An Update on Bed Bath & Beyond

Bed Bath and Beyond, Inc. (BBBY) reported a fiscal 2019 first quarter loss of $2.91 per share, which included approximately $3.03 per share of unusual charges and expenses. Excluding these unusual items, adjusted EPS was $0.12 per share, at the high end of management’s guidance range of $0.07-$0.12, but lower than last year’s adjusted EPS of $0.38.

Net sales of $2.57 billion declined 6.6% from the prior year, slightly below the company’s guidance of $2.6 billion. Comparable store sales also declined 6.6%, as a higher percentage decline in store sales was partially offset by an increase in sales through digital channels. Today’s sales are driven by various types interactions among customers, in-store personnel and digital media, so it is difficult to classify with pinpoint accuracy the breakdown between in-store and digital sales. Nevertheless, the 6.6% decline in net sales is a concern, even though it was only slightly below the company’s guidance.

Recent Share Price Performance. Despite delivering earnings within management’s guidance, BBBY shares gapped down on the earnings report and have pushed lower since. A weekly chart shows that the stock has continued its downtrend (which extends back to January 2015). Although this year’s late March-early April rally raised hopes that the stock was finally breaking out of its long-term decline, the subsequent sell-off has brought it to a new 52-week low. At this point, the stock is still in a downtrend. A reversal off a potential double-bottom is still a possibility, but today’s decline reduces the odds of a sustained reversal at this time. Still, the relative strength index suggests that the stock is oversold.

New CEO, New Board of Directors. This was the first conference call for newly appointed interim CEO Mary Winston, who assumed the role following the resignation of Steven Temares on May 13. Mr. Temares had been BBBY’s CEO since 2003. Besides Ms. Winston’s appointment, BBBY has made significant changes to its Board since April, after reaching a settlement with activist shareholders Legion Partners, Macellum Advisors and Ancora Advisors, who collectively controlled about 5% of the outstanding shares. Since the settlement, the company has made the following changes to its board of directors.

  • Lead director Patrick Gaston was appointed Independent Chairman of the Board;
  • Five existing independent directors stepped down; the remaining four independent directors, including Mr. Gaston, continue to serve. Three of the four – all except Mr. Gaston – are relatively new to the Board, having been appointed in 2018;
  • Co-founders Warren Eisenberg and Leonard Feinstein transitioned to new roles as Chairmen Emeriti and stepped down from the Board;
  • Nine new independent directors have been appointed to the Board;
  • The Board has formed a Business Transformation & Strategy Review Committee;
  • It has also reconstituted the Audit and Compensation Committees; and
  • The company has adopted a new executive compensation plan – with a higher percentage of total compensation now performance-based.

The Search for a New CEO and the Fate of the Existing Management Team. The changes in the Board raise questions about BBBY’s new CEO search and the fate of the existing management team. On the 19Q1 conference call, interim CEO Mary Winston said that the Board has hired a leading executive search firm and is seeking a leader with a “multi-faceted” skill set, including demonstrated experience in transforming retail organizations and in e-commerce and marketing. She made no mention that internal candidates would be considered, even though BBBY’s President and COO Eugene Castagna is a 25-year veteran of the firm and would have been an obvious choice to succeed Mr. Temares.

The management and Board changes appear to be a consequence of the failure to meet turnaround performance targets. As late as mid-2018, management had said that it would: a) achieve comparable store sales growth in fiscal 2018; b) moderate declines in operating profit and c) achieve EPS growth by fiscal 2020.

Troubling Multi-Year Performance Trends. BBBY’s fiscal 2018 sales declined 2.6% to $12.0 billion, including a 1.1% decline in comparable store sales. This was the first year in the company’s history that total net sales declined. This was also the third consecutive year that comparable store sales have declined. (Comparable store sales declined 0.6% in fiscal 2016 and 1.3% in fiscal 2017.) Furthermore, BBBY’s net earnings have fallen for five consecutive years. The company posted its first net loss ever in fiscal 2018.

The fiscal 2018 net loss was due to a $510 million pre-tax ($413 million after-tax) charge to write-down goodwill and intangible assets (i.e. tradenames and trademarks). With the 2018 and 2019 first quarter impairment charges, the company has now written off all its goodwill and all but $134 million of its intangible assets.) On an adjusted (non-GAAP) basis, excluding the impairment charges, BBBY reported net earnings in fiscal 2018, but they were still down from the prior year.

The Uncertain Status of BBBY’s Transformation Plan. Since Mr. Temares has thrown in the towel, the status of BBBY’s transformation effort is unclear. Prior to his departure, during the 2018 fourth quarter conference call, Mr. Temares pointed out that the company was 18 months into a transformation plan that aimed to address four key objectives: growing revenues, improving gross margin, cutting SG&A costs and improving working capital management. During that time, the organization overhauled many of its operating practices. Mr. Temares said that this effort benefited from the commitment of the entire organization as well as input from third-party experts. He also said that this hard work was beginning to show in improved performance.

To be sure, there has been no tangible evidence of improvement in the company’s financial performance. In fact, the steady deterioration in sales appears to be accelerating, even though the decline in adjusted (non-GAAP) operating profit moderated in 19Q1. The lack of improvement in the company’s fiscal 2018 second half performance appears to have set the stage for the emergence of the activists and the subsequent changes to management and the Board of Directors.

Yet, even without tangible results, it would be wrong to say that BBBY has made no progress during the first 18 months of its transformation plan. Some of the implemented changes may need more time to produce better results.

One key question is whether the new CEO and Board of Directors will build off the achievements of the existing transformation plan or seek to start from scratch. Given the company-wide effort and achievements already made to date, it seems clear that they should use the transformation plan as a base to determine the company’s next steps. The new leadership team may have to make some adjustments, including pushing forward more aggressively to accelerate the transformation, but it would be unwise in my view to recreate the effort and try to take the company in a completely new direction.

The Next Generation Lab Store. A key part of the transformation plan has centered on developing a new store prototype (aka the next generation lab store) for its Bed Bath & Beyond (BB&B) chain.  The next gen stores will adopt a new mix of merchandise and new merchandise displays to enhance the attractiveness of the stores to customers. As of the end of fiscal 2018, the company had rolled out 21 of these lab stores and had plans (previously announced in mid-2018) to open 20 more in fiscal 2019.

Next generation stores offer a new assortment of products designed to increase shopping trips, the number of transactions and transaction value. They have more scarcity product, including seasonal items, home decor, treasure hunt and deep value products. They also offer more food & beverage and health & beauty care consumables. The stores reportedly do not have a single set format, but rather vary the merchandise mix to adapt to local customer preferences.

To date, the next gen lab stores have generated sales that are 2.2% above the average for comparable stores. That may not sound much, but any initiative that stabilizes sales or delivers growth will likely spark a sharp rebound in the stock, given its current extremely low valuation.

I recently toured the next generation BB&B store located in Rutherford NJ. A slide show of that visit with commentary is available here.

Although Mr. Temares touted the next gen lab store initiative frequently in his communications with investors, he did not provide much information about when the rollout would be complete. The target completion date will depend both on the pace of the rollout (when it begins in earnest) and the company’s plans for the BB&B store base. (The company may seek to be a smaller chain, especially if it cannot meet its lease cost reduction targets.). With only 40 or so next generation stores planned for the first two years, it could conceivably take more than a decade to upgrade all 996 BB&B stores. Unless BBBY intends to keep the existing format for a large number of stores, either the pace of the rollout must accelerate, or the company must reduce its store base.

Other Aspects of BBBY’s Transformation Plan. A key strategy choice might conceivably be whether BB&B will compete on value or price. However, it is unlikely, in my view, that BB&B can compete successfully against Wal-Mart, Target and Amazon on price. The company’s next generation store clearly signals that BB&B will seek to emphasize value – specifically, the greater selection and personalized services that distinguish BB&B from its giant competitors.

Yet, concerns remain about the company’s continued reliance on discounting. BB&B is well known for its 20% discount coupons mailed directly to customers. Although management says that it has reduced discounting, the company is clearly finding it difficult to wean itself from the practice. Consequently, managing the transition from competing on price vs. value will continue to be a major challenge. (In truth, BBBY will almost certainly continue to compete on both value and price, but it needs to increase the proportion of value-based sales over time.) In my mind, the company should cut its list prices across many of its products and product lines as it reduces its couponing to improve its competitive positioning.

The Beyond Plus membership program is potentially a key aspect of its strategy. I have been a Beyond Plus member for about six months. During that time, I have received almost no correspondence or marketing materials from the company. The only benefit has been the perpetual 20% discount that can only be obtained by downloading a coupon. (I have not received a membership card that I can bring to the store.) If this program is to support a value-based strategy, I should receive regular marketing offers emphasizing the broad selection and special services offered by BB&B. I should also receive “members only” discounts on special product offers. Either management should develop Beyond Plus into a true membership program or it should drop it entirely.

Other aspects of the plan which should or will be addressed by the new CEO and Board include the company’s ecommerce strategy. While the BB&B website certainly appears to be functional and well-organized, it is not clear whether the company is using the data that it collects from visitors as effectively as it could to craft digital marketing campaigns to boost sales.

The installation of the new CEO and Board will hopefully mark a transition to an accelerate pace of implementation of the transformation plan and better results from the implementation. Under Mr. Temares, management developed a strategy for turning around the company’s performance, but the implementation to date has not achieved the desired results and key parts of the plan have been not yet been fully implemented.

Potential Sales of Other (Non-Core) Businesses. Besides the changes to its core BB&B chain, there have been calls, especially from the activists, for BBBY to sell some or all of its smaller store chains, including buybuy BABY, Cost Plus World Market, Christmas Tree Shops and Harmon, as well as Linen Holdings, which sells textile products, amenities and other goods to primarily to hospitality and healthcare institutional customers. The company does not report results separately for these entities (or collectively, apart from BB&B), so it is difficult to know what they are worth. Altogether, the other retail chains operated 539 stores at the end of fiscal 2018 or 35% of BBBY’s total 1,533 stores. (The Bed Bath & Beyond chain had 994 stores at the end of fiscal 2018.)

It is almost certain, in my view, that each of these non-core chains – perhaps with the exception of Christmas Tree Shops – had lower sales per store and were less profitable than BB&B. Over the two most recent quarters, BBBY incurred pre-tax charges of $911.2 million, including $716.3 million in goodwill impairments and $171.9 million of intangible asset write-downs, that were attributable to the acquisitions of these store chains over the past 10-15 years. Under the accounting rules, the company was required to test the carrying value of goodwill and intangible assets due to the sharp drop in its share price. The charge was determined by comparing the current estimated fair value of the net assets of these businesses against their carrying value.

By writing off all of its goodwill, BBBY has acknowledged that the fair value of these other chains is substantially less than what it originally paid for them. As such, it could set the stage for their eventual sale.

Valuing these businesses without their financial results is a speculative exercise at best. Although they represent 35% of BBBY’s store base, it is highly likely that they generated less than 35% of the company’s consolidated revenues, profits and EBITDA. While there may be a few strategic buyers for the businesses, the most likely buyers, in my opinion, are private equity firms. I think that collectively the businesses are most likely worth less than $1 billion pre-tax and probably significantly less.

As a guess, I believe that BBBY is more likely to keep Christmas Tree Shops, buybuy BABY and Linen Holdings and more likely to sell Harmon and Cost Plus World Market; but actual sales will depend upon expressions of interest from potential buyers. Although each of the chains is different from BB&B, there is some overlap in key product lines which probably boosts BBBY’s purchasing power. (That savings would of course be lost, if the businesses are sold.) Although selling these other businesses would help focus management’s attention on BB&B, the decisions to sell will likely depend upon whether any bids meet BBBY’s minimum price thresholds for each of the businesses.

Thoughts on Fiscal 2019 Performance. Management’s guidance for fiscal 2019 anticipates net sales of $11.4-$11.7 billion (at the low end of the range), diluted (non-GAAP) EPS of $2.11-$2.20 (also at the low end of the range) and capital expenditures of $350-$375 million.

As noted above, 19Q1 adjusted EPS of $0.12 declined from $0.38 in 18Q1. Given that $0.26 shortfall, management’s fiscal 2019 guidance looks aggressive. At the low end of the range, the fiscal 2019 non-GAAP EPS guidance of $2.11 is better than fiscal 2018 non-GAAP EPS of $2.06. In order to achieve this guidance, therefore, non-GAAP EPS over the remaining three quarters of the fiscal year will have to exceed prior year levels by $0.31. Yet, net sales (taken at the low end of management’s guidance), are expected to decline 4.8% over this same period.

More importantly, non-GAAP operating margins were down 110 basis points year over year in 19Q1 and had been running down 200-300 basis points in the immediately preceding quarters. The company missed its goal of stabilizing operating margins in fiscal 2018. Management did not provide any evidence that it would be able to stabilize – let alone improve – operating margins in the remaining quarters of fiscal 2019. Thus, it is not surprising that the consensus estimate for fiscal 2019 of $1.92 is below management’s guidance.

If the new CEO and Board take steps to accelerate BBBY’s transformation, as they should, the company will probably incur restructuring charges associated with store closings, lease terminations and perhaps asset disposals. These charges would probably be classified as non-GAAP, but there almost certainly would be cash expenditures associated with them and they would still reduce GAAP earnings.

Similarly, the new CEO will likely want his or her performance to be measured off the lowest possible earnings base; so BBBY may “clean house” by recognizing additional costs in the first quarter or two after the new CEO is hired. This house cleaning could affect both GAAP and non-GAAP results for fiscal 2019.

Altogether, the company’s continuing weak performance combined with the appointment of a new Board and CEO will likely put additional downward pressure on its financial results in fiscal 2019. This could result in additional stock price volatility. Yet, it is difficult to predict how BBBY’s stock will respond to the news. Conceivably, if investors like what they see from the new leadership, they could bid up the share price; but a significant deterioration in operating performance from current baseline expectations could add uncertainty about the ability of the company to achieve a turnaround, as well.

BBBY Appears to Have Ample Financial Resources to Complete Its Transformation. The company had $902 million of cash and investments at the end of the 19Q1. It had no borrowings under its $250 million credit facility (which matures on November 14, 2022) and no direct borrowings under two separate $100 million lines of credit. (But it had $68.8 million in outstanding letters of credit under these credit lines at 18Q4.) BBBY has no existing debt coming due until August 1, 2024, when $300 million of 3.749% Senior Notes mature. Thus, it should have sufficient financial resources and flexibility to complete its transformation.

The Shares Are Cheap. BBBY’s current valuation already discounts a significant amount of bad news. At the most recent price of $9.81 (midday 7/18), a new 52-week low, the stock trades at only 5.1 times consensus fiscal 2019 estimates of $1.92 and 4.7 times the consensus earnings forecast of $2.08 for fiscal 2020. As discussed above, the consensus fiscal 2019 estimate is below management’s guidance.

By comparison, BBBY’s peer group (which I define broadly as AAP, AZO, BBBY, DSKS, DG, DLTR, FL, GME, KSS, LB, M, ODP, ORLY, ROST, TJX and WSM) is currently trading at average forward multiples of 13.9 times projected 2019 earnings and 12.9 times projected 2020 earnings. Obviously, a move back to the peer group average forward P/E multiple would more than double BBBY’s share price.

The stock is also cheap by other measures. It has a price-to-book value ratio of 0.6 times, well below the peer group average of 9.3 times (or 3.5 times excluding ORLY).

BBBY’s ratio of market capitalization (book value of debt plus market value of equity)-to-trailing 12-month EBITDA is only 4.2 times. Excluding the $902 million of cash and investments, its adjusted market cap-to-EBITDA ratio is less than 3.0 times.

BBBY’s trailing 12 month EBITDA is just under $650 million. That compares with about $750 million in fiscal 2018 and average annual EBITDA of $1.4 billion from fiscal 2015 to fiscal 2017.

A Hefty Dividend Yield That May Not Be Sustainable. With the recent decline in its share price. BBBY’s stock also sports a dividend of $0.68 per share, which translates into a 7.0% yield at the current quote. That’s significantly better than the peer group average of 4.6% (or 2.6%, excluding GME). In an apparent expression of confidence, the old Board raised the quarterly dividend by a penny on April 10.

Over the past three fiscal years (which is as long as BBBY has been paying a dividend), the company has generated significantly more free cash flow (which I define as cash flow from operating activities plus cash flow from investing activities excluding the change in investment securities) than required to meet the annual payout. However, in fiscal 2018, $462.4 million of its free cash flow came from inventory liquidations, trading investment securities and reductions in other current assets, all of which are only temporary sources of cash. Excluding this $462.4 million, BBBY still had more than enough free cash cover the dividend in 2018; but its 19Q1 free cash flow fell short of the dividend requirement. Consequently, even though the dividend yield is not so high as to flash warning signals of an imminent dividend cut, investors should pay close attention to the company’s free cash flow generation for the balance of fiscal 2019, especially since BBBY’s capital expenditures are anticipated to be $25-$50 million higher this year and there may be an added cash cost, if it decides to accelerate its transformation program.

The Stock Has Attractive Long-Term Upside Potential. Putting it all together . . . While it is possible that the stock could still hit new lows in 2019 – if earnings disappoint and the new leadership team cleans house – my analysis suggests that the stock has significant upside. That conclusion depends upon several key conditions:

  1. The new Board and CEO do not screw up the company’s transformation plan or its implementation;
  2. The economy does not suffer a significant downturn over the next two or three years;
  3. The company does not face any major problems that have not yet been disclosed from which it may be difficult to recover.

While the second and third caveats are explicit, the first requires some explanation: It was somewhat troubling to me to hear BBBY’s new interim CEO suggest that the new Board would be starting from scratch (and presumably not building upon the achievements already made under former CEO Steven Temares). It is perfectly understandable that the Board would want to consider carefully and thoroughly the company’s current position and future opportunities. It is also understandable that the new Board would want to position itself to benefit as much as possible from the company’s future success.

Yet, my analysis suggests that the company has made considerable progress in its transformation program, especially as reflected in its next generation prototype. The new leadership team should build upon these efforts. It may need to make some significant changes (or perhaps some tweaks) in certain areas, including accelerating the transformation program, converting Beyond Plus to a true membership program, altering certain aspects of its e-commerce strategy and others, and it may opt to sell some non-Core businesses; but it would be quite costly to simply start over.

With these caveats, I believe that the stock has the potential to more than double in price over the next 18-24 months as it closes its valuation gap with peers. Investors who buy today may not be buying at the absolute bottom, but they should still realize a significant above market return as the new leadership team begins to deliver.

July 18, 2019

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246
admin@larkresearch.com

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