Sleep Country (TSE: ZZZ) is a potentially undervalued company with a quantifiable competitive advantage. This edge allows it to create value for shareholders that is measurable. As a result, long-term investors interested in retail exposure may want to consider ZZZ stock.
Can Sleep Country’s Competitive Advantages be Quantified?
There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating a company’s earnings power value (EPV).
Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value (the cost to reproduce/replicate the business) can be measured using a company’s total asset value. If the earnings power value is higher than the reproduction value, then a company is considered to have a competitive advantage.
The calculation is as follows:
EPV = EPV adjusted earnings / WACC
C$1,363 million = C$126.8 million / 0.093
Since Sleep Country has a total asset value of C$979 million, it can be said that it has a competitive advantage. In other words, assuming no growth for Sleep Country, it would require C$979 million of assets to generate C$1,363 million in value over time, which is ideal.
The second method to determine if a company has a competitive advantage is by looking at its gross margin because it represents the premium that consumers are willing to pay over the cost of a product or service. An expanding gross margin indicates that a sustainable competitive advantage is present.
If a company has no edge, then new entrants would gradually take away market share, leading to a decreasing gross margin as pricing wars ensue to remain competitive.
In Sleep Country’s case, its gross margin has remained relatively flat since Fiscal 2014, hovering within a range of 34.6% to 38.5% and uptrending in the past three years. As a result, its gross margin indicates that a competitive advantage is present in this regard as well.
Sleep Country Creates Value for Shareholders
As a result of Sleep Country’s competitive advantage, the company is able to create value for shareholders. This can be quantified by measuring its economic spread, which is defined as follows:
Economic Spread = Return on Invested Capital – Weighted Average Cost of Capital
Great companies often have great management teams that can effectively allocate capital to profitable projects. An investor can get a good idea of management’s efficiency by simply looking at the numbers.
The idea is straightforward; if the return on invested capital is greater than the cost of that same capital, then the company is creating value for its shareholders through well-thought-out projects. Otherwise, the company is destroying value and would be better off simply investing money into risk-free bonds.
For Sleep Country, the economic spread is as follows:
Economic Spread = 13.7% – 9.3%
Economic Spread = 4.4%
As a result, the company is creating value for its shareholders, implying that management is efficiently allocating capital.
What Do Analysts Think of ZZZ Stock?
Sleep Country’s stock has a Moderate Buy consensus rating based on five Buys and two Holds assigned in the past three months. The average Sleep Country price target of C$38 implies over 50% upside potential.
Final Thoughts – A Dominant Company
Sleep Country is a solid business with a measurable competitive advantage. As a result, the company has been able to maintain a dominant position in the Canadian sleeping-products market. Therefore, investors with a long-term horizon may want to consider looking into ZZZ stock.
