Friday, August 14, 2009

Select Comfort Corporation (NASDAQ:SCSS): upgraded at KeyBanc

KeyBanc is upgrading their rating on Select Comfort (NASDAQ:SCSS) to BUY from previous rating of NOT RATED. They believe shares are compelling, supported by improving macroeconomic trends, company fundamentals and liquidity outlook.

Sales Trends Improving. Select Comfort's sales have benefited from a number of factors. Mattress sales and consumer spending, in general, are showing signs of improvement. Mattress industry sales in June declined 12.0%, continuing the improving trends that began in May, based on the monthly ISPA data we receive. Furthermore, the higher-priced specialty category, in which Select Comfort operates, declined 18.8%, the best performing month in at least nine months. We believe the Company's new merchandise offering, with lower-price entry level models, is helping Select to drive incremental sales. More recently, SCSS reported that July sales declined 10%, with comps of +1%, putting the Company on track for its lowest quarterly sales declines since 2007, a trend that we expect to continue, especially if the consumer and the housing market improve.

Margins Improving Despite Sales Declines. Despite ongoing sales declines, SCSS is driving operating margin improvement through better gross margin and lower operating costs. Gross margin has benefited from the product re-design (featuring lower-price entry level models), lower commodity costs and supply chain expense reduction. Furthermore, aggressive selling, marketing and store operating cost reduction have enabled expense leverage in spite of sales declines. The Company has closed 51 stores (12% of the chain) and plans to close another 15 by year-end. We believe many of these expense efforts will be permanent, enabling significant leverage should sales continue to improve.

Earnings Outlook Positive. Our new 2009 estimate of a loss of $0.02 is $0.06 above consensus and our new 2010 estimate of $0.14 is $0.12 above consensus. These estimates assume the proposed sale of shares to Sterling Partners is complete. There are currently four analysts covering the stock and we represent the only BUY recommendation. Furthermore, a number of analysts have dropped coverage of the stock in the last year. We believe the Company is relatively underfollowed and underanalyzed as a result of the smaller market cap and questionable liquidity position earlier this year.

Balance Sheet Significantly Improved. SCSS continues to operate under short-term waivers to comply with covenants associated with its $75 million credit facility. While this may scare some investors away, we believe it adds an interesting liquidity discount to the stock that is likely to further dissipate with improvement in fundamentals. The balance sheet is much stronger than at year-end; debt stands at $44 million, down from $79 million at year-end. The Company has agreed to a $35 million investment from Sterling Partners, which could further strengthen the balance sheet. However, given the overall improvement in the economy and SCSS's balance sheet, we believe the risk of a bankruptcy is now behind us, even if the Sterling investment does not go through.

Sterling Investment a Win-Win Scenario. SCSS shareholders are in the process of voting on a proposed sale of 52.3% of the Company to Sterling Partners at a price of $0.70 per share (for $35 million), with the vote scheduled to conclude by August 27. We view this deal as a win-win situation. If the offering is approved by shareholders, the balance sheetimproves significantly. Even adjusting for dilution from the deal, we believe shares are attractively priced. However, if the deal is rejected, we believe SCSS could raise capital (or perhaps continue to operate on its revolver) at rates that would be much less dilutive for EPS. While some liquidity overhang would remain with the Company operating under waivers, such a scenario could have positive implications for EPS and potentially be a catalyst for the stock.

Action: I like this call by KeyBanc. They make a good case for owning the shares even after the great rally over the past few weeks. Add some momo to the mix and we can see the shares making a new 52-week high today.

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