A week ago we wrote about At Home, a home decor company that is facing challenges as its brick-and-mortar business model is facing pressure from Amazon (AMZN), Target (TGT), and Wayfair (W) - a problem enhanced by financial engineering. The once sleepy furniture and decor industry has become highly dynamic and is changing rapidly.
The furniture industry once provided a moat for retailers. In order to reach customers, furniture makers relied on furniture stores that made decisions about what inventory to carry. Traditional furniture retailers must balance inventory costs with limited space and selection. A low dollar value to weight ratio creates logistics challenges that have historically been difficult for new entrants to solve, making it hard to go direct to the consumer or sell online. Because of these barriers, the furniture industry is highly fragmented, with little brand loyalty.
Amazon, Wayfair, and a plethora of trendy startups are upending the once sleepy furniture industry. This is just one example of how eCommerce is now creeping into once protected niche businesses, such as hardline home goods. Wayfair and Amazon offer an unmatched selection with fast shipping due to their specialized distribution networks. Meanwhile, a wave of new entrants offers creative designs, innovation, and quality assurance targeted at a maturing millennial consumer.
Another potential casualty of these dynamic changes is Lovesac (NASDAQ:LOVE ). Lovesac is a niche player that was founded in 1998 as a foam bean-bag retailer. Shortly after bankruptcy in 2005, Lovesac developed a modular sofa in 2006 that constitutes the majority of the company's revenue today. We believe that Lovesac has masked a structurally unprofitable business with "adjusted" non-GAAP metrics, trendy buzzwords, a new look, and impressive sales growth. Furthermore, we believe that Lovesac has pitched itself to investors as a disruptive tech company with a differentiated model, when in fact it is not.
Lovesac has two key products. The genesis of Lovesac is a foam-filled beanbag like product called "Sacs", that come in various sizes. They feature covers that can be removed or swapped for a different style. They range in price from about $350 to about $1,800, depending on various size and fabric options. Sacs accounted for 25% of Lovesac's revenue in FY2019.
The majority of Lovesac's revenue comes from a modular sectional sofa called the "Sactional". This was unveiled in 2006 and is the focus of the business today, accounting for 72% of revenue in FY2019. The average purchase price of a first time Sactionals buyer was $3,789 in FY2018, but prices can be in well excess of $19,000 with a large set-up, premium filler, accessories, custom fabric, or more pieces added.
The sofa (the company prefers the term couch) consists of two different pieces that can be combined to create a variety of different arrangements, depending on how many pieces you have, including being arranged to have a bigger depth or combined with an ottoman to make a bed arrangement. Like many sofas, Sactionals have removable slipcovers that can be washed or replaced, but this is marketed by Lovesac as a key differentiator.
Other value propositions include the ability to purchase more modular pieces to expand the size or design later, a lifetime guarantee, and sustainable fabric options. Lovesac also sells a variety of accessories, including blankets, ottoman tables, charging/power ports, and drink holders. This constituted about 3% of revenue in FY2019.
Lovesac sells most of its products through its retail locations, which are mostly located in shopping malls. Lovesac also sells through pop-ups at Costco and a 4 location shop-in-shop test at Macy's. The products are then shipped via FedEx to customers, who unpack and/or assemble them, which can be a lengthy process.
Lovesac was founded by Shawn Nelson, who previously went by "Shawny D." before the Lovesac IPO. Despite owning just 1.2% of the shares outstanding, Nelson is still CEO of the company today. He is at the center of the Lovesac story. In 1995, he built a giant bean bag in his parents' basement shortly after graduating high school. In college, he began selling these foam-filled sacs with friends as a fun side business. After visiting a trade show in Chicago, he received an order for 12,000 sacs from the Limited Too.
The tiny company cobbled together the equipment needed and Nelson went to China to establish relationships with a supplier. Amazingly, the company was able to complete the large order, though it was barely profitable. With the order complete and the equipment purchased, Nelson opened the first store, and shortly after signed on the first franchisee. With the strong suburban housing market of the early to mid 2000s, Lovesac took off. By 2006 the company reached 70 locations, 40 of which were operated by franchisees.
The rapid growth of the company propelled Nelson onto the stage of reality TV, where he competed against other young entrepreneurs and professionals in The Rebel Billionaire: Branson's Quest for the Best in 2005. Nelson was ultimately crowned the winner, taking home a $1M prize and briefly becoming president of Virgin Worldwide.
Then, in early 2006, Lovesac filed for Chapter 11 Bankruptcy, with $3.2M owed to creditors against just $500k in assets. The company had 74 stores. In the wake of the bankruptcy, many allegations emerged against the company. A key supplier was out $1.2M and claimed that Lovesac always had trouble paying him. One former employee alleged that Nelson "humiliated him in front of staffers for drinking on a company trip" and discriminated against him because he was not Mormon. Another former employee wrote that he "was never paid in paper currency, only in Lovesac products." One creditor sued several company insiders, including Nelson, for "allegedly engaging in a complicated shell game that stripped it of its equity stake."
Lovesac emerged from bankruptcy after closing around 62 stores, this likely included all franchise locations. The company was bought out for $600,000 by a consortium of investors that included a couple private equity firms, growing to 28 locations. Then the real boost came in 2010 when Lovesac received an undisclosed investment from private equity firm Mistral Equity Partners. This was followed in 2017 by a $10M follow-up deal that included participation from both Mistral and Satori Capital, another private equity firm.
The private equity investments supported two rebranding efforts. First, in 2012, Lovesac rebranded its stores with a new logo among other things. The sexual innuendo was toned down to reflect the diversification into modular sectional sofas that Lovesac calls Sactionals. To drive sales per square foot, Lovesac added an array of accessory products such as rugs, lamps, and bowls. In 2016 Lovesac underwent another rebranding with a new showroom concept that used a smaller format that focused only on marketing Sacs and Sactionals. This was likely an attempt to stop Lovesac's operational cash burn, which was $8.9M in the fiscal year ended January 2016.
The injections of cash had supplemented the cash burn enough (as described in the risk portion of the S-1 filing) to create steady growth without real profits. Alongside the new image, it was also time to start shaping up the company for the public markets by steadily building an executive team.
The company first brought in Jack Krause to fill the role of President. Krause is the former president of Vitamin World which went bankrupt less than 2 years after his departure. Next, they brought in Donna Dellomo to act as Exec VP, CFO, Treasurer, and Secretary. Dellomo has spent most of her career as CFO at Perfumania, a role that ended shortly before Perfumania filed for bankruptcy in 2017. Lovesac also added CTO/CIO David Jensen, who was previously at J Jill (JILL), which has declined to nearly $1/share despite an IPO of over $12/share in 2017. It should come as no surprise that Nelson is the only executive serving on the board, which is made up almost entirely of current and former private equity guys.
A company whose operations are alone is burning cash, before any capital expenditures are considered, is a tough sell to investors - even if the company is growing revenue. To pitch this to investors for an IPO, the private equity sponsors tapped ROTH Capital. ROTH was the sole book-runner for the Lovesac IPO. ROTH has a long reputation built on events featuring topless models and pitching clients on Chinese companies that were actually scams. ROTH has provided market access or investment banking services to a number of companies that we've written articles about, including VUZIX (VUZI), Barfresh Food Group (BRFH), and ElectraMeccanica (SOLO). Here is a clip of the ROTH MD discussing his excitement about the deal.
Lovesac today is essentially what you might expect given its background and evolution. The company has basically tried to reinvent itself to justify its money-losing brick-and-mortar-with-FedEx-shipping business model that has evolved out of mall-based a retailer that lacked a distribution system capable of delivering sectional sofas. It is a business model in search of a justification amid a rapidly changing market, and the target market reflects that.
On one hand, Lovesac's S-1 filing describes it as being in the "premium segment" of the market. In a recent investor presentation, Lovesac says it is positioned as "mid-luxury", targeted at 35-39-year-old "Young parent want-it-alls". Is that niche to small? Don't worry. Lovesac is also everything to everyone, with the mission to "own the couch category" by convincing buyers to spend more on a couch because they can put new slip covers on it and add new modular sections to it. The CEO said on one earnings call that they "can absolutely be in every home in the United States."
Despite a clear target market, an unproven strategy that burns cash, and a series of delusional remarks by the CEO, Lovesac has swooned buy ratings from Oppenheimer, D.A. Davidson, Stifel, and Canaccord since its IPO. Stifel wrote about Lovesac's "competitive moat" when it initiated coverage this summer. Stifel recently cut to hold, as it is obvious to anyone of millennial age buying furniture that Lovesac has no moat (more on this later)... Why would Stifel have given Lovesac such a vote of confidence in the first place?
It's important to understand that investment banking equity research analysts have a habit of supporting stocks when their respective capital markets or M&A groups might benefit. This was obvious at At Home (HOME) when analysts touted At Home's lofty potential at the same time that M&A rumors were circulating. Lovesac is no different. If the cash burn continues, the company will need to raise additional capital, a key function of investment banks. Despite a disappointing quarter that pummeled the stock, Lovesac stock popped shortly after marketing event hosted by Oppenheimer, a sign that Lovesac is developing banking relationships that it may call on later to try to raise capital. We view this as an indication that Lovesac will continue to burn cash.
Despite all of the clever investor marketing and buzzwords, Lovesac is still largely a mall-based retailer with only around 20% of sales taking place online in FY19. From the company's history, it seems clear that this evolved as a mall retail business that is now marketing itself to investors as "a technology-driven, omni-channel company", a clever spin. Lacking the logistics network to deliver furniture and delivering via FedEx instead has been rebranded as "an ecommerce-first approach." It's also unclear how this is a company based around invention considering it has two core products, the Sactional developed in 2006, and the Sac developed in the late 1990s.
It's hard to believe that this is an actual quote, let alone one that happened on the most recent earnings call. First off, the company has no profits to reinvest as it is deeply unprofitable, LTM EBITDA was -$5.9M with -$12.2M (LTM) in net income on the bottom line. The operations didn't even generate cash, burning $29.2M on an LTM basis, up from $7M in FY19. This is on top of $10.7M in Capex in FY19 ($9.1 LTM). The cash used to 'invest in infrastructure' has come from $59M raised in the IPO and a $25M follow-on round.
Lovesac may be able to create new "adjustments" to come up with its own custom EBITDA that does not adhere to GAAP accounting standards, such as adding back tariffs, but it has struggled to have real positive EBITDA.
This directly contradicts the information given in the company's annual report:
We have had to rely on a combination of cash flow from operations and new capital in order to sustain our business. We have historically operated at a loss, which has resulted in an accumulated deficit. Despite the fact that we have raised significant capital in recent periods, there can be no assurance that we will ever achieve profitability.
Given the risks as outlined in the annual report, the company is potentially structurally unprofitable, which would explain why it has historically operated at a loss. The cost of operating a business that is acquiring customers by opening stores in malls, then shipping products via FedEx, maybe too high to be profitable. In FY2019 Lovesac spent over $25M on shipping costs. Revenue was just $165M, making that nearly 15% of revenue. Operating income has been negative for every fiscal year the data is available.
At the speed Lovesac has burned cash over the last 4 quarters, it will run out of cash in less than 12 months (-$29M LTM CFO, -$9.1M LTM Capex, $28M cash on balance sheet). Additionally, Lovesac has over $61M in lease obligations. As was the case with At Home, these lease obligations quickly start to look like debt if the company gets into a bind.
Raising the cash that Lovesac will almost certainly need may get more difficult. The risk of structural profitability issues is being enhanced by competitive threats. There are a number of impressive competitors that we will examine next. The company took specific action against one of them, Burrow, which is backed by a VC consortium that includes the famous Y Combinator. Burrow offers a modular design that is very similar to Lovesac. The case was dismissed without any mention of a settlement.
Rather than comparing itself to any of its competitors or the real disruptors in the furniture and decor industry (Amazon and Wayfair), Lovesac instead prefers to ignore them and compare itself to Tesla...
In addition to potential structural profitability issues in its business model, Lovesac is facing an onslaught of competition. On one hand, Wayfair and Amazon are having a disruptive force on the industry. On the other hand, a remarkable wave of disruptive and innovative startups with chic and trendy designs is emerging. Both compete directly against Lovesac, offering many of the same value propositions and features.
Wayfair offers over 15,000 sofas and over 3,500 sectionals, including many with customization options. Wayfair also offers nearly 1,000 different beanbag chairs. On an LTM basis, Wayfair has grown revenue by $1.8B over the prior fiscal year. Revenue is on track to grow over 600% since 2014.
Armed with hundreds of millions in capital, Wayfair is disrupting the entire furniture and decor industry by reaching economies of scale large enough to solve the distribution issues that Lovesac mitigates by breaking its Sactionals down into many FedEx packages, which made a lot more sense in 2006. Wayfair has made furniture freight delivery easy and accessible to the average consumer online. In addition, Wayfair is building out its own distribution network for rapid delivery, 2 days or less.
Over half the traffic coming into Wayfair's ecommerce platform is from a mobile device. Its app features a "View in Room 3D augmented reality tool" and has 633,000 ratings at an average of 4.8 stars. By comparison, Lovesac's app, touted as a success by management, has just 66 ratings at an average of 3.2 stars and has no AR capability despite Lovesac's self-described focus on technology.
Amazon has also entered this category with Amazon Home, offering over 1,000 different sofas, loveseats, futons, and sectionals. Amazon Home offers 558 different sectionals alone, including 170 that ship with Amazon Prime.
There is also the rapidly growing Article.com, which offers a wide range of sofas starting around $900, for a flat rate shipping fee of $49.
Competing even more directly with Lovesac is a wave of innovative DTC startups with chic and trendy designs. Lovesac's management may claim that it is "the only couch built for the internet age" and "the only couch that can be deployed right to your doorstep via FedEx" but that is blatantly false.
Inside Weather offers a range of sofas and sectionals that start at about $898. Inside Weather offers free shipping and a range of customization options including foam support level and fabric (just like Lovesac). Inside Weather claims that their sofas are made of durable fabric that is "life-proof" (slipcovers are waterproof nylon and can be removed/washed). Unlike Lovesac, which makes its products in Asia, Inside Weather claims their products are made-to-order in California with "smart manufacturing". Inside Weather offers other shippable home furnishings such as chairs and tables to complete the look and has received rave reviews in the press.
Hem is a Stockholm-based design brand that "creating a new generation of furniture, accessories and lighting." Its products are shippable and customers say delivery is easy and the products are simple to assemble. Hem offers a wide range of sofas and sectionals with unique modern designs that appeal strongly with young consumers. It has an extensive team of designers and this really shows through in the imaginative products. Prices are a bit on the high side, but they are certainly comparable to Lovesac and have the added quality bonus of being made by "renowned European manufacturers".
One particularly formidable opponent is Detroit-based Floyd. Floyd makes one sofa with an optional chase. This is next business day shipped via FedEx or UPS. Floyd's Sofa is made in the Great Lakes Region, with cold-rolled steel, durable powder coating, and real birch. A 3 seat sofa costs just $1,295. Floyd has a design ethos to reduce disposable furniture, just like Lovesac, and they come with a 10-year warranty. Floyd is backed by a consortium that includes La-Z-Boy Inc., according to data provided by Bloomberg.
For consumers looking for more customization, there's The Inside. The Inside offers an insane array of custom fabric options in numerous sofa and sectional sizes and styles. This is all "made by hand in the USA" and costs a fraction of a custom Lovesac. Looking for a 3-seat mid-century modern sofa in "porcelain coquina"? The Inside has you covered for just $2,199 with free white-glove delivery included. How about a modern sofa in 100% cotton "banana palm" for less than $1,600? They even have kid & pet friendly fabrics. The Inside is backed by Forerunner Ventures that has also backed Dollar Shave Club, Jet.com, and Bonobos (according to data provided by Bloomberg).
Some need more of a balance between customization, price, and high touch service. For them, there is Interior Define. Interior Define offers a range of sofa and sectional designs, including their highly modular and versatile "Toby" model. Customers can choose from leathers or a very wide variety of fabrics, wide variety of legs, cushion options, fill options, and length/sizes (example). A basic sofa starts at just $1,295 and sectionals start at $1,795.
Interior Define offers an AR app and live design advice. Flat rate delivery includes assembly and clean up. In 2017, Interior Define tripled its revenue for the 3rd year in a row. The company has raised $23M from a VC consortium according to data provided by Bloomberg and operates 6 showrooms in major US cities.
While other entrants offer new and exciting value propositions, no other is at Lovesac's throat quite like Burrow. Burrow offers a highly modular design that breaks down similar to the way Lovesac's Sactional does. Burrow, founded by two Wharton grads in 2016, has expanded at incredible speed to offer a variety of modular sofa/sectional styles and even tables, rugs, and accessories. Burrow's 3-seat sofa starts at just $1,395 and shipping is provided by FedEx or UPS. The loveseat starts at $995.
In addition to its highly modular design, Burrow offers other features that are in the Lovesac proposition, such as scratch/stain resistant fabric and a built-in USB charger - even on the most basic model. Reviews for this have been excellent. Lovesac was so threatened by Burrow, which was backed early on by Y Combinator, that it launched a recently dismissed lawsuit against the company, mentioned earlier in this article.
Even Lovesac's namesake product, the Sac, is under intense competition from competitors that are a fraction of the cost. Amazon offers the Chill Sack with prime delivery, the "huge 6' memory foam' model costs just $208. CordaRoy's offers a "king sized" bean bag that converts into a bed for just $389. It was featured on Shark Tank. Lovesac's products are allegedly higher quality, but they are blisteringly more expensive. Imagine the average debt-burdened millennial paying $1,000 for a "SuperSac" or $1,300 for the "BigOne" when Amazon has something similar for a couple hundred bucks.
Cracks from these competitive pressures are already bubbling to the surface. Diligent Seeking Alpha contributors @Lord Baltimore and @Gary Alexander were quick to provide their analysis of the most recent quarter, detailing decelerating revenue growth and "burgeoning losses".
But there are even deeper signs of issues at Lovesac. Lovesac has a 1.5-star rating on the BBB website along with 38 complaints. If you search Lovesac on YouTube, one of the first videos to come up will likely be from this customer that is so unhappy with her Sactional purchase that she is returning it. This video has nearly 95,000 views - close to 10x as many subscribers as Lovesac's very active YouTube channel has. Other videos complain about Sactional quality with one claiming that "over 75%" of the peg/feet were "not manufactured correctly". The high repeat customer stats touted by management may even be boosted in part by dissatisfied customers figuring out they need more pieces.
Our prediction is that Lovesac's pitch to investors will prove to be desperate attempts to mask a structurally unprofitable business model, that gets laid to rest by Wayfair/Amazon Home and tucked-in by a plethora of chic and trendy DTC competitors with unique value propositions.
In summary, we believe two private equity firms cobbled together a management team, dressed a mall-based furniture retailer up with a new image, and then relied on a lower middle market investment bank with an unscrupulous history to sell it to investors for an IPO exit. Supporting this theory is the fact that they've since steadily wound down their position.
We analyze the CEO's track record as a history of recklessness. Another example would be taking the day off to assist his friend's ex-wife in setting up her living room in the same year that the company burned nearly $10M in negative cash flow from operations and capital expenditures. Here's a clip of Nelson explaining that "quality trumps size" when helping her select a TV. In another segment, the Lovesac CEO explains to her that he feels perfectly fine about drilling a hole in her wall because he is "sober" and "perfectly in control" of his "capacities". Investors should note that the CEO spends his time split between the company's headquarters in Connecticut and "HQ2" located in his home state of Utah, a perk awarded to him despite owning just 1.2% of the shares outstanding according to data provided by S&P.
The CEO also has a history of making statements that arguably misrepresented the business. In one example, when securing the early deal with The Limited Too, Nelson led the customer to believe the Lovesac operation was much larger than it really was and doubled down on this to secure financing while the customer was unaware of the counterparty risk they were actually taking. In another example, he led the first franchisee to believe the company was larger than just one location. Now, we believe the CEO is pitching Lovesac as a differentiated tech disruptor, when it is really a financially challenged mall retailer facing a wave of competition.
Investment bankers building company relationships are likely ignorant of the wave of competition that is changing the industry, as it is in their best interest to be nascent of the situation. They may also be competing for potentially lucrative deals related to other companies in the PE sponsors' portfolio, companies other than Lovesac. This is only suspicion, but it certainly can't be ruled out.
In conclusion, because we suspect that Lovesac is structurally unprofitable and will continue to burn money, we believe that its future relies on its ability to raise more capital. Because we believe that this ability is predicated on marketing on claims that are seemingly disprovable and increasingly challenged, we are willing to be against this happening.
Risks that would cause us to revise our short thesis include historically strong comp store growth and a modest margin tailwind from shifting production out of China to avoid tariffs. We believe both of these factors are outweighed by our profitability concerns. Therefore, we are short LOVE. If Lovesac cannot raise additional capital we believe there is a serious risk of bankruptcy in the next 12-18 months even if the economy remains strong.
This article was written by
Disclosure: I am/we are short LOVE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.