Purple Is The New Green – An Asymmetric Investment Opportunity – Purple Innovation, Inc. (NASDAQ:PRPL)
We believe Purple (PRPL) has the potential to be one of the great growth stories of the next few years. It has gone from $5.8 million in sales in 2015, to $66.5mn in sales in 2016 (its first year selling mattresses), to an estimated $190-194mn in 2017, representing a 189% y/y growth rate in 2017, almost 3x that of the industry. At the midpoint of guidance, the company anticipates 121% growth in 2018, to $425mn, again almost 3x industry forecasts. Notably, this has all been self-funded, until Friday, February 2nd‘s business combination with Global Partner Acquisition Corp. Some working capital adjustments and the repayment of $8mn on its Wells Fargo (WFC) secured revolving loan facility should leave the company with over $35mn in cash on its balance sheet and an approximate neutral net debt position (We anticipate a new working capital line to be put in place at better terms).
We believe that Purple could achieve revenues in excess of $1bn by 2021 through ongoing growth in its core DTC (direct-to-consumer) channel, the addition of brick-and-mortar partners, product extensions in the sit and stand segments, and via international expansion. At $1bn+ in sales, with a 15% EBITDA margin (the high-end of management’s 3-5 year, medium-term margin outlook), we believe shares could triple based on a 9.4x EV/EBITDA multiple – the current blended multiple of Sleep Number (SNBR) and Tempur Sealy (NYSE:TPX) – with the potential for a premium multiple given Purple’s superior growth rate. Of course, if it appears this trajectory is achievable, the share price should appreciate well in advance.
We note that Purple also has warrants (PRPLW) that trade freely. They have a strike price of $11.50 and a duration of 5 years from the close of the transaction. Based on our Black-Scholes analysis (modified to account for the callable nature of the warrants), we believe fair value is $1.35-1.50 based on the current price of the underlying equity, or 50-70% upside. It’s worth mentioning that warrants traded as high as $1.28 in January, prior to the closure of the transaction being a certainty.
We note, miniscule, money-losing British bed-in-a-box (BIB) company Eve Sleep (EVE.L) went public last May at 12x trailing revenue – its shares are up 20% since its IPO. Its sales grew ~130% in 2017 (a rate well below Purple’s), meaning Eve shares now trade at 5.3x trailing EV/revenue and 2.6x 2018 vs. under 3.1x and 1.3x for Purple, respectively. While Purple is expected to be only modestly profitable in 2018, its price-to-sales is lower than slow growth at Tempur Sealy.
Purple is somewhat of an unusual investment for Dane Capital. Traditionally we are very cheap – we like EBITDA multiples in the mid-single-digits and FCF yields that exceed 10%. Based on current metrics it doesn’t look cheap, but we believe the risk/reward is highly asymmetric. Admittedly, this could eventually prove to be a great short, but we think anyone shorting today is probably at least several years too early given the company’s significant runway for growth.
There’s a lot we like about the Purple story.
It’s hard to catch lightning in a bottle.
– Anonymous Idiom
A lot to like about Purple
We will go into greater detail on several of these topics later in this report, but we wanted to lay out a number of points upfront.
- Strong grassroots/viral interest in Purple’s offerings
- Highly differentiated form factor, that has IP protection (78 patents including Hyper-Elastic Polymer™), in an otherwise increasingly crowded BIB market
- Substantial opportunity for product, channel and geographic expansion
- Impossible to integrate/dislocate a mattress into another product (i.e., Fitbit (NYSE:FIT) or GoPro (NASDAQ:GPRO) can be imitated and integrated into other products) – that can’t be done with a mattress
- Meaningful scale, but still only 1% market share, so lots of runway for growth. Purple can grow 5x solely domestically, and still have just 5% market share
- Secular tailwind supporting rapid move to online versus brick and mortar mattress purchases
- Significant insider ownership
- While there is little in the way of hard book value (true of public mattress comps as well), we believe there is a healthy margin of safety and a significant asymmetric risk/reward profile
We note that Dane participated in a $25mn subscription (8-K here, see Baleen Investment) given our confidence in Purple’s prospects, with several well-regarded, long-term, value-oriented funds as our co-investors.
Table of Contents:
1b. Our thoughts on consumer brands – catching lightning in a bottle
2. 3 basic questions
3. Industry background
4. Company background
5. SPAC deal dynamics and valuation
8. Catalysts and conclusion
We believe that Purple has the potential to experience significant growth for the next several years due to:
- Ongoing shift to on-line from brick and mortar in the mattress segment
- Successful viral marketing (over 1 billion YouTube (NASDAQ:GOOG) (NASDAQ:GOOGL) views) and unique technology driving a differentiated bed feel (bolstered by 78 patents or patents pending)
- Growth in adjacent products such as sitting and standing (for example, insoles)
- Potential to expand into brick-and-mortar channels (a 50 store pilot with 3500 store chain Mattress Firm has been going well, with additional locations to be added) and a pilot program with a different 1000 store chain in the works – pilot to begin with 9 stores in February – not to mention many additional conversations with potential channel customers
- International expansion
Based on management guidance for 2018, our view of Purple’s market share gains and the trajectory of the industry, we present 2 cases:
We believe that in crowded segment, Purple stands out as highly differentiated. Its hyper-elastic polymer creates a different feel than any other mattress in the market and is unique versus traditional memory or polyurethane foam.
It also has viral YouTube videos.
We believe that Purple’s Goldilocks ad, with over 145mn views, has more views than all other BIB brands have on YouTube combined.
Source: Purple YouTube Goldilocks Video
We think creating something truly viral is not simply a matter of spend, it’s a matter of luck, timing, and capturing the public’s imagination. If it were that easy, big consumer players would build brands and not buy them.
We believe that Purple can maintain its momentum. In our view, with almost $200mn in annual sales, but with just 1% market share and patents that ensure no knock-off products, we think the runway for growth is significant.
1b. Our thoughts on consumer brands – catching lightning in a bottle
Dane has some strong views regarding what makes a successful public consumer product stock
- We look for differentiated form factor/product design/market niche
- Huge grassroots/viral interest (lower than peer user acquisition cost)
- Inability to make knock-off/me-too products or to integrate functionality into existing products/brand
- Low market share, but enough scale to be a player
Ideally, such a stock comes at a very low valuation, but that’s infrequently the case with hyper-growth companies. With Purple, we believe we have an asymmetric investment which could grow its business markedly for several years, and in our view, has limited downside.
Our firm’s view on high growth consumer stocks reflects my experience from my first job after college, working at Snapple Beverages (DPS), soon after its original IPO in 1993. Having frequently reflected on what made Snapple an enormous success, the things to come to mind are 1) differentiated form factor, and 2) huge grassroots interest. Snapple was not an overnight success. It was founded in 1972 and only introduced its iconic iced tea in 1987 – a far better product than the artificial swill sold in cans by dominant incumbents Lipton and Nestea. Snapple only moved beyond the Northeast beginning in 1988. The company’s 3 co-founders realized that their “summer drink” was selling more and more all year round – they had literally caught lightning in a bottle; there was no business plan that said they were going to make it big with iced tea. There was a burgeoning groundswell of grassroots interest as Howard Stern and Rush Limbaugh (who both legitimately liked Snapple) pitched the product. There was no wild spending to drum up interest. There certainly were no focus groups – I personally saw Snapple CEO and co-Founder Lenny Marsh in the kitchen as the sole taste-tester for potential new flavors. That was the extent of it.
By the time I arrived at Snapple, the company was receiving hundreds of letters a week in fan mail – fan mail for a beverage, that’s nuts! That’s also something you can’t manufacture by spending.
Snapple grew revenue 22-fold from 1989 to 1993
Source: Snapple 1993 annual report, page 3
Lipton and Nestea, with much greater resources and bigger parent companies behind them, came out with their own clear-glass products, although neither garnered the popularity of Snapple. When a product becomes truly popular or goes viral, it’s hard to imitate, no matter how many dollars are thrown at competing products. Little wonder that Dr Pepper Snapple (NYSE:DPS) recently spent $1.7bn to acquire Bai Brands (approximately 4x forward revenues). To pay $1.7bn for water and flavoring seems crazy, but it’s not easy to build a brand from the ground up – we believe this is a concept with which Warren Buffett would concur. Consider all the acquisitions in the food and beverage industry (not to mention other sectors) of early-stage companies at seemingly insane valuations, for products that could, in theory, be knocked off.
Snapple met two of our investment criteria with innovative/differentiated packaging and strong grassroots/viral interest. However, central to our thesis is that a high/hyper-growth company must have enough scale to matter, but still be a small part of the market (or have room for meaningful brand extensions).
In the case of Snapple, it accurately claimed that it only had 1.5% of the $66bn non-alcoholic beverage market. However, a fair question is how many Coke (KO), Pepsi (PEP) or 7up drinkers (or numerous other beverage drinkers) were going to forego soda for Snapple? We’d argue that of the $66bn non-alcoholic beverage market, Snapple had a sizable portion of what was truly addressable to it by the time it went public.
Source: Snapple 1993 annual report, page 10
On November 3 1994 Quaker Oats acquired Snapple, concurrent with Snapple’s 3Q earnings, which were down 74% y/y with a 6% decline in revenue. Snapple had hit the growth wall within 2 years of its IPO and hit it hard – although it was about 7 years into hyper growth at that point. Still, day-1 Snapple investors had almost tripled their money.
When we look at some of the winners and losers in consumer over the past decade or two, we think about innovative products with a strong grassroots/viral following. Companies that come to mind include successes such as Lululemon (LULU) and Under Armour (UA) and failures (thus far) such as Crocs (CROX), Fitbit and GoPro. Fitbit and GoPro might have proved tremendous investment successes had they come to market at an earlier point, but by the time they came public, each had too much market share (it appeared the only direction to go was down), and also had technologies that could be integrated into other devices – watches, smartphones, etc. Crocs was growing exponentially and quickly hit the wall in terms of size, not helped at all by competing knock-offs.
As the chart below demonstrates, the winners enjoyed hyper growth prior to their IPO, but still had low market share at the time of IPO, allowing them to maintain strong growth in the years following their IPO, whereas the losers had substantial (unsustainably high) market share.
Clearly, the above is not a comprehensive academic study, but we draw several conclusion from it. First, even with the blow-ups (including Snapple), it wasn’t until years 5-8, before they had a down quarter – 2018 is only year 3 for Purple selling mattresses. Second, Crocs, Fitbit and GoPro returned 5x, 2x and 4x respectively at their peaks, before imploding. Lastly, we certainly don’t expect Purple to implode, we expect it to compound, and think that anyone who would consider shorting it is several years too early.
When we look at Purple it has many of the characteristics of a winner. It has garnered over 1 billion YouTube views for its various videos. Despite being a year younger than Casper, Purple has almost as many Facebook (FB) followers as Casper.
Source: Purple Page on Facebook
Source: Casper Page on Facebook
We will touch more on competition later, but we think it’s worth mentioning that, according to Casper’s CEO Philip Krim, his company has raised $240mn in outside financing, and according to Fortune, has spent upwards of $80mn per year on advertising, including billboards, trains/subways, and traditional TV. Based on industry estimates, Casper’s growth slowed to 50% y/y in 2017 to just over $300mn, just over 50% above Purple, despite seemingly limitless resources. According to Stifel analyst John Baugh’s January 31, 2018, report, following the Las Vegas Market (the bedding industry’s primary trade show), he believes “Casper’s units were flat/negative in this very crowded market.” (he does not specify over what time period in the report).
To summarize, we think Purple has found the magic formula. It has strong consumer interest, differentiated product, IP that protects them from imitation, and low, but quickly growing market share. It’s not something you can plan with a bunch of MBAs and consultants (although they may be useful once you’ve gotten going).
2. 3 basic questions
As with any of Dane’s investments we consider 3 core questions:
- What is the reason for this mispricing (aka why should we be so lucky)?
- What is our margin of safety (aka what protects us from a permanent loss of capital)?
- What is the asymmetry of the opportunity (aka what are we playing for)?
What is the reason for this mispricing?
We believe there are 3 primary reasons for this mispricing. First, Purple became a public entity via a SPAC, which is typically arbitrarily priced and widely ignored in the short term. It’s a topic we have discussed at great length including in an interview here. Second, despite the company’s exceptional growth, it remains something of a show-me story. If the company hits the midpoint of 2018 guidance, 121% y/y revenue growth, then we can easily see 50-150% upside in shares over the next 12 months. If the pilot program at 50 Mattress Firm stores goes well and a national roll-out occurs, Purple could achieve far more significant growth in 2018. Notably, management has indicated that new installed equipment (and an additional Mattress Max™ in 2H 2018) will provide production capacity for up to $600mn in revenue. Lastly, during the de-SPACing process, Purple reduced its EBITDA guidance solely due to higher operating expenses. The company maintained both 2017 and 2018 revenue and gross margin estimates, but added to op-ex, thereby reducing 2017 EBITDA to ($3mn)-0, from prior $7mn, and 2018 to $0-26mn from $34mn. This was done in conjunction with bringing in a new CFO, Mark Watkins, who comes with solid experience, and probably wanted to reset to unmissable numbers. We’d add that while we in no way minimize these changes, we believe there is now a great deal of conservatism built in. Equally important, the company took a hatchet to valuation, reducing Enterprise Value from $1.1bn to approximately $500mn. We think this reduction has created a compelling entry point, and if Purple demonstrates that its growth trajectory remains intact, it could quickly see its price back at $20, the price implied by its initial SPAC-merger valuation.
What is our margin of safety?
We believe that Purple is likely to enjoy substantial growth. We note that in June Casper raised $170mn at a $750mn valuation, including $75mn from Target (NYSE:TGT), with approximately $200mn in trailing year revenue at the time of investment. It was reported by ReCode last May that Target had offered at least $1 billion to acquire Casper, but they could not come to terms, so they merely led the round. If Casper is valued at $1bn+ by a potential acquirer, then we believe Purple is worth more. It has similar trailing revenue to Casper at the time of the Target conversation. Moreover, we think it has a likelihood of faster future growth than Casper enjoyed, differentiated technology and design, a better and more viral business model and better unit economics. We believe Purple has held discussions and/or received term sheets that valued the company above its current market cap, but chose the SPAC route in order to become public and to maintain its independence.
In a world where Amazon (AMZN) buys Whole Foods, we don’t think it’s crazy that they would buy a mattress company. It’s notable that Amazon sells Amazon-branded mattresses in the UK. In the US, why start from scratch – it makes sense to just buy one of the BIB companies. And if it were to do that, why buy another me-too memory foam player when it could buy Purple (if Purple would sell), which possesses a truly unique product, has an aptitude for digital marketing, and could allow Amazon to blow out the category. We’re not predicting this outcome – we think Purple wants to execute on its strategy for several years before an acquisition is considered, but the bottom line is that we see few ways that our investment is permanently impaired, unless business decelerates precipitously, although we see no signs that will be the case.
What is the asymmetry of the opportunity?
As we have explained above, we believe the downside to shares is limited. Should things go well, we can envision Purple becoming a $1bn+ revenue company in a few years, and potentially much larger if they successfully penetrate brick and mortar and international. It’s worth noting that both Sleep Number and Tempur-Sealy derived a significant portion of sales from telemarketing in their early years before becoming reliant on retail. We believe that Purple, with the first unique product innovation in decades could become a serious player in both the on-line world and in brick and mortar (which is still ~85% of the market). The big picture is that there is a lot of runway, and if the company executes for 5 or 6 or 7 years, we can see a path to multiple hundred millions in EBITDA, and a stock price many times where it currently trades. Or it simply could be acquired at a hefty premium.
3. Industry background
Since there is an abundance of public information and sell-side research regarding mattresses, we will keep this section relatively brief.
Depending on the source, the domestic mattress (and associated products) market is estimated to be between $15bn and $22bn.
According to Furniture Today and SunTrust Robinson Humphrey estimates, the top 5 mattress players in the industry comprised 74% of revenue in 2016, led by Serta (19.8%), Sealy (18.2%), Simmons (17.9%), Tempur-Pedic (13.0%), and Sleep Number (5.1%). Serta and Simmons are owned by a private equity consortium, while Tempur-Pedic purchased Sealy in 2013.
According to SunTrust Robinson Humphrey, in 2016, 45% of bedding sales came from bedding specialty stores, 30% from furniture stores, 12% direct to consumer (which includes bed-in-a-box), 5% department stores, and 8% from other (warehouse clubs, other, and factory direct). Clearly, traditional channels still matter, although they are losing share.
According to KeyBanc’s December report, “Mattress/Bedding: The Emerging E-Commerce Threat (Vol. 6)” it anticipated 2017 e-commerce mattress sales of $1.4bn, a $200mn positive revision from their June report. $1.4bn represents 75% y/y revenue growth, which pales versus Purple’s 189% y/y growth. KeyBanc noted that emerging e-commerce players now comprise 8% of overall industry sales, up 3.4% from the 4.6% it represented in 2016. It expects emerging e-commerce players to grow by another $600mn in 2018, representing an additional 43% growth. If Purple achieves the midpoint of its targeted revenue, it will grow nearly 3x the rate of the market. According to industry data, Purple has taken substantial market share:
It is estimated that there may now be in excess of 100 BIB players, which has helped accelerate the move to online and has also pushed the prices of Google adwords and Facebook ads for the mattress category higher. We suspect that in the next few years the market will see a shakeout of smaller competitors. We believe this could benefit Purple and other survivors, as the price pressure behind online ads decreases.
The other emerging threat to traditional players is the entrance of Chinese manufactured mattresses. The top-selling mattress on Amazon is Zinus, which is a manufactured in China. While there are always concerns about price pressure, leading suppliers have maintained prices, or raised them in the face of rising input prices, with limited consumer push-back.
There were two major developments last year with Mattress Firm, the largest retailer of mattresses in the United States with over 3500 locations. The first was the termination of its relationship with Tempur Sealy last January. According to Tempur’s 10-k Mattress Firm represented 21.3% of its over $3.1bn in annual revenue in 2016 – or over $660mn in lost sales. We believe Purple, which has been running a pilot program with Mattress Firm for the past several months has a meaningful chance to gain significant share (not materially included in our estimates). The second development was the surprise news in December that Mattress Firm parent Steinhoff had accounting irregularities and its CEO resigned, which also resulted in several management changes at Mattress Firm. Steinhoff had announced its acquisition of Mattress Firm less than 18 months earlier. Industry analysts suggest that Mattress Firm will need to cut 600 stores or more. Even a smaller Mattress Firm represents a huge opportunity for Purple. Moreover, we’d argue that given its challenging position, its need for a distinctive brand like Purple is greater than ever.
Source: Purple investor presentation, page 22
4. Company background
A good place to start for anyone analyzing Purple is its investment deck. We also recommend reviewing the purple.com website which is not just a commerce site, but gives significant background on the company’s history and science. We also recommend the various videos Purple has on YouTube.
As we have previously stated, we believe Purple will be a prime beneficiary of the inexorable shift from brick and mortar to online in the mattress industry and believe the company has the potential to become a mainstream brand. Purple is uniquely positioned to continue to take overall mattress industry market share for the reasons we’ve already mentioned: 1) organic DTC growth, 2) product extensions (sit and stand), 3) symbiotic and additive brick and mortar relationships, and 4) geographic expansion. We note that Purple sees itself as more than mattresses, but that its focus is on comfort technologies with the potential to expand to sit (they already have seat cushions) and stand (coming later this year), with additional potential products extensions.
Purple was founded in 1989 in Utah by brothers Tony and Terry Pearce. Tony Pearce is, quite literally, a rocket scientist, with experience in advanced aerospace materials, while Terry had experience in manufacturing, design, and project management. In 1993 they perfected Floam™, the world’s lightest-weight cushioning fluid. Floam’s first use-case was cushioning for wheelchairs, but they soon licensed it to Hill-Rom (HRC) for critical-care medical beds, Nike (NKE) for footwear, and Johnson & Johnson (JNJ) for ankle and knee braces.
The brothers’ next major breakthrough came in 1996, with the invention of Hyper-Elastic Polymer. This material can stretch to 15 times its size and never take a body impression. It was licensed to companies like Dr. Scholl’s and Stryker Medical (SYK). The material has more than 30 licensees.
The Secret Sauce – Hyper-Elastic Polymer
In 2013, after several years of effort, and several million of expense, the brothers developed the patent-pending machine called Mattress Max which could produce large enough pieces of Hyper-Elastic Polymer to manufacture king-size bed, and to do so in scale and a compelling price point.
In 2016, the company introduced its Purple Mattress to the market and did $65mn in sales, thanks in large part to effective digital marketing and a superior product. Purple has a product that doesn’t look or feel like all the others.
Given the company’s strong and accelerating growth, the company brought in Sam Bernards as CEO (he is a nephew of the Pearces) in August 2016. We believe Mr. Bernards is well qualified for his role given his background in supply chain, efficiency improvement, and innovation during his 5 years at Walmart (WMT). He also was a Principal at an early-stage venture fund that gave him exposure to a variety of experiences with developing companies. In our conversations with Mr. Bernards and the team, it’s clear that they have a strong, long-term vision for the company. Of course, they will need to execute, and we’re confident they will.
In 2017, sales are expected to have grown to $190-194mn (full-year results expected in 1H March). Purple has guided 2018 revenue of $370-480mn. Below is its revenue bridge to the midpoint of $425mn.
We are optimistic that revenue will exceed the midpoint of guidance. This view is founded on the likely success of new, higher price-point, higher margin models, and on the likely expansion at retail and of new products (i.e., stand products).
On February 7th, Purple officially put 4 new Purple mattresses on sale on its website. The mattresses have support coils and a higher price point, and have been on sale at Mattress Firm, with positive market feedback.
Assuming there is even modest customer shift to the Purple 2, 3 or 4, there should be revenue and margin uplift, for the same marketing spend.
We also believe that success at retail could generate upside. We made calls to approximately 20 Mattress Firm stores that are carrying Purple in its pilot test. The feedback we received was widely positive, with several salespeople (even those who did not personally prefer the bed) saying it was among the best-selling mattresses in the store. Another frequent response was that it was inexpensive based on its features, versus some of the higher priced mattresses in the store.
Our view was corroborated in a February 5th research report by Bradley Thomas of KeyBanc titled, “Mattresses: Purple/Mattress Firm Checks Suggest Positive Initial Reception.” Mr. Thomas and his team called every Mattress Firm in the pilot (50) and states, “The initial feedback suggests that Purple is being well received with above plan sales.”
We recognize that Mattress Firm is going through a period of uncertainty which may slow final decisions. However, in our view, in the most draconian scenario, Mattress Firm goes through a pre-packaged bankruptcy and closes 1/3 of its doors. That would still represent a multi-hundred million dollar opportunity for Purple.
Purple has also stated that it will launch a pilot in 9 stores of a 1000 store chain in February, and is in conversation with multiple additional brick-and-mortar opportunities.
While Purple makes less gross profit dollars selling wholesale, there is significantly less SG&A, resulting in greater operating profit contribution per mattress in the retail channel. We think the mix of online and brick and mortar creates a virtuous cycle (a view seemingly shared by leading online brands including Bonobos and Warby Parker).
In the event that Purple continues to enjoy dynamic growth, it is far better equipped to add capacity than it was historically. The company has reduced the time it takes to build out a Mattress Max from 9-12 months to 3-4 months. Last year capacity tightness and inefficiency resulted in capacity constraints, which we do not expect to be the case going forward.
We expect Purple to continue to grow marketing and advertising to ensure that it continues to gain mind and market share. We note that the company recently began experimenting with TV advertising, primarily on tier-2 networks such as the History Channel and Fox Sports. TV carries a far lower CPM than Mattress Firm’s traditional digital marketing outlets. We believe management will be judicious in evaluating the benefits of TV before it commits a larger budget to its usage.
5. SPAC deal dynamics and valuation
Purple merged with SPAC Global Partner Acquisition Corporation (GPAC), which was created in a $135 million IPO led by Deutsche Bank (NYSE:DB) in July 2015. On July 27, 2017, GPAC and Purple issued a joint press release regarding their proposed merger. During the course of the de-SPACing process, news broke about Mattress Firm parent Steinhoff’s accounting issues and Purple reduced its EBITDA forecast for 2017 and 2018 (to what we believe are exceptionally conservative numbers), although there was no change to top-line or gross margin guidance. Concurrent with reducing EBITDA forecasts, the company also cut the company’s valuation by more than 50%. We believe this cut was excessive, although we appear to have been in the minority.
As mentioned earlier in this report, Dane was part of the “Baleen” investment group that purchased $25mn of equity to vote in favor of the transaction and not to redeem shares. An additional $65mn was backstopped by Coliseum Capital in both preferred shares and equity. Coliseum also received a Board Seat. While we don’t know the team at Coliseum, they have backstopped Hennessy Capital’s first two SPACs, now Blue Bird (BLBD) and Daseke (DSKE). According to our review of filings, Coliseum did not sell shares of BlueBird until shares reached $17. We are hopeful that the other funds in our consortium and Coliseum all have a long-term orientation and will comprise a solid shareholder base.
We also note that there is strong insider alignment in this transaction. The Pearce Brothers and other insiders continue to own over 80% of Purple. We believe a significant reason that they were willing to reduce the valuation to help ensure the transaction was completed is that they sold only a minimal portion of their holdings. In our view, we think insiders are very confident about the sustainability of Purple’s growth and the likelihood shares will appreciate.
Given the early stage of development of Purple and difficulty in evaluating the timing when the company’s growth moderates, valuation is fairly arbitrary. Below we present a comp sheet (Purple has its own on pages 35-36 of its presentation, which has a wide array of comps).
We think the most relevant metrics are price/revenues and EV/EBITDA. With EV/EBITDA we look at normalized EBITDA margin, which we expect to be 10-15% for Purple within the next few years. Assuming Purple grows as we expect it to, the company’s shares will look inexpensive in a matter of time.
We also consider the valuation of Eve Sleep. It’s a far smaller company than Purple and it saw its EBITDA loss increase in 2017. It has guided to UK level profitability in 4Q 2018 (it operates in multiple countries) and overall profitability sometime in 2019, whereas Purple should enjoy equally rapid growth in 2018 and be solidly profitable for the year.
Finally, we consider private market valuation, including that of Casper. We believe that given Purple’s growth profile, if the company executes for the next several quarters, it will certainly carry a $1bn+ valuation.
We note that Purple has 13.5mn 1/2 warrants with a strike price of $11.50 and a duration of 5 years from the close of the transaction. The warrants are callable by the company if they trade above $24 for 20 of 30 trading days. Based on our Black-Scholes analysis (modified to account for the callable nature of the warrants), we believe fair value is $1.35-1.50 with shares trading at current prices, or 50-70% upside. It’s worth mentioning that warrants traded as high as $1.28 in January, prior to the closure of the transaction being a certainty.
Competitive market place. The mattress industry is increasingly competitive with more entrants continuing to come into the BIB market and relatively few exiting (so far). This could cause ongoing upward price pressure on online market spend, as well as take attention from Purple to other brands. We believe that given its momentum and strong and increasing brand awareness, Purple will continue to rapidly grow, in addition to the fact that it has a differentiated product. We suspect the pace of new industry entrants will prove unsustainable and that Purple will end up being among the winners.
Execution. We believe that it’s a challenge for any company to manage hyper-growth, but are confident that Purple is well equipped to manage this process. Any issues with execution could harm Purple’s growth trajectory.
New product acceptance. We expect Purple to leverage its brand and technology into ancillary products. It’s possible that Purple’s new products will fail to gain market traction and won’t contribute to sales, and could also prove a management distraction.
Failure to penetrate new channels. While we believe that Purple’s unique mattresses and value proposition make it a likely success in brick-and-mortar locations and internationally, it is possible that the company may fail to successfully expand in those channels. We note that brick and mortar continues to account for 85% of industry-wide mattress sales.
7. Catalysts and conclusion
We believe that Purple represents an early-inning opportunity to invest in a high-growth company at a reasonable (below private market) price. Purple has lots of runway for growth and represents the first dramatic technological change in mattress technology in decades. We think extensions into additional markets and products will prove successful.
We are optimistic that Purple shares will produce outsized returns over the next several years. We also believe that Purple’s warrants are very attractive and priced well below what is implied by Black-Scholes.
We believe catalysts will include 4Q results and 2018 guidance, which will be reported during the 1st half of March. Given the negative revision while the company was de-SPACing, if it is clear that Purple’s growth trajectory is intact, we believe shares could move substantially higher.
We also expect the sell-side to provide coverage, likely post earnings, when they are comfortable that business is progressing solidly. We note that the mattress sector is well-covered, but there are few publicly traded plays in the space. We think this will make for a very exciting growth story, with a good deal of coverage.
We expect further developments with Mattress Firm or other brick-and-mortar partners, as well as new products introductions, to potentially accelerate growth and be positively received by the financial markets.
Looking out further, we anticipate shares being included in multiple small-cap indices. With a near $600mn market cap at current share prices, demand should be significant relative to the number of freely tradeable shares.
Finally, while we have strong preference for buybacks when shares are undervalued, we suspect that if the company performs well and shares trade higher, that after lock-up expires the company will have a secondary. We believe in this case, a greater float could prove beneficial as it will put shares in the hands of more institutional holders. We note that we expect that after 2018 Purple should be sustainably and increasingly cash-flow generative. In 2018, the company may use some cash to support cap-ex and to build inventory to support a potential broader retail launch, which would be a very good thing.
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Disclosure: I am/we are long PRPL, PRPLW, DSKE, DSKEW.
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