Sleep on This Play

 | Oct 01, 2012 | 10:00 AM EDT
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Rehan Jaffer manages H Partners Management, an activist hedge fund that holds a small number of small-cap stocks. Jaffer's top holdings include Six Flags Entertainment (SIX), W.R. Grace (GRA), and Boyd Gaming (BYD) (you can read our discussion of Jaffer's portfolio here). Jaffer's strategy, which he developed while working with Dan Loeb at Third Point, is to gain management's ear by taking large stakes in a given company.

The fund's third largest holding as of June 30, Sealy (ZZ) has struggled since its IPO in 2006. The company's shares fell flat and by 2008, the company had suspended its dividend. According to its 13F regulatory filing, H Partners held 15.5 million shares of Sealy at the end of June, and the fund has been building this position steadily over the past year and a half. On Aug. 21, the fund reported that it had upped its total holdings by 1.8 million shares to 17.28 million shares. Sealy's stock has lost 90% of its value since its IPO, and the company is saddled with $760 million in debt. It market cap is only $227 million.

H Partners has had very harsh words to say toward KKR (KKR), the private-equity firm that owns about 44% of the company. Tempur-Pedic (TPX) agreed on Thursday to acquire the KKR-backed Sealy for $229 million. This was a 2.85 premium to its closing price on Wednesday. Jaffer's H Partners, who built the majority of its position in the second quarter 2011, essentially comes out with its principle.

H Partners indicated earlier this year that given its steady increase in sales, the company could be worth around $7.50 a share. Despite cries of mismanagement, favoritism and the like from H Partners, Sealy and Tempur-Pedic management, spearheaded by KKR, indicated that the acquisition would not be put to a vote since more than 51% of the shareholders approved the sale. Mattress firms, with their relatively steady flow of cash, are attractive to private equity firms such as KKR. In 2004, KKR purchased Sealy from Bain Capital and, in 2006, took the company public at about $16 a share.

Tempur-Pedic, which presently maintains a 15.5% net margin in its premium mattress business, is thus purchasing the beleaguered Sealy, which maintains a negative net margin, effectively combining the two largest publicly traded mattress companies. These companies have been very sensitive to the downturn in the recession (both have betas above 2). Tempur-Pedic's sales decreased 28% in 2011, but, along with economic conditions, are projected to increase 1% in 2012. Mattress unit sales in general rose 3.5% in 2012, but Tempur-Pedic's product line did not allow it to compete in a number of different parts of the market.

With the acquisition of the Stearns & Foster, Sealy and Sealy Posturepedic brands, Tempur-Pedic will be able to move into a number of different bedding markets. Tempur-Pedic CEO Mark Sarvary noted that "Tempur-Pedic and Sealy together will have products for almost every consumer preference and price point, distribution through all key channels, [and] in-house expertise on almost all key bedding technologies."

About 50% of the mattress market, however, is for premium mattresses, which is an area that will allow a fair amount of growth for the newly-formed mattress conglomerate. We think the newly combined company could be an interesting play as a growth-oriented company in a very stable business. Mattress companies are also excellent ways to play an improvement in the housing market. That said, given the volatile price action of both companies and the circumstances surrounding the merger, we would wait for the merger to proceed before initiating a position.

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