% from the same period in 2014. So, the sales side of the business has been experiencing solid growth for the past 4.5 years and the growth is maintaining a similar pace through the first six months of this year.

Now, we all know that revenue growth in nice, but profits are what determine the real value of any business. Not only do I expect a business to have profits, I expect it to have profits that are growing at approximately the same pace as the sales. In the case of Select Comfort, in 2010 the business had a net pre-tax profit of $50 million on sales of $606 million or 8.25%. Against the 2014 sales of $1.157 billion, the company generated a net pre-tax profit of $102 million or 8.81%. In addition, on a trailing twelve-month basis, against sales of $1,271 billion, the company generated net pre-tax profits of $124 million or 9.75%. So, not only is the company growing its sales at a very rapid pace, it is doing so without sacrificing profitability.

Far too often, I see businesses that are far more concerned with expanding sales than with growing profits, and that is just a bad habit to get in to and a difficult one to break once it is established. Clearly this is not a problem for the management team at Select Comfort.

How is the Business Currently Valued to the Market?

Based upon the current share price of $26.03 divided by 2014’s earnings/share of $1.25, the business is currently valued at a price to earnings multiple of 20.82. We can refer, once again, to the company’s financial summary and see that over the past 12 months, the company has reported net diluted earnings/share of $1.54/share or a trailing 12-months’ P/E of 16.9.

The table below displays the earnings per share anticipated for the company by the 9 analysts covering the stock. As you can see, the business is expected to earn $1.37/share in 2015 and $1.75/share in 2016. If the actual performance meets the expectations of these analysts, the stock is then assigned P/E ratios of 19 times 2015 earnings and 14.87 times projected earnings for 2016. This puts the valuation right in line with that of the S&P 500 for this year and well below it for 2016.

When considering analysts’ earnings estimates for any business, I like to review the recent past to see how accurate their projections have been over the past several quarters. The table below shows these results for the past four reporting quarters. Based on the consistency with which the company has beaten the expectations of the analysts over the past four quarters, I think we can expect the company to meet the expectations at least in the immediate future.

Given the relative accuracy of the recent earnings projections from the analysts cover the stock, and the reasonable valuations they produce in terms of current and forward valuation, Select Comfort shares appear to be very fairly valued against the broad market in terms of current and past valuation with the S&P 500 currently valued at around 16 times trailing earnings with far lower projected growth of 7.23% over the next five years.

How Does the Current Market Value Compare to the Industry?

Historically, it is not unusual for different industries to have valuations in the market that are quite a bit higher or lower than the broad market averages. Therefore, I like to consider how richly or cheaply a business is trading compared to similar businesses.

Yahoo! Finance lists Select Comfort as having two major competitors that are private businesses (Serta and Simmons) and Tempur Sealy International (TPX, Financial) that is a public company in direct competition.

The table above shows how Select Comfort compares to Tempur Sealy in several key areas of value and price to performance. In the areas of TTM P/E ratios and Price to Earnings Growth ratios (PEG), Select Comfort would need to rise about 50% to trade on par with Tempur Sealy. The same holds true for the price to sales ration where Tempur Sealy trades at 1.54 times trailing twelve months’ sales and Select Comfort is priced at only 1.05 times sales. Again, a 50% increase in the price of Select Comfort would merely bring its valuation to par against Tempur Sealy.

How is the Business Currently Valued Compared to Its Own Historic Valuation?

Establishing the current fair value of a business must not only consider the current market valuation compared to the overall market and within its particular industry segment, it must also consider how the business is currently valued compared to its historic norms of valuation.

In the chart below, the green line illustrates the movement in the share price of Select Comfort’s stock. It closed last Friday at $26.06/share. The blue line displays the share price of the stock if it were to be trading at its median TTM P/E of 20.517. The share price produced by that valuation would be $31.10 or 19.34% above the current price. The red line in the chart shows that the shares would be trading at $35/share if the business were currently valued at the historic median valuation of the price to book ratio. For the stock were to reach its median price to book ratio, the shares would have to rise 34.4% from the current level.

Based on the calculations above, it would appear that the stock is undervalued by up to 50% against its publicly traded direct competitor and by between 20% and 34.4% compared to own historic valuation based on P/E & P/B ratios.

Final Thoughts and Actionable Conclusions

Based upon all of the facts I have analyzed in this analysis of Select Comfort, the stock appears to be priced somewhere between 25% and 35% below its current fair value. In addition, with earnings expected to grow at 18.6% per year for the next 5 years, new investors should expect annual returns of almost 17% per year even if the stock price continues to remain below the historic norms of valuation. The current price of the stock appears to offer an excellent opportunity for new investors to open positions in a very undervalued stock at a time when the broader market is becoming priced for perfection.