GP PROFILE: Downturn Tests KKR Capstone’s Vaunted Operational Team

March 6 was a rough day for Sealy Corp. and its private equity backer, Kohlberg Kravis Roberts & Co. The 25-year-old mattress maker’s stock, which a year earlier traded around $8 a share, closed at 55 cents.

But what investors didn’t know at the time is that Sealy was implementing intense measures under the guidance of KKR Capstone, the operational arm of the iconic mega-firm. The results of these measures would serve up a surprise for analysts following the company less than a month later when Sealy posted better-than-expected results for the first quarter. The surprise profit revived interest in the company’s stock, which was trading at $3.04 per share at press time.

“We knew we were doing the right things for the business,” KKR Capstone Co-founder Dean Nelson, told Buyouts. “We were disappointed but not anxious.”

With little debt available to finance deals, almost every buyout professional says they’re spending most of their time on the operational side, guiding their companies through the recession. Executives at KKR, once the industry poster boy for financial engineering, have for years preached the importance of operational know-how in generating top returns. In 2000, KKR launched its KKR Capstone division, a team of operational consultants that works alongside management at KKR companies.

But as the recession forces companies of every kind to re-evaluate their business plans, KKR Capstone finds itself facing what perhaps has become its most daunting challenge yet. The unit’s performance today is crucial to the parent company’s returns tomorrow. Sealy Corp. is an example of the challenges the firm faces and the measures it’s taking to generate solid returns. The company manufactures mattresses in 24 plants in North America and sells them through more than 7,000 retail outlets, including department stores and warehouse clubs. It posted $1.5 billion in sales in 2008 and has a market capitalization of about $1 billion.

KKR bought Sealy in 2004 from a group of buyout firms including Bain Capital, in a deal valued at $1.5 billion. The New York-based firm invested about $436 million in equity in the deal and financed the rest with debt. It moved quickly to recover some, if not all, of its investment from the company. Just three months after the deal, KKR recouped about $109 million in a dividend recapitalization. Then, in April 2006, KKR took the company public, raking in about $150 million while maintaining a 59 percent stake. The firm now holds a 51 percent stake after selling additional shares. It’s also realized returns through dividends.

At the time of the investment, KKR joined a cadre of buyout firms, including Bain, Thomas H. Lee Partners and Fenway Partners, which were drawn to the profitable mattress business. But after 30 years of rapid growth, the housing crash is hurting the industry. THL Partners-backed Simmons Bedding Co.—Sealy’s rival—has reportedly hired bankruptcy lawyers and is seeking alternative funding. In the fourth quarter of 2008, Sealy posted a surprise loss of $42 million compared to a profit of $17 million a year earlier, due to the economic downturn and the high cost of raw materials used to make its products. KKR executives factored into their original investment thesis a possible housing downturn but didn’t anticipate it would turn out this bad, Nelson said.

KKR Capstone consists of about 25 investment professionals in the U.S., 10 in Europe and four in Asia. While Nelson, a former senior partner with The Boston Consulting Group, works with three or four companies at a time, most KKR Capstone professionals concentrate on one particular company, usually spending four days a week on-site, working in tandem with the management teams. All told, KKR Capstone professionals will work on-site for anywhere between a few weeks or a few months, depending on need.

KKR Capstone’s fundamental goal with Sealy is to gain market share while maintaining EBITDA margins. To do that, it’s trying to cut costs without skimping on the quality of the company’s products. As a result, KKR Capstone professionals are spending most of their time examining costs in sales and general administration, or SG&A. With KKR Capstone’s help, Sealy simultaneously reorganized its sales strategy and launched revamped mattress lines. The idea is to shave expenses without negatively affecting the customer. “If it doesn’t touch the customer, be especially aggressive about it,” Nelson said.

Larry Rogers, Sealy’s CEO, told Buyouts that Nelson and Capstone professionals Matt King, Andrew Low Ah Kee and David Luck have worked extensively with him in examining every process involved in the manufacturing, distribution, and selling of Sealy mattresses. Sealy reduced its workforce, from plant workers to executives, by 25 percent, or about 1,800 jobs, in 2008. Partly as a result, the company’s SG&A expenses declined $19.5 million in the first quarter, from $116.2 million to $96.7 million. “They’ve significantly cut their fixed cost on the SG&A side,” John Baugh, an analyst at Stifel Nicolaus & Co., told Buyouts. “I give the CEO and CFO relatively high marks for the progress they’ve made.”

With KKR Capstone’s guidance, Sealy dramatically reorganized its sales force in the latter half of 2008. Using U.S. Census data to identify geographic areas with more buying potential, Sealy cut the number of its sales districts (places in which Sealy aims to sell mattresses), from 18 to 10, and the number of its sales regions, which oversee the districts, from four to two. The result was a leaner, more efficient sales force. The company also reduced travel and entertainment expenses for salespeople. Meanwhile, Sealy cut shifts at most of its 24 plants in North America from two to one, and it closed one plant altogether in Clarion, Pa.

The cost-cutting has imbued the company with a focused, lean culture. “You develop a lean and more conscious mentality about what is ‘must have,’” said Rogers. A 30-year veteran of Sealy, Rogers became interim CEO in March 2008, after the company’s previous CEO, David McIlquham, resigned after conceding the company did not meet its expectations in 2007. Rogers was officially named CEO in July, and during his tenure the company also hired a new head of sales, a new head of human resources and a new head of marketing.

The company also re-examined how it designs and makes mattresses (Rogers and Nelson declined to discuss specifics, for fear of providing tips to competitors) which reduced waste and cost. Meanwhile, Rogers and Nelson claim, Sealy invested in product development to improve the quality of the new Posturpedic line, introduced in July 2008, and the new Stearns & Foster line, which is in the midst of its launch. KKR is not about “mindless cost cutting,” Rogers said. “They’re not myopic about this. They think in a very holistic way about every constituent, including customers.”

KKR Capstone is also saving money with Sealy’s trucks. With guidance from the Environmental Defense Fund, Sealy shaved 8 percent off its fuel costs in 2008 through a series of progressive initiatives. The company installed specialized governor devices, for example, that turn an engine off if it’s been idling for five minutes. It also installed components called air foils which cut wind resistance, and began using routing software to make sure Sealy trucks were delivering in the most efficient manner.

Through these cost-cutting measures, and the introduction of new Posturpedic and Stearns & Foster lines, Sealy and KKR executives say they’re gaining market share. Though he declined to discuss specific numbers, Rogers cited internal data which points to the fact that retailers are increasing the amount of floor space reserved for Sealy beds. Another reason for the progress, he said, is that retailers plan sales months in advance, and in difficult times they tend to back reliable companies they’re confident will be able to deliver mattresses when the sales come around.

Sealy pays Capstone on average about $500,000 to $600,000 per quarter in consulting fees, although KKR is not earning management fees, which it recouped in bulk after the 2006 IPO. Rogers, who oversees the billing, called the rates a bargain. Having been at Sealy for more than 30 years, Rogers offers a unique perspective because he’s worked with a number of private investors that have invested in the company, including Gibbons Green Van Amerongen, Sam Zell, and Bain Capital. He rates KKR Capstone at the top in terms of its talent and its devotion to the company. “One of the things that has really distinguished them from others is that the people you’re working with are working full time on your business,” he said. “It’s not like they have two or three other assignments.”

So what has been the result of KKR Capstone’s initiatives so far? The company beat analysts’ expectations for its first quarter earnings, despite a 71 percent drop in profit and a 21 percent drop in revenue. Sealy also reduced its debt to $732 million, a reduction of $64 million compared to 1Q 2008, giving it a leverage ratio to 4.96 to 1. On April 1, the day after its earnings announcement, the company’s stock surged, rising 80 percent at its high for the session, before closing at $2.70.

There’s also some wind blowing at the company’s back, as prices for raw materials are declining, and its main competitor, Simmons, is facing a tougher struggle. But, as Baugh, the Stifel Nicolaus analyst cautioned, Sealy is not nearly out of the woods. “Demand is still weak, and I anticipate it will remain that way for the foreseeable future,” he said.

A lot rides on how KKR Capstone’s cost-cutting and reorganization measures will continue to influence the company, and on how the company’s new Posturpedic and Sterns & Foster lines perform. Jeff Ackerman, CFO warned in the Q1 conference call that he doesn’t expect the company to reap the benefits of the latter brand until the third quarter. “The turnaround is still in process,” Nelson said.