Sleep Country Canada (TSE: ZZZ) sells mattresses and other sleep-related products, such as pillows, blankets, and bed frames. It operates in two segments SCC (Sleep Country Canada Holdings Inc.) and Endy (its subsidiary).
The recent market sell-off hasn't been friendly to cyclical retailers such as Sleep Country. Sitting about 35% off its 52-week high set in November, we believe the stock is now undervalued and deserves a closer look. Additionally, we are bullish on the stock.
Sleep Country can Handle a Potential Recession
Economic fears have left many investors feeling fearful. However, if you invest in the right companies at the right price, you should be able to get decent returns over the long run.
Sleep Country was founded in 1994, meaning it has gone through recessions before. The company is as strong as ever; and can most likely handle yet another one.
Even if a recession were to occur, it could be a positive for the company in the long term because it would be able to make acquisitions at lower cost.
Management even stated that the company had taken market share in every recession it went through because it is opportunistic, owing to its strong balance sheet, which is sometimes used for acquisitions.
Although Sleep Country has a net debt position of C$44.16 million due to having C$76.95 million in debt against C$32.79 million in cash, this is a minuscule amount of debt relative to the amount of money it makes.
ZZZ has earned over C$149 in free cash flow in the past 12 months and is expected to generate another C$116.5 million in free cash flow in fiscal 2022. Therefore, the company could pay off its net debt in less than half a year, if it chose to do so.
Similarly, its trailing-twelve-months interest coverage ratio of 11x means that it had the capacity to pay off its annual interest payments 11 times over using its TTM operating income. This is a sign of a very healthy company. It can take on more debt if it needs to, and, as stated earlier, this debt could be used to acquire companies at a low price if a recession was to occur.
Another positive factor is that much of its business comes from high-end customers. Although the company experienced some weakness in its products priced under $1,000, management had this to say about its higher-end business: "The biggest part of our business is the mid-to-high end, which is where the strength of our business has always been was -- our pricing power allowed us to drive prices higher to compensate for any loss in units below $1,000."
When it comes to recessions, low-to-mid-ranged consumers are usually hit hard. This can negatively affect Sleep Country. However, high-income individuals are generally less impacted by inflation, and they will help the company offset any weakness in its lower-priced products.
In fact, the company makes more money off its higher-priced products, as it costs the same to deliver a $1,500 mattress than it does to deliver a $500 mattress, according to management.
Much of this softening in the economy is due to high inflation because of issues with the global supply chain. Regarding supply-chain issues, 80% of Sleep Country's business is manufactured in Canada, which has allowed the company to deal with this issue better than most other retailers.
Strong Earnings Results
Last month, Sleep Country delivered its best Q1 in its history, which caused the stock to close 8.49% higher the next day. Its Adjusted EPS came in at C$0.56, easily beating the C$0.29 expectations. Also, revenue was C$207, beating the expectations of C$195.2 million. The company has beat EPS expectations every single time in the past eight quarters.
Notably, its revenue increased 13.1%, and its adjusted diluted EPS increased 115.4%, while its operating EBITDA increased 48.5%. Profitability growing faster than revenue is nice to see, as it demonstrates operating leverage.
The company's gross margin increased 710 basis points, hitting 34.6% for the quarter and 38.5% for the past 12 months. Its gross margin has remained relatively stable since fiscal 2014, but it has been ticking higher in the past two years.
This implies that a competitive advantage is present, as competitors haven't been able to chip away at its profitability metrics. ZZZ's same-store sales also grew 8.8%, which definitely helped with profitability.
Juicy Dividend Yield, Potential Buybacks
Sleep Country currently has a 3.2% forward dividend yield. For a company with a five-year revenue and diluted EPS CAGR of 11.9% and 12.7%, respectively, this is a pretty enticing starting yield.
Sleep Country's fundamentals allow it to easily be able to increase its dividend by 10% a year for the next five years or so. It recently increased its annual dividend rate (paid quarterly) from C$0.78 to C$0.86, a 10.3% increase.
Regarding its dividend, management said, "We had mentioned that we intended to increase our Q1 dividend by at least 10% and increase our annual dividend at a minimum growth rate of 10% for the near-to-medium term going forward."
Also, its payout ratio is just under 30%, giving it ample room to increase its dividend, even if earnings stay flat. This is great news for investors that love dividends.
Sleep Country also has the ability to purchase 5.31% of its public float through its buyback program. We believe it would be prudent for the company to buy back some of its shares, as its valuation is low.
Low Valuation
Sleep Country's stock seems undervalued at the moment. Using analysts' 2022 free cash flow estimates of C$116.45 million, its forward price-to-free-cash-flow multiple is 8.5x. When taking its 2023 estimates of C$137.9 million, this multiple drops to 7.2x. If the company keeps beating expectations over and over again, you can expect its cash flow to come in even higher.
A 7.2x multiple would imply a 13.9% free-cash-flow yield for 2023. We think this is too low for a high-quality, growing company like Sleep Country. Also, its revenue is expected to grow at a 5.8% CAGR over the next two years, which is respectable considering the current economic environment.
Wall Street's Take
Turning to Wall Street, Sleep Country comes in as a Moderate Buy. This is based on four Buys and two Hold ratings assigned in the past three months. The average Sleep Country price target of C$37.33 implies 38.8% upside potential.
Conclusion
Investors have left many retail companies in the dust due to inflation and recession fears. However, if you know where to look, you can find lots of value in this market.
We believe Sleep Country can easily handle a potential recession and has the pricing power to keep raising its prices if it needs to. A recession is a real risk, but the price of the stock already reflects this potential, and the company can use its balance sheet to acquire more companies in a recession.
Overall, ZZZ stock seems like a prudent bet on retail. Therefore, we are bullish.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
