LOVESAC: Why Investors are Concerned and Why I Still LOVE It
Some history: We began buying stock in Lovesac back in 2020 and I wrote an article about it in 2022.
Introduction
Lovesac (popularized by the “giant beanbags”) is a designer and retailer of furniture, primarily modular, sectional couches called sactionals. Their patented design fitting together “seats and sides” couples unmatched utility and value for customers while it endows a unique and durable competitive advantage to Lovesac. As a result, Lovesac has consistently grown by taking market share from incumbents, disrupting the status quo.
Why are Investors Concerned?
No business is perfect. We believe the stock is cheap (I’ll expound later), but opportunity does not occur in a vacuum. So why is this stock underpriced? Here are the warts:
1. Furniture (industry sales are weak) + Retail (high risk of failure) = Scary for Investors
Macro: The furniture industry is facing a hangover from the pandemic-induced buying spree. According to Factset and the US Census Bureau, furniture & home furnishing stores have experienced a 5.6% decline in seasonally adjusted retail sales from December 2022 to November 2023. Below is the longer-term chart for industry sales. Uncertainty as to when furniture sales will begin growing again in the face of a potential recession causes investors to avoid the industry.
Past Bankruptcy: Lovesac filed for bankruptcy in 2006. At the time, the company primarily sold Sacs (the giant bean bags), had too many stores, too much debt, and some bad franchise agreements. When private equity firms got interested in the business, they suggested filing bankruptcy to restructure the business model to feature sactionals while reducing the number of stores and products offered and focusing on company-owned showrooms (stores).
Retail Sales: Furniture & Home Furnishings Stores. Data from US Census Bureau Powered by FactSet
2. Corporate Governance/Controls
Restated Financials: In June of 2023, Lovesac announced they would need to restate financials from the quarter ending April 30th and the fiscal year ending January 29, 2023 as they incorrectly capitalized $2.2M of shipping expenses found errors in the design of the accrual calculations for last mile freight expenses. Net income for the fiscal year ending January 29, 2023 was restated from $28.2M to $26.5M. The restatement for the quarter ending April 30th reduced the net loss from $4.2M to $4.1M. Following the announcement, Lovesac changed CFOs hiring Kieth Siegner in replacement of the outgoing Donna Dellomo.
Compensation Adjustments: In Fiscal 2022, the company extended the term of 495,366 stock options through June 5, 2024. These options have an option price of $38.10 per share. The company has a stated policy to not “reprice” options which is a sound policy in my opinion. However, this decision seems to be against the spirit of that policy.
As the company calculated performance metrics for executive compensation for fiscal year 2023, they added back rising freight costs for the calculation of adjusted EBITDA as this was outside of management’s control. It is difficult to ascertain whether the company made the offsetting adjustments for the following year as those costs normalized.
3. CEO Publicity
In early 2024, Shawn Nelson published a book and corresponding podcast entitled “Let Me Save You 25 Years” about his entrepreneurial journey and the lessons learned. This may prove to be a positive to the extent it boosts Shawn image and Lovesac’s brand, but the timing is unfortunate with the concurrent accounting issues.
What Gets You Excited About the Investment?
As I said, every business has its issues to work through. Companies that are growing quickly often have growing pains and issues they must figure out on the fly. So why is this company special?
1. Founder-led
Some studies suggest that founder-led companies tend to outperform. Shawn Nelson built his first Lovesac in 1995 and opened the business in 1998. The business is a culmination of his life’s work. He understands what makes the business special and why it resonates with customers. Shawn has also learned a great deal from past mistakes and has staked his reputation on the success of the company. Sometimes founders are not able to grow their skillsets as fast as the business necessitates, but despite some setbacks, Shawn has shown a unique ability in this regard.
2. Culture of Innovation, Persistence, and Resourcefulness
Shawn (and Lovesac) have shown a penchant for innovation, consistently trying radical ideas with the ability to spot and focus on the ones that really work.
Sacs – Shawn made the first Lovesac in 1995 as sort of a joke. It had strong appeal and as people kept asking him to make more, he decided to turn it into a business. He had to invent the production process for this new category, at one point repurposing an old hay shredder and then a tractor to chop the recycled foam that fills the Sac.
Retail – Lovesac originally desired to sell their Sacs through existing furniture stores, but upon finding no takers they decided to open their own retail stores.
Sactionals – Customers kept asking to buy a couch they had in the showroom, but they had no way of actually delivering them. In classic Lovesac fashion, they decided to “cut up” the couch into a modular design that would allow shipping via Fedex. Sactionals are the crown jewel separating itself from the competition as a platform.
The truly modular nature (seats and sides) allow for the most adaptable set up on the marketplace. They are relatively easy to rearrange to different setups including separate chairs or even a bed. When the situation calls for it, you can add on more pieces. The covers are machine washable and interchangeable so instead of replacing your couch, you can just order different covers. For the environmentally conscious, the fabric is made from recycled plastic bottles. And they are built to last a lifetime. The desire to add on or upgrade an existing assembly led to 45.6% of transactions to come from repeat customers in FY2023.
StealthTech – Lovesac continues to reimagine what furniture should be, partnering with Harmon to deliver an unprecedented experience with a sound system embedded within a couch.
Other Innovations – The Power Hub addresses one of my biggest complaints about couches by adding a power source on the couch itself. No more moving the couch to find a plug in! Other notable items include seat storage as well as cupholders and trey tables that integrate with the couch.
Patents and Branding – Lovesac holds a growing list of patents (74 as of January 29, 2023) in the US and overseas and has shown an ability to protect their IP. In 2022, they successfully defended a patent against Joybird (subsidiary of La-Z-Boy) after Joybird launched a line of modular couches resulting in the product being pulled from the market.
Designed for Life – While the sactional platform is designed to adapt to consumers changing needs, their products come with exceptional warranties to back up the motto. Below is the warranty section from Lovesac’s website as of 01/22/2024 which includes a lifetime warranty on “All hard Sactionals pieces”.
3. Business Model and Competitive Advantages
The business model really hinges on the modular and interchangeable nature of their products on which everything else is built. Everything Lovesac sells can be shipped via Fedex. Even the largest Sac, which seats 4 people, is shrunk down when packaged. Customers then self-assemble the Sactionals at home or can hire help.
Showroom Concept – Because Lovesac mostly sells “seats and sides,” they only need to have a couple of couches on display. Showrooms are small (800-1,000 sq ft with about 6 employees total) where customers can try out various cushions and work with store associates to select an assortment of pieces and their desired cover. Incumbent furniture brands and stores have an innovators dilemma where they would need to completely upend their business model to compete effectively. Lovesac showrooms have higher sales per square foot ($2,771 in FY2023) than any other retail concept except Apple and Tiffany with an average payback of less than 2 years. The small format also allows Lovesac to create shop-in-shops (about 200 sq ft) at retailers, such as Costco and Best Buy, to extend the brand.
Unit Economics – I estimate that the average showroom generates about $2.5M in annual revenue. On average, I believe each showroom they add will produce in excess of $500k in annual operating profits once the store reaches maturity. This includes estimated employee costs (about $327k), rent (about $63,000), marketing (about 12% of sales), and other expenses like utilities. These are my own estimates based on the publicly available data I can find. It does not include operating expenses tied to the company headquarters for example. The takeaway though, is that if they can replicate the model for even just another 100 showrooms it could add upwards of $50M to operating profits minus any incremental overhead. Keep in mind, this is an average and many showrooms are not yet at a mature operating level.
Fulfillment – The modular design lends itself to several advantages in product fulfillment. Products are shipped from regional warehouses via FedEx rather than local warehouses or from the store itself. Products in boxes can be packed on a truck more efficiently than fully assembled couches, and because it leverages existing 3rd party parcel delivery infrastructure, it can arrive to a customer’s home in as little as 2 days.
Inventory – Almost half of Lovesac’s sales are generated by 2 SKU’s (seats and sides). One of the lessons Shawn learned was to steer clear of seasonal and/or fashion risk inventory. This product is evergreen resulting in a significantly lower risk of inventory write-downs. Along with the unique utility of the product, lower inventory risk contributes to gross margins that are typically north of 50%.
4. Long-Term Insider Ownership
Private equity got involved in Lovesac around the time of the bankruptcy, encouraging Shawn to exit its old franchise agreements and seasonal inventory to focus the future of the business on Sactionals and company-owned Showrooms. They remain a significant investor in the company. Satori Capital still owns just over 4% of the company as of 12/12/2023 and retains a board seat through John Richard Grafer. Grafer also owns just under 3% of LOVE shares as of 04/06/2023. In addition, Andrew Heyer is the Chairman of Lovesac. Heyer is the managing director of Mistral Capital Partners which recently exited its stake, selling to Mr. Heyer (owns just over 2% as of 12/27/2023). It is encouraging that these insiders have invested so heavily for so long in the company.
5. Growth Opportunities
So long as the company continues to innovate and its products resonate with customers, there should be ample opportunities for expansion.
Showrooms – 230 as of October 29, 2023. Lovesac is aiming for 400 in the next few years.
Shop-in-shops and Pop-up shops – The company operates 41 shop-in-shops with Best Buy and had 147 physical pop-up shops with Costco in 3Q23.
New Products – Recent patent filings suggest the company is working on a modular bedding and mattress system. Also, within the last 2 years, the company has added executives with Sleep Number (Todd Duran, CIO) and Purple (John Legg, Chief Supply Chain Officer) on their resumes.
International – Lovesac has no retail presence outside of the United States. However, they file their patents internationally and plan to eventually generate revenue overseas. The timing of this is uncertain as they focus on capitalizing on the domestic market first.
6. Marketing Spend
Lovesac generated an average of $3,309 in revenue for new customers in FY2023 with customer acquisition costs of $628. With 45.6% of transactions coming from repeat customers, marketing spend becomes a very profitable expansion tool as each cohort of new customers matures.
7. Valuation
Retail concepts are difficult to value because there is such a fine line between success and failure. Lovesac also has very little hard assets to fall back on. I have built discounted cash flow models for 3 different scenarios to estimate the value of the stock given various outcomes.
Bear – Should Lovesac fall on hard times because they failed to protect their intellectual property or perhaps consumers decide that modular couches are an outdated novelty, the stock is essentially worthless. Retail is extremely competitive, and the failure rate is high relative to most industries (see Sears, Blockbuster, Bed Bath & Beyond, Toys “R” Us, etc.)
Base – If Lovesac is able to continue to outpace the category (though at a slower rate than they have historically), growing sales to $2B by 2032 with operating margins around 14%, I believe the stock is worth about $41 per share.
Bull – If Lovesac can grow the topline to $5B by 2032 and achieve better margins with scale, it could be worth in excess of $116 per share.
Which Scenario is Correct?
Only time will tell. However, I suspect Lovesac would be disappointed with the base case scenario as it falls well short of their ambitions and projects a marked slowdown in their growth. I would peg something between the base and bull case to be the most likely, but I would caution that this type of business is extremely difficult to project with significant confidence. Given that we are investors in the stock, it is easy to ascertain that my expectation is that they at least achieve the base case.
Final Thoughts
At Aurora, we are constantly looking for attractive investment opportunities for our clients. We look for businesses with economic moats, quality balance sheets and attractive upside potential. This blog represents our thinking at the time of publication. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding our asset allocation and individual stock strategies, please reach out to us! For more information on our investing philosophy, check out www.auroramgt.com.
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Asset Management, an Indianapolis-based subsidiary of Aurora Financial Strategies which is located in Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
