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Buy This Small Cap to Sleep Easy

Sleep Country Canada Holdings Inc. (TSX:ZZZ) reported solid three-quarter earnings November 2, yet its stock is down 16% since its announcement.

Fool contributor Joseph Solitro, whose December 2015 recommendation of the mattress retailer has paid off handsomely for anyone who took his advice, is now suggesting that the recent slide makes for a great entry point.

On the surface, it’s hard to argue with his assessment. However, before I second his recommendation, I’d like to take another look at Leon’s Furniture Ltd. (TSX:LNF), a stock I first recommended in September 2016.

I believe there might be a financial metric that sets these two companies apart. Let’s have a closer look.

Free cash flow

It’s one of the best financial metrics you can use to assess a business’s true capabilities. After all, it’s much more difficult to manipulate free cash flow with accounting tricks than earnings.

The Globe and Mail recently picked out 18 dividend-paying stocks that provided investors with safety and good value. The stock screen criteria includes only those companies with a market cap of $1 billion or more, free cash flow yield (FCF / enterprise value) of 4% or greater, a dividend yield of 2% or higher, a dividend payout no higher than 100%, earnings momentum, and a low debt-to-equity ratio.

  Criteria

LNF

ZZZ

Market cap > $1B

$1.34B

$1.22B

FCF yield > 4%

6.8%

5.8%

Dividend yield > 2%

2.6%

2.0%

Dividend payout < 100%

35.5%

43.1%

Earnings momentum

11.2%

15.8%

Low debt-to-equity ratio

53%

44%

Sources: Morningstar, Yahoo Finance

The findings

If you analyze the numbers, there’s not much difference between Leon’s and Sleep Country.

Leon’s provides better value, pays out less of its earnings than Sleep Country does, has slightly lower earnings growth than Sleep Country, and higher leverage, but other than that, they’re pretty darn similar.

Regarding revenue growth, using the most recent quarterly comparison available — Sleep Country already announced its Q3 earnings; Leon’s reports November 14 — Sleep Country had it all over Leon’s with same-store sales growth of 7.5% — 650 basis points better.

However, the one thing I’ve learned about retail is that same-store sales growth is great, but only if they deliver earnings growth as well.

In Leon’s second quarter ended June 30, it grew adjusted earnings per share by 25% compared to 19% growth for Sleep Country. If you’re growing same-store sales by 7.5% each quarter like Sleep Country is, you ought to be moving the earnings needle a little more than 19%.

Bottom line on Leon’s and Sleep Country

All of Sleep Country’s stores are corporate owned, whereas Leon’s is a combination of corporate and franchise stores, making the comparison somewhat apples to oranges.

While this is a tough call, I’d go with Leon’s over Sleep Country, because Leon’s free cash flow yield is 100 basis points higher, providing a slightly better value. That said, Sleep Country is by no means a bad stock and is one of Canada’s better retail operations.

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Fool contributor Will Ashworth has no position in any stocks mentioned. 

 

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