LUVU: A Sexy Stock

It’s been a while since I did a proper stock writeup. I’m now working full time, have been very busy and just moved out so the length, frequency and quality of posts on this substack will likely drop due to time constraints. However, I appreciate everyone who reads what I write and thinks I have something worthwhile to say. This month I think I have a unique and interesting idea that I haven’t seen anywhere else. A tiny, illiquid, unloved company with a little bit of sex appeal.

Luvu brands ($LUVU) is a furniture retailer trading on the OTC markets that has an interesting specialty. While they own a few brands, 65% of their revenue comes from Liberator, a specialty erotic furniture brand (hence the clickbait cover photo). The company dominates an interesting niche and trades at a very cheap valuation. However, they are currently likely overearning and have no amazing track record or capital allocation policy. At the very least it’s an interesting story that I want to dig into.

Liberator was founded in 2002 by current CEO Louis Friedman with the aim “to provide you with the best in comfort, elevation, and support so that you can focus on what’s most important”. Essentially they create furniture that is specifically made to have sex in, on and with. This entails using specific materials and shapes for better comfort, ergonomics and convenience compared to regular furniture, plus plenty of extra features. After expanding strategically into medical products through Avana and bean bags through Jaxx the company rebranded into LUVU brands. While we will discuss the other brands, I want to focus on Liberator as that is the core of the business.

The reason this company interests me so much is because Liberator sits in an interesting competitive position. Liberator is the premium brand within a sector that it essentially created itself (kind of like another company I like Fever Tree). While erotic furniture may seem like an area that could be commoditised, sex is an area that people are willing to pay a premium for as seen by the success of many premium brands such as Bad Dragon, Fleshlight, Lovesense and Hitachi (don’t ask me how I know all these brands). You can purchase a cheap knockoff of Liberator’s signature wedge pillow on Amazon for $33 dollars vs an eye watering $200 for their base product, but people pay up. The brand premium is earned, with Liberator products earning incredible reviews everywhere I looked. Liberator products are all made in America, with a manufacturing facility in Atlanta. While naturally this results in an increase in labour costs, they save in shipping costs, have very low turnover amongst their workers and are able to use higher quality machinery than what’s available in Chinese factories.

Liberator’s segment sales were pretty much flat from 2013 to 2020 before exploding in 2021. The combination of the pandemic stimulus boost, progressive attitudes towards sex and mainstream attention such as Netflix show ‘How to Build a Sex Room’ (HTBASR) have seen sales well over double in the two years since. Covid stimulus has already run through the economy with their sales holding strong (every other furniture brand has dropped off). There will likely be a decline as ‘How to Build a Sex Room’ loses relevance. Additionally, while they haven’t commented on it publicly, I suspect that a not-insignificant number of sales for Liberator products come through sex workers such as prostitutes, porn stars and only-fans models. These industries have experienced huge growth in the past few years however are fairly exposed to the economy. Regardless of the short term outlook I believe the trends in sex positivity and sex work are extremely favourable in the long term. Liberator is positioned to benefit from two tailwinds in the growth of loneliness (money going towards sex workers) along with more sex positive attitudes (people getting more experimental in the bedroom). This provides a long runway for Liberator to grow as the dominant player within their niche.

The Other Brands

There are 3 other key segments. The first and least relevant is resale, which is generally composed of erotic items purchased from other suppliers and resold on their distribution platform. Historically this has been a significant source of revenue, however the rise of lower cost platforms such as Lovehoney, Adam and Eve and even AliExpress have essentially killed this segment.

The next product is Avana which markets itself as a wellness and medical brand. For the most part Avana products are just rebranded Liberator products with minor changes in design and materials. While revenues have been weak in the past 2 years, Avana is great strategically due to requiring little to no extra investment and allowing them to market Liberator products to a broader market. Avana revenues are actually understated due to booking some of their sales as Liberator revenue.

Jaxx is the most interesting other segment, as Jaxx was created as a way to use the offcuts and waste products created by Liberator production. The company used to just sell their offcuts to various carpeting and materials companies, however as the GFC hit nobody was purchasing offcuts. As a solution the company came up with Jaxx, a leisure brand that sells bean bags and other similar products. I love this strategically, as Jaxx is low effort to produce and has grown revenues rapidly, doubling in the past 5 years. Jaxx is an example of what I love about Luvu, which is creativity and outside the box thinking. It should be noted that Jaxx revenues have dropped significantly over the past year (like most comparable furniture companies) which is obviously a concern. Management has guided to a modest recovery over the next year but we shouldn’t expect to reach back to Covid highs. As stated, Jaxx is low margin and requires limited investment so I’m not as concerned about it’s future compared to the core liberator brand, which contributes significantly more to profitability.

I like that Luvu seems to have a culture of creativity and innovation, while still keeping a tight lid on costs. The premise in itself is novel, while their offshoot segments have all been low investment ways for them to expand and grow sales. Meanwhile on earnings calls Louis seems to have a significant focus on costs, which is actually how Jaxx was born in the first place. This is reflected by their last 7 years of operating profitability along with Friedman’s fairly low salary at $150k.

The Financials

Revenue for the company has grown fairly consistently from $17m in 2016 to $30m in the past 12 months. Profits have been less consistent as margins have varied drastically over this time, though the company has remained consistently operating profitable over that period. Why I’m so interested is because at a market cap of $6.m Luvu has a TTM net income of $1.24m putting it at a PE of around 5. On an underlying basis, sales are likely a bit inflated currently, while the company isn’t paying tax as they work through a sizable deferred loss. I don’t have a clear idea of what more normalised earnings look like but I believe they probably leave them at a PE of under 10 and they are generating solid FCF in the meantime. 

While much of the company's cash flow has gone into growing inventory and other operating assets, Friedman has flagged that working capital will normalise and even decrease a little over the next 2 years. This is great as inventory increases have been a consistent drag on free cash flow. The excess cash flow has been used to steadily pay down debt, which now stands at $2.8m. While not nothing, this is a comfortable level of debt for a consistently profitable business, though I assume they will continue to pay it down. I should add that book value has grown from -$2.5m to $3.5m in the past 5 years, showcasing a significant improvement in the company’s balance sheet.

Why does this Opportunity Exist?

A key question I like to ask myself on all investments is “Why does this Opportunity Exist?”. In this case the answer seems fairly straight forward. Luvu is a $6m company that trades on the OTC market and is very illiquid. Additionally, the company is heavily exposed to the economy in an industry (furniture) that has been crushed this year, and to top it off sells products that are sexual. I suspect that the remaining investors get turned off by this (haha) similarly to what happens with weed stocks. After booming with the shitcos in 2020-2021 the company is now down 8% from it’s highs and has been left orphaned and unloved despite continuing to put up strong results.

Key Risks

While there’s risks to any stock, this is a $6m over the counter listed shitco that’s traded sideways for a decade. The first point to note is that they are naturally very exposed to the broader macro picture. They are a luxury discretionary item and if the US were to enter a significant recession I suspect they would be heavily affected. Even if the US weren’t to enter a recession however it’s very hard to see what normalised earnings look like. I suspect the upcoming quarterly report will give us a better idea whether the HTBASR is just temporary. I really don’t have a view of what the next year looks like. For me I like the brand, the story and the management team and think it has room to grow over the long term.

The other big risk for me is around capital allocation. I reached out to management for this article and a key question was around how they reinvested capital other than obviously paying down debt. At this point in time the company doesn’t seem interested in dividends or buybacks, instead opting to reinvest it all in the business. The Sales Director who I was in contact with detailed these investments as “better middle management, increased sales, creative, and design staff, and increased advertising and marketing budgets...  Likewise, better manufacturing efficiency, additional equipment, and bigger warehouse space.” Naturally I’m sceptical about the ROI of these kinds of investments especially if we hit a rough patch in the economy. There doesn’t seem to be a clear strategy regarding capital allocation. A cheap valuation is fine but if capital isn’t being effectively reinvested that’s how value traps are created.

The last and probably most dangerous risk is brand concentration risk. The company is built around one brand, and the obvious concern is what's to stop other furniture makers from coming in and competing with them? At the lower price point there is already a lot of competition. However, sales and growth has remained resilient in spite of that as people are clearly willing to pay up for quality in this area. More importantly, at the higher price point like any luxury item brand matters. From what I’ve read Liberator uses the highest quality materials and just has the best products. Additionally, according to the company due to manufacturing in America they use specialised equipment that most low cost, international manufacturers don’t have access to. For a big ticket item like this people don’t want to risk going with a less reputable brand. I suspect that for many larger companies it’s just not worth it competing with them.

My Position

Currently I have built a base (3%) position in Luvu for my portfolio. At this valuation I find the idea to be incredibly compelling, however with the macro picture as it is I am concerned about the downside. It’s not hard to see a world where the bottom falls out of earnings and the stock price collapses. If they are able to execute on their potential I think the stock looks incredibly undervalued so I will be happy to watch and average up if I see them executing.