Description

Is there a Beyond for Bed, Bath and Beyond?

Shares of Bed, Bath and Beyond, the great big box growth retailer of the 90s are decidedly out of favor as the company's profitability has disappointed and then disappointed again.

Just a couple weeks ago, BBBY slashed its estimate of earnings for fiscal 2017 from $4 and something to about $3 without something.  The exact details got lost in the howling of shareholders who experienced a 15% gap down.

But for the record, (per Goldman) BBBY reported 2Q17 adjusted EPS of $0.67, well below $1.11 a year ago. Excluding an $0.08 hit from restructuring charges, EPS of $0.75 still tracked well below consensus (Thomson Reuters) expectations of 0.95. Reported EPS also embedded a $0.02 hit from the impact of Hurricanes Harvey/Irma and a $0.01 hit from the adoption of the share-based payment accounting standard. Total sales tracked below forecasts as SSS of -2.6% missed consensus expectations of -0.6%.

Further analysis by Goldman Sachs shows that Bed, Bath, and Beyond continues to lose market share, and at an accelerating rate. Additionally, they point out that recent commentary from home furnishings peers including W, HOME, WSM, and RH has been largely positive, suggesting that BBBY's issues are company-specific (i.e. format, pricing, and omnichannel investment).

So, why the interest?

Bed, Bath, and Beyond is a great company.  It is well run, by professionals for shareholders.  Since 2004 through the end of fiscal Q2 2017, the Company has repurchased approximately $10.4 billion of its common stock through share repurchase programs.  Furthermore, the current remaining $1.6 billion authorization equals more than 50% of the current equity market capitalization.

Bed, Bath and Beyond’s fiscal house is in order.  On August 26, 2017, BBY’s cash and investments totaled $563 million.  Long term debt is a bit less than $1.5 billion.  Net debt is a very manageable 1.1x EBITDA and Gross Debt about 1.85x.  The stock may be in crisis but the company is not.

Bed, Bath, and Beyond’s valuation is attractive on an absolute level at around an enterprise value of 4.6x estimates for FY2018 EBITDA (which have been significantly reduced).  The stock price and projections now clearly reflect the company’s issues.

Yet, the company still generates oodles of cash.  On deeply cut 2018 numbers, BBBY equity generates an 8.8% free cash flow yield.  The cash flow yield is ~12-13% on this year’s numbers and should the company ever reobtain some of its former glory, it’s a >20% free cash flow yield on last year’s numbers (which are sooo FY2016, by the way).

BBBY’s Enterprise Value at $4.2 billion is less than Sears Holdings at $4.5 billion (not including the pension).  Which would you rather own?  Even at the same price?  Yes, BBBY sales are only $12.2 billion versus SHLD at $19.75 billion, but sales should be very similar for both in 2 years given SSS and store closures at SHLD.  BBBY has only 1 turn of net debt, generates several hundred of million dollars of free cash flow (from operations) each year, and its on-line business is growing rapidly.

Bed, Bath, and Beyond has merchandising capabilities and powerful brands which have a future on-line. BBBY has a meaningful on-line business which, while only “15% of annual sales”, is in the order of magnitude of $1.8 billion in revenues and is growing organically at “more than 20%.”  Our guess is that this business is, currently, still, (wait for it) ... not profitable.  Which means that you are getting it for free when you pay 4.5x EBITDA for the lousy brick and mortar retailer.  What is this business worth?  It is of similar size to Overstock but growing much faster (20% vs 10%).  Overstock today has an enterprise value of $555 million but lacks Bed, Bath & Beyond’s growth, brand, and omni-channel capabilities.  On the high end, Wayfair’s valuation at 1.6x sales would peg BBBY on-line’s value at $2.9 billion or 70% of BBBY’s enterprise value.  Using 45% of Wayfair’s valuation to account for the differences in growth would imply 71% of sales, or $1.3 billion.  Assuming the on-line effort is still not profitable, implies the current $21.50 stock price reflects a 3.1x EV/EBITDA for the aforementioned, brick and mortar retailer.

Furthermore, that brick and mortar retailer is not as bad as it seems (and the on-line business is not as good as it looks).  BBBY’s IT systems still leave something to be desired (in this case data).  Which means they cannot tell you where a transaction originated.  They can only tell you where it was consummated.  As such, if a customer buys a Keurig coffee brewer on-line and returns it to a store, the on-line business keeps the revenues in its related Same Store Sales figures and the physical retailer records a contra-revenue to its own Same-Store Sales numbers.  On-line is about 15% of the whole shebang.  If on-line returns to stores are 5-15% of on-line sales then the physical retailer SSS declines could be only -4% (5% returns) to -2% (15% returns) not -4.75%.  That would help change the narrative, a bit.  It is not obvious when/if the company will clear this up.

On-line Margins are lower.  We know that.  Amazon is lauded for it.  Just bring more volume.  I’ll have another sale and another sale, please.  Given the rapid growth of on-line for BBBY, gross and EBIT margins naturally should be shrinking, even if the lousy legacy business held steady.  Remember the old days when bears would cry, “but Amazxon’s SG&A is skyrocketing as they build their distribution system.  It is unprofitable growth!”.  Should BBBY be severely penalized for pursuing the same unprofitable growth?  No, I say.  BBBY just needs different shareholders or different disclosure (or both).  This week they got some different shareholders….

If BBBY does not pursue that same unprofitable growth, now, then it will never achieve scale and retain relevance in the retail ether that is the future.  Maybe, once/if management’s IT systems are better they could break it out?

Resumption in Growth should be in the cards given current trends.

Assuming B&M (Brick and mortar) SSS continue to decline at 5% for two more years and then continue to decline at -2.5%, On-line needs to grow 20% next year and can slow to 16% in 2019 and 2020 and we would see top line growth again for the whole company in 2021.  More, optimistically If B&M stems its sales declines next year to only -2.5% and on-line continues its 20% growth, the company would grow SSS almost 1% in 2018.

You are getting paid to wait.

It is not a lot, but the 15c a quarter in dividend income equates to a 2.6% dividend yield.  It is not nothing.

Cost initiatives could help. 

BBBY has launched several initiatives drive efficiencies in its stores and fulfillment operations.  BBBY expects these initiatives to generate $150 million in cost savings over several years.  At 4.6x EBITDA this is worth about $5 per share.

What does the long-term model look like?

Gross Margins should continue to decline.  On-line margins are lower, but as the company gains scale, it should eventually be able to leverage the investments it has and is currently making in IT and its distribution infrastructure, thereby reducing SG&A margin.

Unfortunately, all the stores are profitable.  Management said on the Q2 call that all the stores are profitable.  I was sorry to hear this.   It means that company profitability cannot be improved simply by closing any unprofitable stores now or when their leases expire.  Still, management continually evaluates the real estate and seems (based on commentary and tone) more inclined to aggressively manage the real estate going forward.  But then again, it’s not so bad.  ALL THE STORES ARE PROFITABLE!...

Two data points do not make a trend.  In a former life, I was a management consultant at a major strategy consulting firm.  We used to say that a consultant needed three data points to draw a line.  A team leader needed only two.  A partner only one.  Well, after Q1 BBBY’s management team was reluctant to reduce their full year guidance based on a single data point.  After, Q2’s data point they brought guidance for 2017 down hard.  The question remains whether they are qualified to draw a line based on two data points. 

Company believes they Will Turn BBBY around… From the Q2 earnings conference call Q&A:

Laura Allyson Champine Roe Equity Research, LLC

The first question is, more generally, why buy back stock at all right now, given the declines in net income and the lack of visibility in the trajectory of the business?

Steven H. Temares Bed Bath & Beyond Inc. – CEO & Director

Yes. Again, it's a great question, and again, I think that it's averaged in -- it is a board decision, it's averaged in. It's the last thing we do with the capital. And listen, the big picture is, is that we know our people here. We know the initiatives we're working on. We know our capabilities, and we know we're going to succeed. So that's how we feel. So again, to average in these things, it could be part of what's the thought process, but we understand the criticism, clearly. But again, just so you know, it's not keeping us from doing everything, and it's not putting us in a position that's -- will put us in a cash position less than the cash position that we were at the end of last year.

Trump and the Republicans to the Rescue

BBBY unlike many retail stocks where the charts show down and to the right is a significant tax payer.  They 37-38% per year on what used to be $1 billion to $1.3 billion of pre-tax income.  Even on $500-$600MM of pre-tax income which is more in-line with what the street is expecting the tax savings from a reduced 20-25% corporate tax rate would be a substantial $68 million to $108 million or 49c to 77c per share per year.  Even at BBBY’s depressed 7x multiple this would be worth $3.50 to $5.50 per share (16-25%).

Private Equity to the rescue

BBBY presents a compelling opportunity for private equity at these prices.  The currently under levered, highly cash generative business is cheap due to 1) share losses which may be reversible and 2) increased costs from investments in the business.  Both a buyout shop and BBBY are likely to be well served to undergo this transition/transformation outside the spotlight of the public markets.

Summary

In summary, Bed, Bath and Beyond appears to be presenting an attractive entry point at $22.91 with long term shareholders poised to benefit from 1) capital return from dividends and share repurchases; 2) earnings growth as slashed numbers may prove to be too drastic as either current trends prove transitory, management can stabilize traffic trends, current high levels of investment wane, and the on-line business gains scale and is able to leverage SG&A; 3) multiple expansion as investors return to the name once the panic subsides.

Price target:  10-12x $4 of EPS or $40 to $48 per share

Risks

B&M retail share losses accelerate

On-line business growth slows materially

Cost initiatives fail or damage the business

General economic slowdown affects demand for household goods.

Catalyst

Share repurchases

Potential Leveraged Buyout

Return to organic growth once revenue growth from on-line eclipses store revenue declination

Improved profitability from growth in on-line, improved productivity from investments