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Short Sellers Think this Stock Could go to ZERO

By: David Sterman
Posted: 2/6/2012 1:00:00 PM
Referenced Stocks: KKR;MFRM;TPX;ZZ

For companies that carry a huge load of debt, there is no room for error. Cash-flow targets need to be met simply to assure investors that funds will be in place to meet future bond redemptions. If that fails to happen, then look out below...

For mattress maker Sealy (NYSE: ZZ ) , a recently-released quarterly report has highlighted that business simply stinks. As short-sellers see it, the company's debt burden may eventually push this company into bankruptcy.

Short sellers have been targeting Sealy for nearly a year. And though they've scored gains already, they're sticking around because they see even more downside. The number of shares held short rose by 300,000 to 13.3 million shares from the end of December to the middle of January. That's had a crushing effect on the stock, as you can see from the chart below.

Chances are short interest -- which currently represents a whopping 45 day's worth of daily trading volume -- will rise even higher. That's because Sealy came out with quarterly results on Jan. 18, a few days after the most recent short data were released, that were simply lousy.
Fourth-quarter sales fell roughly 10% from a year earlier to $269 million.

It's not that people are buying fewer mattresses. It's just that they prefer to buy mattresses from Sealy's rivals. For example, Mattress Firm Holding Corp. (Nasdaq: MFRM ) is expected to boost sales 25% this year (to $860 million), while Tempur Pedic (NYSE: TPX ) is expecting sales growth of at least 10% (to $1.8 billion). Analysts at Hilliard Lyons say Sealy's sales will actually fall around 3% this year to $1.2 billion.

To preserve cash, Sealy intends to reduce spending on advertising and marketing. That may not be wise while rivals are spending heavily to gain consumer attention. And Sealy may not even show gains from that cutback because the rising price of raw materials is expected to pressure margins in coming quarters.

Simply put, Sealy can't afford a sales slump. The just-released fourth-quarter results show what happens when the sales base falls by 10%. Gross profit fell 75% to $24 million. Operating income fell by more than 80% to around $4 million. And a year-ago $0.03 a share profit became a $0.14 loss per share this time around. (Analysts had been expecting a $0.01 a share profit.)

Here's where things get really tough. That $4 million in operating income wasn't nearly enough to cover the $15 million quarterly cash interest expense. In effect, Sealy needs to generate at least $60 million a year just to cover its debt interest costs. That seems quite unlikely based on current run rates.

Even if Sealy somehow managed to hike operating income up to that level, it still wouldn't be building up any cash reserves to meet the company's debts that are coming due in a few years. Right now, Sealy has $108 million in cash and almost $800 million in long-term debt .

Reworking the debt
Back in the spring of 2009, Sealy was wise enough to restructure its debt load . Had it not done so, the company may have already been forced into bankruptcy by now, as then in-place debt covenants would have been breached. Instead, Sealy doesn't face any near-term debt repayments, and instead has until May of 2013 to come up with $100 million. (Another $350 million comes due in May 2016.)

Might Sealy look again to extend its debt to avoid trouble when May 2013 rolls around? Well, the weak recent financial results make it that much harder. Lenders would want to see much stronger cash flow before committing to any fresh debt that replaces the $100 million loan due next year, so Sealy needs to start showing much better financial results -- ASAP.

Even if Sealy can line up fresh funding, then the interest rate would likely be quite high, due to the company's risky financial profile. Short sellers are betting it won't even get to that point, and protection from creditors in bankruptcy court is the more likely outcome.

Risks to Consider: If the U.S. economy grows materially stronger this year, all mattress makers -- including Sealy could see sales come in ahead of current forecasts. That would likely give Sealy more wiggle room in its discussions to roll over its debt. Also, heavily-shorted stocks can be subject to a short squeeze , which can quickly push up a stock as an up-tick in shares leads to a big rally as short sellers seek to cover their positions.

Action to Take --> Kohlberg Kravis & Roberts (NYSE: KKR ) , a private equity group, took Sealy private in 2004, loaded it up with debt, and then brought it public again in 2006. That proved to be a bad move, and the massive debt burden is slowly choking this company. Coming quarterly results are likely to bring the debt concerns into even sharper focus as cash flow remains sub-par. Short sellers appear to have a solid case, and you can profit by also shorting this stock.

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-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.