Sealy debt shows private equity shortcomings

Bloomberg News

Sealy Corp. and Tempur-Pedic International Inc. are mattress makers that were backed by private-equity firms. The similarities pretty much end there.

Tempur-Pedic, founded in 1992, became the biggest mattress company by revenue last year as sales rose 28 percent to $1.42 billion. Sealy, a 131-year-old company that’s been a household name for decades, fell to No. 2 with sales of $1.23 billion, little changed from 2010 and down 28 percent from the 2007 peak.

The companies’ diverging fortunes underscore the highs and lows of private equity, an industry whose impact on the economy has drawn scrutiny this year as Mitt Romney, founder of Boston buyout firm Bain Capital LLC, runs for president. The mattress business has been a particular favorite of deal makers, with uneven results for investors, the companies and their employees.

“A basic mattress company was a great vehicle for a basic leveraged buyout, as long as the economy and debt markets continued to perform,” said Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business in Hanover, New Hampshire.

The top mattress makers had strong cash flows, high profit margins and steady growth, until the 2008 financial crisis exposed the hazards of leveraged buyouts such as KKR & Co.’s $1.5 billion purchase of Sealy. Ascendant now is an approach called equity growth, applied in deals such as TA Associates Inc.’s $376 million investment in Tempur-Pedic a decade ago, in which debt is kept lower and marketing expenditures high, according to Blaydon.

“You can’t play the old LBO game anymore,” he said. “If firms want to attract investors, they need to be telling an equity-growth story.”

Kristi Huller, a spokeswoman for New York-based KKR, said the firm declined to comment.

Tempur-Pedic, based in Lexington, Kentucky, has seen its stock more than quadruple since its 2003 initial public offering, even after a 28 percent pullback in the past week.

“Consumers are increasingly prepared to pay a premium for a product that will enable them to sleep better,” Chief Executive Officer Mark Sarvary said in a Jan. 24 conference call with analysts, describing the company’s success selling mattresses for as much as $7,499.

Shares of Sealy, based in Trinity, North Carolina, have plunged 87 percent since the company went public in 2006, two years after being bought by KKR in a deal saddling it with $1 billion in debt.

Board Backlash

The user of coil-spring technology was slow to respond to inroads by upstarts including Tempur-Pedic, with its foam products, and Select Comfort Corp., featuring air-based mattresses. Such specialty mattresses have become the industry’s fastest-growing segment, while Sealy’s mid-priced Posturpedic lines have become laggards as its target consumers defer purchases.

Shareholders sent a protest message to the company’s board by withholding more than 30 percent of the votes for three of the nine directors at last week’s annual meeting in Greensboro, North Carolina, according to election results released this week by Sealy. More than 20 percent declined to support three additional board members, the company’s 8-K filing shows.

The results indicate some investors sided with New York- based H Partners Management LLC, the 15 percent stakeholder that had vowed before the meeting to withhold votes for a board of directors it said was dominated by KKR, which owns 45 percent of the shares.

‘Significant Progress’

The hedge fund, which started accumulating the stock in early 2011, cast attention on Sealy’s governance in a March 11 letter to the board, saying KKR had “overloaded the company with debt and taken a short-term approach; made numerous strategic errors, resulting in a 50 percent earnings decline; repeatedly made poor CEO selections.”

KKR said in December that Lawrence J. Rogers, the second CEO on its ownership watch, would retire this year and it would conduct a search for a new leader. A successor hasn’t been named.

“The board is working with a world-class recruiter and making significant progress,” Gemma Hart, a spokeswoman at Brunswick Group for Sealy, said of the CEO search announced in December.

H Partners has urged Sealy to seek outside candidates for the job, and, in its letter, criticized the “excess operational influence” of KKR’s in-house consulting unit, led by Dean Nelson, also a Sealy board member.

‘We Love Input’

Before the meeting, shareholder FPR Partners LLC told the head of the board’s corporate governance committee that KKR should have a “very different” role as an investor at a public company. Altai Capital Management LP, another investor, asked the firm to bring H Partners into the CEO search.

“We love input, but we have limited ability to respond for regulatory reasons,” Sealy Chairman Paul Norris said in an interview after the April 18 meeting at the Grandover resort.

The 15-minute meeting was attended by two representatives from H Partners and a former Sealy employee who owns shares, according to Hart, as board members and executives outnumbered investors. Bloomberg News was barred.

Executives told attendees the company has been “transparent and consistent with good governance practices,” said Norris, former chairman and CEO of W.R. Grace & Co. and now a senior adviser to KKR.

KKR’s challenge with Sealy shows how firms that paid up for companies as buyouts began peaking in the mid-2000s have been left to operate them through down times with the burden of high debt, said Lenny Ajzenman, a senior vice president at Moody’s Investors Service in New York.

Smaller Workforce

Sealy’s market value has shrunk to $205 million, compared with Tempur-Pedic’s $3.83 billion, as the stock fell from the $16 initial offering price to yesterday’s close of $2.03 in New York trading.

Sealy’s workforce has been cut by 33 percent to 4,276 employees as of Nov. 27, when the last fiscal year ended, from 6,399 in 2004, according to data compiled by Bloomberg. Tempur- Pedic’s staff has grown by 38 percent to 1,800 as of Dec. 31, the data show.

“Many PE firms had to hold on to companies long beyond their expectations, because there was no available exit or their operating performance was pressured,” Ajzenman said. “With consumer companies in particular, you have to come out with new products and keep up with customers.”

Sealy and another big competitor, Simmons Bedding Co., have been flipped several times since the 1980s. Since 1986, Simmons has traded hands from Wesray Capital Corp. to Merrill Lynch Capital Partners to Investcorp to Fenway Partners LLC to Thomas H. Lee Partners LP. It came out of Chapter 11 in 2010 owned by Ares Management LLC and the Ontario Teachers’ Pension Plan.

Increasingly Competitive

Since 1989, Sealy has gone from Gibbons, Green & van Amerongen Ltd. to Clipper Group to Zell/Chillmark Fund LP to Bain to KKR. Bain led a group buying Sealy in 1997 for $833 million and made more than five times its original equity investment upon selling the company seven years later to KKR, the investment firm led by Henry Kravis and George Roberts.

“It was a good, steady business, with growth in the mid- to-high single digits, kind of tracking GDP, and margins that were reasonable,” said Andy McLane, a senior adviser at Boston- based TA Associates, which led the 83 percent purchase of Tempur-Pedic for $376 million. “But then the industry got more competitive.”

Touting Comfort

Tempur-Pedic, whose chairman is McLane, helped change the competitive landscape. Its foam mattresses were developed by a Danish manufacturer and brought to the U.S. by entrepreneur Bobby Trussell, who touted the comfort of the new design over the traditional coil-and-spring construction used by Sealy and others. Its selling point, a much better night’s sleep, resonated with consumers who could afford its mattresses.

The company, whose sales were a quarter the size of Sealy’s a decade ago, was able to forcefully market that message and develop new products because its cash flow wasn’t as encumbered by loan payments.

TA Associates used $198 million of debt in acquiring Tempur-Pedic, McLane said, or about 3.6 times the company’s 2002 earnings before interest, taxes, depreciation and amortization, according to data compiled by Bloomberg. The firm no longer owns any Tempur-Pedic stock, according to filings.

Sealy’s debt swelled to $1.05 billion after the 2004 purchase, or 5.8 times Ebitda, Bloomberg’s data show.

Highly leveraged deals often go south, Ajzenman said. Thomas H. Lee bought Simmons in 2004, less than four months before the Sealy buyout, and put it into Chapter 11 bankruptcy in 2009 with $1 billion of debt.

Interest Expense

Sealy paid $88 million of interest expense in 2011 on its debt, which is now about $780 million, according to data compiled by Bloomberg. Tempur-Pedic posted net interest earnings of $11.9 million, as its income from interest-bearing investments exceeded its loan payment costs.

Tempur-Pedic spent $1 billion on advertising in the past decade, executives said in a February investor presentation. The current ad budget represents 13 percent of its sales, a ratio similar to those of Nike Inc. and Procter & Gamble Co., according to the presentation.

Sealy didn’t run a national ad campaign from 1998 until 2008, according to a regulatory filing. The company puts $120 million to $150 million a year into cooperative advertising, contributing to mattress retailers’ local ad purchases. Those stores typically promote their sales more than the virtues of Sealy products.

Tempur-Pedic has been joined by other non-coil manufacturers to chip away at Sealy. The high-end mattress market sputtered when the U.S. fell into recession in December 2007, before resuming robust growth in the past two years.

‘Refraining From Replacing’

Sealy, which derives about half its sales from mid-priced mattresses that retail for $599 to $999, still awaits a resurgence. Its earnings before interest, taxes, depreciation and amortization declined 31 percent last year, to $107.8 million.

“The mid-priced category has been hurt by consumers refraining from replacing mattresses,” said Norris, the chairman.

In the past two years, Sealy has moved to bolster its pricier product lines. It produced its first foam mattress, Embody, in 2010. It created a specialty division to develop new- technology product lines in 2011. Posturpedic Optimum, a line of gel-based mattresses, arrives in stores this month.

Sealy expects Optimum to increase sales from specialty mattresses and help it gain ground in a segment where the company is seeking to lift market share to 20 percent from 9 percent, Rogers said in an interview.

Fees, Dividends

The decline in value of KKR’s Sealy holdings has been partly offset by fees and dividends collected during its ownership. The firm and its limited partners were paid a $25 million transaction fee for the 2004 deal with Bain, according to the offering document. When Sealy went public, KKR and its investors were paid a $125 million special dividend from the proceeds. The document also disclosed an $11 million payment from Sealy to KKR and its investors to terminate a management- services contract. The firm and its clients have since collected $9.7 million from Sealy for consulting and other services, according to H Partners.

Sealy must consider CEO candidates from other industries, H Partners said in last month’s letter. Rogers, who has worked at Sealy for 33 years, was picked in 2008 to follow David McIlquham, an 18-year company veteran and holdover from Bain’s ownership retained by KKR.

Outside CEOs

H Partners cited two competitors that chose outside leaders -- Tempur-Pedic’s Sarvary previously ran clothing retailer J. Crew Group Inc. and the North America division of Campbell Soup Co., and Select Comfort CEO William McLaughlin is a former PepsiCo Inc. executive.

“These managers’ strong consumer and general management backgrounds have enabled Tempur-Pedic and Select Comfort to succeed,” H Partners wrote.

Sealy’s revenue rose 2.2 percent in its fiscal first quarter ended Feb. 26, reversing a year-over-year decline in the previous three months. Industry sales are forecast to advance 7.2 percent this year, according to the International Sleep Products Association trade group in Alexandria, Virginia.

Revenue will grow faster as product lines such as Optimum are rolled out, Rogers said in an analysts’ conference call last month. National advertising spending is likely to be unchanged from 2011, he said, with Sealy conserving cash to keep a strong balance sheet.

“They ultimately need to grow to deleverage,” Ajzenman said.

--With assistance from Chris Burritt in Greensboro and Devin Banerjee in New York. Editors: Josh Friedman, Christian Baumgaertel

To contact the reporter on this story: John Helyar in Atlanta at jhelyarbloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertelbloomberg.net