SOMNIGROUP INTERNATIONAL INC. quarterly report, Q1 FY2019

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Business context and reporting period

Tempur Sealy International, Inc. (NYSE: TPX) filed this unaudited Form 10-Q for the three months ended March 31, 2019. The company develops, manufactures, markets and sells bedding products through Wholesale and Direct channels in North America and internationally. The filing concerns Tempur Sealy, not Somnigroup International.

Financial performance

  • Revenue: $690.9 million, up 8.4% year over year; up 10.4% on a constant-currency basis. North America sales rose 12.2% to $544.0 million; International sales fell 3.6% to $146.9 million as reported, but increased 3.0% at constant currency.
  • Profit: Gross profit was $281.8 million, up 6.5%, while gross margin declined to 40.8% from 41.5%. Operating income rose 8.6% to $60.5 million, with an 8.8% operating margin versus 8.7%. Net income attributable to the company increased 22.9% to $28.4 million; diluted EPS was $0.51 versus $0.42. Adjusted EPS, a non-GAAP measure, was $0.54 versus $0.46.
  • Segment trends: North America operating income increased to $64.3 million from $54.0 million, and margin expanded to 11.8%. International operating income declined to $25.2 million from $28.7 million, and margin fell to 17.2% from 18.8%. Direct-channel sales grew 36.1% in North America and 49.8% in International at constant currency.
  • Cash flow: Continuing-operations operating cash flow was $4.6 million, compared with $0.9 million. Capital expenditures were $19.1 million; investing cash flow was negative $20.3 million and financing cash flow positive $11.0 million. Cash declined $6.2 million to $39.6 million. Discontinued operations used a further $0.7 million of cash.
  • Liquidity and debt: Working capital was $127.5 million, down from $136.4 million at year-end 2018. Total debt was $1,666.8 million (debt net of deferred financing costs: $1,659.6 million); cash was $39.6 million. The company reported $477.3 million of revolver availability after letters of credit. Its covenant leverage ratio was 3.84x against a 5.00x maximum; it reported compliance with all debt covenants.
  • Other metrics: The effective tax rate rose to 36.8% from 28.1%. Trailing-12-month Adjusted EBITDA was $431.8 million; first-quarter Adjusted EBITDA was $92.8 million. These are non-GAAP measures.

Material changes versus the prior comparable period

Revenue and earnings increased, led by North America and Direct-channel growth. Gross margin weakened by 70 basis points: North America faced commodity inflation, higher floor-model expense and unfavorable merchandising mix, partly offset by brand mix and pricing; International was adversely affected by foreign exchange. Operating expenses rose 5.3% in dollars but declined as a share of sales. Net income benefited in part from $7.2 million of income on the sale of an interest in an Asia-Pacific joint-venture subsidiary. The tax provision increased $6.9 million, reflecting higher pretax income and unfavorable discrete tax items.

Outlook, management commentary, risks and unusual items

  • Guidance and plans: Management expected 2019 capital expenditures of $70–$75 million, product-innovation spending of about $15 million, and cash interest payments of $80–$85 million. It expected over 60 company-owned stores by year-end 2019, with a longer-term target of 125–150. Management cited about $30 million of pricing actions and expected commodity and tariff effects to be flat to slightly favorable for full-year gross margin, while warning that higher tariffs could hurt margins.
  • Product launches: Tempur Breeze and Stearns & Foster launches began in Q1, with rollouts expected to finish in Q2. Management expected product-launch costs comparable to 2018 and said consumer trade-down to entry-level Tempur products could pressure North America profitability through Q2, with improvement expected in the second half as higher-end products reach retail floors.
  • Acquisition: On April 1, 2019, after quarter-end, an affiliate acquired substantially all net assets of Innovative Mattress Solutions (iMS) for approximately $24 million, including a credit bid of DIP financing, assumed liabilities and cash costs. The company had advanced $9.5 million of DIP financing during Q1. Management expected Sleep Outfitters store operations to incur $5–$8 million of Adjusted EBITDA losses in 2019, with results expected to approach break-even after the first year and become profitable thereafter.
  • Tax uncertainty: The Danish tax matter includes a $127.3 million liability for the 2001–2011 settlement and a $144.5 million deposit held by SKAT. For later years, the company accrued approximately $35.8 million of Danish tax and interest while transfer-pricing negotiations continue. Management warned that an adverse resolution or changed facts could materially affect earnings.
  • Other risks and contingencies: Risks cited include economic weakness, competition from low-priced Chinese imports and pending trade investigations, foreign exchange, commodity costs, customer/retailer financial distress, product acceptance, supply-chain execution, leverage and interest rates. A securities class action was dismissed with no further appeal; related derivative suits remained pending, with the company expecting resolution in coming months and not anticipating a material adverse effect. Other proceedings were not expected to be material.
  • Accounting and unusual items: Adoption of lease accounting on January 1, 2019 recognized $197.2 million of right-of-use assets and $203.3 million of operating lease liabilities, with no material effect on operating results, cash flows or debt covenants. The company resumed share repurchases and bought 15,731 shares for about $0.8 million in Q1.

Important facts for investors to verify

  1. Whether North America growth, Direct-channel momentum and planned store expansion translate into sustainable sales and operating-margin improvement.
  2. How new product launches, consumer mix, promotional activity, commodity costs and tariffs affect gross margin through the remainder of 2019.
  3. Progress and final economics of the iMS acquisition, including purchase-price adjustments, assumed liabilities and Sleep Outfitters’ projected losses.
  4. Cash conversion, working-capital needs, capital spending and debt reduction, especially given modest quarterly operating cash flow and substantial leverage.
  5. Developments in the Danish tax negotiations and potential liabilities for post-2011 years; the filing says the potential impact of future uncertain-tax-position changes cannot currently be estimated.
  6. Whether the reported leverage ratio remains within covenant limits and the company’s 3.0x–4.0x target range; review non-GAAP reconciliations when comparing results.