Description

Build-A-Bear is a St. Louis, Missouri-based interactive retail store, which lets customers design and build their own teddy bears and other stuffed animals. The company operates 373 corporately-managed locations, including 313 in North America and 60 in Europe and Asia, and supports a franchise base of 97 additional stores in 11 countries.

Like many mall-based retailers, Build-A-Bear suffered a difficult year in 2018. The company’s revenue dropped 4.9% overall (adj. for revenue recognition changes and an extra week in 2017)—with a low single-digit decline in its North American business and a double-digit decline in its European business. While the business has been structurally challenged by declining mall traffic, which has sunk almost 50% over the past 6 years, Build-A-Bear was particularly hurt in 2018 by two incremental, powerful headwinds: an unusually bare slate of family-friendly movies and the bankruptcy and subsequent liquidation of Toys“R”Us, resulting in an optically deteriorating financial trajectory, lowered sentiment and depressed sentiment.

THESIS:

We believe the business is in a structurally advantageous position as a fundamentally differentiated concept that serves as a traffic driver to brick & mortar retail with highly attractive ROIC.  We believe there are near-term, medium-term and long-term drivers that are poised to positively inflect fundamentals and accelerate EBITDA & FCF generation which the market will appreciate in the coming quarter(s), as the following elements of the business become evident to the market:

1.      Fundamentals are improving and will benefit from lapping  i) an uncharacteristically weak slate of family-centric licensed move properties which made organic 2018 performance artificially weak and sets a low base for ’19 growth, and ii) Toys R Us’ liquidation process.

2.      Margins will expand as the company focuses on re-negotiating leases and re-locating current units, above and beyond what operational leverage implies from revenue acceleration

3.      Walmart relationship will expand as the retailers establish a more meaningful relationship

4.      International franchise growth is set to inflect meaningfully higher with 40 units to open in India/China

Fundamentals are improving and will benefit from lapping  i) an uncharacteristically weak slate of family-centric licensed move properties which made organic 2018 performance artificially weak and sets a low base for ’19 growth, and ii) Toys R Us’ liquidation process.

Two catalysts will bolster Build-A-Bear’s revenue in the short-term: (1) a superior slate of family-friendly movies and (2) the final closure of Toy“R”Us. We’ll consider each catalyst in depth.

First, the coming year promises a crowded slate of highly-anticipated family-friendly movies, especially compared with last year’s rather empty slate (partly the result of Disney’s decision to push the release-dates of two highly-anticipated family-friendly films from 2018 to 2019). This development will help drive Build-A-Bear’s revenue in 2019—transforming what was a serious headwind into a powerful tailwind. According to our proprietary data, in the past quarter alone, products associated with the latest ‘How to Train Your Dragon’ film have already sold extremely well. That early success portends a lucrative year for Build-A-Bear’s licensed-product sales. In the coming months, we expect Build-A-Bear to profit handsomely from ‘Detective Pikachu’ (May), ‘Aladdin’ (May), Toy Story 4 (June), Cars 4 (June), Lion King (July), Frozen 2 (November), and ‘Star Wars: Episode IX’ (December).

We think the company’s underwhelming performance in 2018 had much to do with the year’s unusually bare slate of family-friendly films. In fact, we estimate that $16M (or roughly 55%) of Build-A-Bear’s overall revenue decline in 2018 can blamed on this anomaly. A fuller slate of popular family-friendly films will amplify Build-A-Bear’s sales in a number of different ways. For one, successful films drive traffic to Build-A-Bear stores. In North America, 85% of Build-A-Bear’s retail stores are located within two miles of a movie theater—meaning that film studios’ marketing efforts, aimed mainly at luring moviegoers to movie theaters, come with a secondary effect: drawing customers to Build-A-Bear. (This effect lowers Build-A-Bear’s customer acquisition costs, too.) What’s more, licensed-product sales earn 20% more dollars-per-transaction than do sales of non-licensed products, as licensed products typically sell at higher prices and combine with optional add-on items. So family-friendly films both increase traffic to Build-A-Bear stores and inflate the average price-per-transaction at Build-A-Bear stores. As a result, when 2019 ushers in a long list of family-friendly blockbusters, the company stands to benefit enormously.

In 2018, Build-A-Bear’s revenue from the sale of licensed products plummeted to its lowest level since 2013, while Build-A-Bear’s revenue from the sale of non-licensed products soared to its highest level since 2014—further evidence that Build-A-Bear’s business was severely disrupted by the poor showing of family-friendly films in 2018. That disruption will be corrected in 2019. For reasons we just highlighted, it’s difficult to overestimate the importance of that correction to Build-A-Bear’s bottom line. A brief historical example can provide useful context here. In 2014, the release of Disney’s animated blockbuster ‘Frozen’ drove Build-A-Bear’s same-store sales growth from [-2%] to [+9%]. On the extremely conservative assumption that 2019 sees the release of just 3 films which prove only half as a successful as the original ‘Frozen’ did, we should expect Build-A-Bear’s same-store sales to jump at least [15%].

Finally, it’s worth noting that Build-A-Bear’s particularly poor showing in the United Kingdom in 2018 played a major role in depressing the company’s overall performance last year. Movie-related products have historically outperformed in the UK. That fact helps explain why Build-A-Bear’s UK segment fared so poorly in the last year. More importantly, though, it also indicates that Build-A-Bear’s UK segment should undergo a robust recovery in 2019, with the proliferation of good family-friendly movies.)

Second, in 2019, Build-A-Bear will recuperate from the major disruption imposed on it by the shuttering of Toys“R”Us in 2018—and go on to capture market share left open by the defunct toy giant. Almost 75% of Build-A-Bear stores are located within five miles of a former Toys“R”Us. In 2018, Toys“R”Us liquidation sales hurt Build-A-Bear’s business: Build-A-Bear stores located near Toys“R”Us liquidations saw their sales drop in the aftermath of liquidation sales. On the assumption that Toys“R”Us liquidations reduced store sales by 10% in 2018, Build-A-Bear should re-capture $50k per store, or roughly $25M in total sales, in 2019.

That’s not the only benefit Build-A-Bear will reap from Toys“R”Us in 2019, though. The demise of Toys“R”Us also creates an $8 billion gap in the toy market, which Build-A-Bear can capitalize on in several ways. Consider one. While Toys“R”Us had a large birthday-celebration business, birthday celebrations are also the top-ranked occasion that brings customers to Build-A-Bear stores. (Indeed, almost a third of Build-A-Bear’s in-store revenue is birthday-related.) We thus expect the fall of Toys“R”Us to provide a substantial boon to Build-A-Bear’s own birthday-celebration segment, tangibly boosting in-store revenue.

Margins will expand as the company focuses on re-negotiating leases and re-locating current units, above and beyond what operational leverage implies from revenue acceleration.

Astute portfolio management has shifted stores towards short-term lease extensions, pre-negotiated rent reductions and % of sale arrangements. Through lease management, over 60% of corporate leases expire or have options within the next 3 years, while 0% of the Company’s store base is up for lease renewal this year alone. Management has acknowledged a meaningful opportunity to re-negotiate economics with landlords and a willingness to shutter stores when they are not yielding an acceptable returns on capital. Today, approximately 1/3^rd of retail locations are on ‘percentage of sales’ lease terms; the on-going lease negotiations offer the ability to transition a larger percentage of the Company’s locations to a variable rent arrangement providing a natural hedge to profitability. BBW has already demonstrated its ability to favorably navigate lease arrangements as occupancy costs were down in 2018 despite a higher store count.  The Company paid ~$45M in rent expense in 2018; in 2019, ~$20M is up for renewal (40%) and if BBW can negotiate a reduction of 10% it would contribute an incremental $2M in EBITDA with retail sales held constant (sales growth guidance of MSD% to HSD%).

Management communicated its expectation to close 30 stores over the next 2-years (50% from North America / 50% from Europe). Based upon our follow up calls, we believe they are posturing to extract better economics 4from their landlords. Today, 95% of the North American stores are profitable and the Company has demonstrated ability to transfer sales from shuttered locations to nearby units. The Company’s global store portfolio continues to diversify to increase accessibility and to facilitate a migration away from legacy mall-based locations.

In order to extract leverage over its landlords, BBW has proactively experimented for proof of concept with alternative locations including theme parks, tourist attractions, and retail partners (e.g. Cabelas, Walmart, etc.). Demonstrated success in implementing the Build-a-Bear experience in off-mall locations now provides negotiating leverage as BBW can transfer sales from legacy mall-based locations to locations with expanding traffic counts and more attractive unit economics.

Based upon our work, we believe that in the coming years, BBW will establish a more meaningful store-in-store relationship with Walmart.

In October 2018, Build-A-Bear debuted a promising pilot program, opening six full-service stand-alone stores inside select Walmart locations. The holiday season brought tremendous success to the experiment, generating through-the-roof sales at Build-A-Bear’s new Walmart locations. For its part, Walmart was elated. The mega-retailer has long been searching for ways to magnify traffic, and partnering with traffic-driving retailers has recently emerged as a promising strategy. (Indeed, Walmart’s new partnerships with PetIQ and National Vision underscore its commitment to this idea.) The rapid success of the pilot prompted Build-A-Bear to develop plans for expansion, which Walmart embraced with great enthusiasm. In the coming few years, we expect Build-A-Bear’s partnership with Walmart to grow into an important, and very lucrative, alternative to its mall-based retail model. In the next year alone, Build-A-Bear intends to open roughly 20 more stores in Walmart supercenters—a stunning growth rate of 250%. We think Build-A-Bear can continue to build 20-30 such stores each year, boosting annual EBITDA by at least $3M. In fact, we think that estimate is conservative. If each new Walmart location generates $650k, given a 15% contribution margin at the store-level, each new unit will yield approximately $100k in cash. Just from its Walmart expansion alone, Build-A-Bear’s EBITDA can grow at least $15M within the next five years.

Build-A-Bear’s partnership with Walmart achieves a lot more than higher revenue, though. Indeed, it endows Build-A-Bear with considerable negotiating power, which the company can wield in upcoming lease renegotiations with landlords. As we just emphasized, in the last few years, Build-A-Bear has adroitly managed its portfolio of mall-store leases. Within the next year, 40% of its mall-store leases come up for renewal; within the next three years, 60% percent of such leases will expire (or can be exited). Build-A-Bear’s flexibility on this front will now combine with its capacity to relocate its stores to Walmart supercenters, downsize to kiosk-based mall stores, or join up with other large retailers. (Build-A-Bear has also begun partnering with the indoor water-park chain, Great Wolf Lodge, and Bass Pro’s hunting-equipment seller, Cabela’s.) This kind of optionality gives the company tremendous leverage. In recent weeks, we have spoken with leadership at several of the top mall-owing REITs in the United States. A clear consensus emerged: Major commercial landlords recognize the threat posed by Build-A-Bear’s impending leverage—and for good reason. In fact, in their conversations with us, landlords have already expressed their willingness to grant Build-A-Bear rent reductions. In the next few years, then, Build-A-Bear’s leverage will translate into substantial cost-saving gains.

BBW’s international franchising efforts offer a long runway for growth, most importantly within the Indian and Chinese market (8 today set to grow to 40 in 2019)

Whilst international franchise growth admittedly stagnated in 2018, importantly BBW added a new franchise agreement in India, with Lulu Group (a UAE based multinational conglomerate company that operates supermarkets and retailers). To date, BBW has opened 3 locations in India and 8 locations in China and will expand to 40 stores in these regions by the end 2019 (on a current total international franchise base of 97). The Company delivered $3.7M in international franchise fees in 2018 but with green shoots in the world’s two most populous and fastest growing nations that number will be meaningfully higher in 2019 (30% to 40% unit growth from India and China alone). In today’s market, franchise revenue streams are valued alone at 10-15x EBITDA. The immediate benefit and future growth potential of a recurring high margin income stream generated from growing the international franchise base is effectively a free option at this share price. Over the longer term, we believe BBW’s international franchising efforts offer a long runway for growth, most importantly within the Indian and Chinese market (8 today set to grow to 40 in 2019). Today, international franchising represents $3.7M of high margin royalty revenue. With the contribution of 32 incremental franchises in 2019, we expect 2019 international franchising Revenue of $4.5M and EBITDA of $3.5M; if you were to value it at a true licensed comp multiple of 10.0x EBITDA, it creates the rest of the business at ~1.8x 2019E EBITDA.

Note as per usual we're having difficulty pasting valution and price target sections into our submission. We will follow-up with our thoughts on valuation and price target in a follow up restponse to this posting. The punchline however is that we believe Build-A-Bear is worth at least $10 per share, approximately 70% more than its current price. Build-A-Bear trades at 4.4x its Street 2019 EBITDA of $16.3M and 3x our own base-case 2019 EBITDA of $24.1M. If either or thesis on Walmart of license titles takes hold in any material way, the stock could be a double or even a triple over the next few years.

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Catalyst

CATALYST:

In our view, there is no reason for BBW to be trading at

We believe 1Q 2019 will serve as a positive catalyst for Build-a-Bear. The quarter will demonstrate the continued positive momentum in the underlying business (as mentioned above) and more importantly, provide a potential disclosure of a more formal relationship with Walmart, as Build-a-Bear accelerates its store-in-store roll out. The option value inherently attributed to a relationship with Walmart is alone worth more than today’s equity value – we believe investors are missing the strategic importance and potential of this relationship.

On March 26^th, Kanen Wealth Management disclosed a 9.7% activist stake via a 13D filing disclosure – we believe this will further accelerate the catalyst path, as an engaged shareholder will now be looking to engage the board in to more directly create shareholder value.

2018 undoubtedly presented BBW with a number of unique and transitory challenges. We believe the current dislocation provides the opportunity to buy a differentiated retail concept at a price suggestive of imminent demise. We view the story as providing multiple ways to win combined with optionality this is not at all priced in. The underlying fundamentals are already turning a corner, the Wal-Mart relationship is in its early innings and the international franchise growth is set to inflect meaningfully higher. BBW gets bucketed in to the dying, secularly challenged, in-line retailer category, it’s a classic case of Wall Street investors missing the forest for the trees and thus presents a compelling asymmetric opportunity.