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  Tempur-Pedic could make for a rough night's sleep

BENJ GALLANDER and BEN STADELMANN

Friday, June 27, 2008

Fellow investment writer Larry MacDonald recently interviewed us about "value traps," and that kept our minds swirling about this fascinating topic.

Investopedia defines the term as "a stock that has experienced a large price depreciation and is mistaken to be a value stock." That's quite straightforward. The curious thing is that they can only be recognized retrospectively.

In a market transaction, the buyer and seller agree on the price, but are fundamentally at odds about their assessment of a stock, with one thinking the price will go up, the other down. Whether the purchase of a beaten-down stock is an opportunity or a mistake can only be known in time — perhaps years later.

The fact that the company is out of favour and can be bought at a relatively low price with the potential to sell it high, puts it into our contrarian territory. Whether or not to make a play is a matter of deciding whether that enticing bargain is real or illusionary.

The "trap" metaphor doesn't just refer to being stuck with an inglorious loser; it suggests that the corporation exhibits many of the characteristics of a classic value stock — particularly, favourable ratios such as price/earnings, price/book and dividend yield. It's almost as if the company is batting its eyelashes and giving the hapless investor a sultry come-hither look.

It was with this in mind that a reply was considered to a question from a subscriber to our investment letter, Contra the Heard. The gentleman wondered if Tempur-Pedic International was of interest. The mattress maker certainly shows some dandy value attributes. The trailing price/earnings is 5.2 and the forward figure is a still-superb 5.9. The dividend yield is a tidy 3.8 percent.

Other metrics testify to the company's success over the past three years. Revenue bounced ahead at an annualized 43 percent clip to $1.1 billion (U.S.) in 2007, while earnings per share bulged from 77 cents to $1.77.

But at the moment, Tempur-Pedic's stock price is sagging badly at around $8, far from its crisp 52-week high of $37.87. The entire home-furnishing sector sits forlornly at the curb: mattress competitors Sealy and Select Comfort have also taken huge lumps. The housing breakdown is the primary culprit, but the U.S. consumer is in a foul mood in general when it comes to big-ticket items, and replacing a mattress is the type of decision that is easily shunted down the list of priorities.

That said, few of us contemplate getting used to sleeping on the floor, and the boomers need extra support for their aging bones. This is a sector that is bound to spring back to health at some point. The pertinent question, then, is: Which participants in the field will be able to ride out this difficult period and prosper when the next mattress-replacement cycle kicks in?

It is in this context that Tempur-Pedic suddenly looks like a bad case of "coyote arm." In order to achieve its explosive growth, the company borrowed a lot of money. Since the end of 2006, debt jumped from $361 million to almost $600 million today. Over the same period, the debt/equity ratio went from a highish 1.7 to a scary 12.5. Tangible book value is negative.

And while sales grew, inventory mushroomed from $62 million to $107 million. At the end of fiscal 2007, management put forward a plan to reduce inventory. Instead, it climbed even higher in the first quarter of 2008.

There are other reasons for caution. Freights costs are up, as are the prices for the chemicals used to make foam. It will be difficult to pass these increases on to consumers. Chief executive Thomas Bryant, who had guided the firm since 2001, announced his retirement in February and has yet to be replaced. Whoever takes the job will have to figure out how to deal with the mountain of unsold mattresses, while rolling out new products, absorbing higher manufacturing costs, all the while avoiding violations of the company's debt covenants. As chief financial officer Dale Williams pithily put it in the last conference call, "It's hard to catch a rock rolling downhill."

As the mantra says, "Invest so that you can sleep at night." In the mattress industry, our ability to snooze remains tempered by the possible bed bugs of a value trap.


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