Why I Invested in Lovesac
Excellent Growth Potential With Underlying Profitability
It’s All About Cash
Lovesac is self-funding aggressive investment in robust growth in a market that it is years away from saturating. If Lovesac can hit $2.5 billion in revenue in 7 years with potential for FCF yields of 20%, they will be throwing off $500 million in cash, assuming investment in further growth has tapered off. The business currently has an Enterprise Value of $330 million, so that’s a 151% cash flow return given today’s price. I hope they carry on investing those cash flows in further profitable expansion.
To give some perspective, even with the recent decline, Tesla has a FCF potential, when adding back in growth spend, of perhaps up to $120 billion if they can grow revenue at a 35% CAGR over the next 7 years and maintain industry-leading margins (I’m feeling very generous). Tesla has an EV of $655 billion today, which would be an 18% cash flow return in 7 years, or just 12% of what Lovesac will be generating. I firmly believe Lovesac is a far better investment than Tesla.
With a potential for $2.5 billion in revenue in 7 years and a 10% net income margin, a PE ratio of 10 would, perhaps rather obviously, yield a market cap of $2.5 billion, or 6.75x their current market cap of $370 million. Over 7 years, that’s a potential CAGR of 34%. Considering I think a 15% return is great, I have a considerable margin for error here.
Key Drivers
Strong track record of revenue and equity growth through comparable sales and store expansion (CAGR of 30% over past 3 years)
6 to 7 year growth runway in North America before they even consider international.
FCF/EV yield of 25% to 30% when stripping out growth investment.
Debt free with $37.7 million in cash and the cash-generative 4Q ahead.
Unique, innovative products that can be dispatched almost immediately.
Fueling their own rapid growth with cash flow from the business.
There is still room for huge expansion in brand awareness.
Who are Lovesac?
Lovesac is a furniture company that sells modular sofas, chairs, and accessories. They are known for their innovative designs and their commitment to sustainability. They started out selling giant sacs before hitting a niche with their sactionals, which now account for almost 90% of net sales.
Source: https://www.lovesac.com/
What Makes Lovesac Different?
Redefining the Sofa Experience: you don’t walk into Lovesac and try out thirty different sofas - they have a laser-sharp focus on their stylish, modular, and adaptable sactionals and sacs in a far less cluttered environment. You get to play with sactional configurations and experience their stealth tech. Once home, you can go online and play with your ideal layout, considering how you might adapt it in the future - sactionals are designed for life - with new pieces and tech. Then choose your material before placing an order and having it delivered in weeks. Record time for a furniture retailer. Can’t afford your ideal sofa? Buy a two seater and add new tech or pieces in the future, when you can afford them. Sactionals grow with you.
Footprint: they don’t need big stores or waste too much time with a vast array of product offerings; they’ve kept things extremely simple, which simplifies the overall business and yields impressive sales per square foot (slide 26).
Evergreen inventory: sacs and sactionals are not seasonal; they don’t need to discount them heavily to clear stale inventory.
Innovation: they aren’t afraid to try new things out and have created some very desirable products like stealth tech and angled sides. Even if you bought your sactional pieces 10 years ago, you can upgrade them with new tech and styles for a fraction of the price of replacing your sofa.
Branding: Lovesac is investing heavily in their brand. They still have quite a way to go to reach a level of awareness that drives peak sales.
Sustainability: designed for life - no more sending sofas to landfill. You can start with a two-seater for your single life, then keep adding pieces and creating different layouts as you expand. You can even split the sofa if you have to separate! There is no bulky sofa to move either; it can be packed flat!
Product Belief: you can return your new sactional sofa within 60 days if you don’t like it. That’s how confident they are in their product. They also have a lifetime warranty on the more sturdy aspects of their products. Even employees love selling this product.
Let’s take a look in more detail…
Fueling Their Own Growth
Self-funded growth is a hallmark of a strong, sustainable business. It signifies that your company is generating enough revenue to fuel its own expansion, demonstrating financial stability and underlying profitability. By relying on your own resources, you're free from the constraints of external funding, avoiding the dilution of ownership and the demands of creditors.
Lovesac IPO’d on June 26, 2018, raising around $58 million to accelerate their growth. There was a subsequent offering that raised around $21 million in 2019. So that’s around $80 million raised net of expenses. In the past 3 years, they’ve realised $88 million in net income while generating revenue growth of 120%, i.e., they’ve already generated more income than the capital raised while investing heavily in growth.
While cash generation is more important to me, I also like to look at how equity has evolved with revenue. They’ve grown equity by 29.5% over the past 3 years without raising any additional capital or big swings in working capital. Most of that equity is property, cash, and inventory used to fuel their growth. By comparison, Alphabet (GOOGL) has grown equity by 8.7% over the past 3 years, although they have bought back around 6% of stock net of stock-based compensation over that period too, so 10.5% is probably a fairer comparison.
Where Could Revenue Top Out?
Lovesac’s capital raise in 2018/19 had a dramatic effect on growth.
Lovesac has yet to achieve full market penetration in North America. Any successful retailer with a profitable model can keep opening stores, e.g., Five Below and Arhaus. Lovesac will be in around 245 showrooms in FY24. They can probably double that number before they begin to saturate the market. Ashley operates more than 790 in North America and over 1,100 globally. Then the stores need to reach maturity, so you have a year or two beyond that to reach peak revenue and profitability. Beyond that, you have international expansion, with Canada, Germany, and possibly the UK as obvious targets. China’s growing middle classes and Japan could also prove interesting markets for their products.
I believe we could be looking at $2.5 billion to $3 billion in peak revenue from US expansion. From their anticipated base of $710 million in revenue in FY24 and growing at around 17%, that would take around 8 years. At 25% CAGR revenue growth, we’d be looking at 5 years.
We also have to factor in their stealth tech. They have captured some of the home audio market and have potential for further product innovation. Lovesac don’t break this out unfortunately, so we’re a little blind. However, it will be a driver for sales beyond that of a typical furniture retailer.
“Sales of StealthTech continue to grow and augment our differentiation in the landscape, widening our opportunity.” - Lovesac 3Q 2024
They also have some interesting patents that may help them expand into one or two more lines of modular furniture, leveraging their expertise with sactionals. I’d be pretty excited about a modular home console system where I can extend, adapt the style, and add technology over time.
What About Profit?
Lovesac is in a high growth phase. Just like Amazon under Bezos, they are investing heavily in future cash flows and sacrificing short-term profitability. Any profit they make is likely to be the result of Q4 sales, where they can’t invest the income as fast as they make it. This has the added benefit of reducing taxes.
Amazon’s lack of profitability hasn’t hurt their business or share price appreciation, with a CAGR of almost 34% over the past 15 years. By investing aggressively, they have likely grown much faster, achieving greater long-term shareholder value by reinvesting rather than making distributions to shareholders.
Source: Amazon’s tiny profits, explained
Let’s try to strip out some of the investment and see if we can come up with a rough idea of how profitable Lovesac really is. We’ll start with current net income expectations. In FY24, Lovesac is expected to generate, on average, around:
$24 million in net income for FY24.
It’s been higher in the past—$45 million in 2022—but we’ll start with $24 million.
New Store Investment
I’m going to take a shot in the dark here and suggest they incur around $5 million of expense when opening stores in the current period. I suspect not all of it is capitalised.
$29.5 million
SG&A
Mary Fox is very cost-conscious, so I suspect we couldn’t strip a large portion of SG&A, but most growth companies have some inefficiencies. I’ll suggest a 7.5% reduction in SG&A, but I think between 10% and 20% is possible.
SG&A for FY24 is likely to come in around at least $260 million. 7.5% is $19.5 million, and adding that back in gives:
$49 million
Advertising and Marketing
Lovesac has been aggressively marketing their business. This has helped them generate a 30% CAGR in revenue. Once they reach saturation, I’d expect this to scale back. Again, I think they could probably cut in excess of 10% to 15%, but I’ll go for 7.5% again.
FY 2024 advertising and marketing spend is likely to be at least $90 million. 7.5% reduction frees up $6.75 million, which improves our net income further:
$55.75 million
This is just under 10% of revenue, which isn’t hard to imagine for a furniture retailer with Lovesac’s business model. What does that look like?
Lovesac is really on a PE of 6 when you strip out growth
Free Cash Flow would be higher than net income as you’d add back in depreciation, amortisation, finance, stock-based compensation, etc. Perhaps even as high as $70 million to $80 million, including our cost cutting. That would be a FCF to EV yield of 24% for FY24.
I know Lovesac invests in R&D, but I won’t strip it out as I consider it an investment in maintaining their market-leading position.
When to Exit
Lovesac’s growth is almost 100% driven by store expansion, which, to be fair to them, is funded through their own cash flows. That may change as they add to their product lineup. I’ll be monitoring store saturation and changes to cash flow ratios. Before growth slows, and if the valuation doesn’t support cash flows, e.g., less than 10% underlying cash flow to EV, I would consider selling. If we’re still getting, say 20% of underlying cash flow to EV, then I’d remain invested, as buybacks and dividends would generate value for shareholders regardless of growth slowing.
I’ll be rethinking this investment when revenue hits $2 billion and seriously considering what further opportunities for expansion they have. International expansion will make me nervous. I’d like to see their strategy and approach before any international expansion. Ideally, they would start sticking a toe in the water in a preferred location well before North America becomes saturated.
Any merger, major acquisition, or significant diversification away from their core competency will make me very nervous.