Bed Bath But Not Beyond Hope

  • BBBY has lost 70% of its value over the past three years. Profits are down sharply mostly because of price competition. Store comparable net sales have been falling mid-single digits, offset by growth in online/mobile sales and other areas.
  • Management is seeking to grow revenues in key product categories, increase store traffic, deleverage gross margin and SG&A expenses, reduce lease costs, upgrade digital offerings and improve working capital management.
  • Management’s guidance and goals suggest that EPS will decline through fiscal 2019 but at a slowing rate.
  • At 9 times 2018 EPS and 10 times 2019 EPS, BBBY trades at a discount to peers. My price target is $30, assuming a return to EPS growth in 2020. Meanwhile, the stock has an attractive and reasonably safe 3.2% dividend yield.
  • From a technical perspective, the stock looks like it will retest the recent May 9 low. If it does successfully, it may then face resistance as it bounces back to the $21-$24 range.

Recent stock performance vs. benchmarks.
Specialty retailers have been strong relative performers so far in 2018. The S&P Retail Select Industry Index posted a total return of 8.28% through June 29, better than the S&P Composite 1500’s total return of 2.91%. By comparison, the stock of Bed Bath and Beyond produced a negative total return of -8.04%, extending a decline that has seen the stock lose 70% of its value over the past three years.

Historical financial performance: fiscal 2017.
Although net sales increased slightly over the past two fiscal years, operating profit was cut in half, due to a steady erosion in gross margin and increase in the SG&A expense ratio. Over this period, BBBY realized steady gains in online sales and from the newly-opened stores of its smaller retail concepts, but comparable store sales at its core namesake chain fell by a mid-single digit percentage in fiscal 2017, faster than the low-single digit percentage decline experienced in fiscal 2016. In fiscal 2017, the decline in comparable sales was due primarily to a drop in the number of sales transactions, partially offset by an increase in the average transaction amount.

The 150 basis point decline in gross margin from 37.5% in fiscal 2016 to 36.0% in fiscal 2017 was due to a decline in merchandise margin, an increase in couponing and an increase in shipping costs for online purchases.

The company’s SG&A expense ratio increased by 160 basis points from 26.6% in fiscal 2016 to 28.2% in fiscal 2017. The increase was attributable to higher salaries, store management restructuring charges, higher advertising expense (including an increase in digital advertising) and higher technology expense.

With flat net sales, the decline in gross margin and increase in SG&A, BBBY’s operating margin fell 310 basis points from 9.2% in fiscal 2016 to 6.1% in fiscal 2017 and its operating profit plunged 32.9% to $731.3 million. That followed an operating margin decline of 240 basis points and an operating profit decline of 19.8% in fiscal 2016.

BBBY’s net interest expense declined modestly and its tax rate rose in fiscal 2017, due in part to the implementation of the new tax law. The company cut share buybacks sharply in 2016 and 2017; but it also initiated a $0.50 annual dividend fiscal 2016 that has since increased in two steps to $0.64 in 2018. Stock buybacks helped cushion the drop in EPS. BBBY’s diluted EPS declined from $5.10 in fiscal 2015 to $4.58 in fiscal 2016 and then to $3.04 in fiscal 2017.

Historical financial performance: 18Q1.
The company reported 18Q1 net earnings of $43.6 million or $0.32 per diluted share, down 42.1% and 39.6%, respectively from the $75.3 million and $0.53 reported in 17Q1. Net sales increased 0.4% to $2.8 billion, as strong growth in sales in digital channels and a small number of new store openings was mostly offset by mid-single digit percentage decline in comparable store net sales. Gross margin declined by 150 basis points to 35%, as a result of increased couponing and online sales shipping costs. The SG&A expense ratio increased 100 basis points to 32.1%, due to increases in payroll-related expenses (including severance), higher technology spending and higher consulting fees (associated with strategic initiatives). BBBY’s operating margin thus fell 250 basis points from 5.4% to 2.9%.

The company’s free cash flow (which I define as cash flow from operating and investing activities minus the change in investment securities) increased from $116.3 million to $143.5 million, more than all of which was due to changes in assets and liabilities, including merchandise inventory liquidations and a positive swing in other current assets. Capital expenditures were $97.8 million, up from $80.8 million in 17Q1.

BBBY is an omnichannel retailer of domestics merchandise (e.g. bed and bath linens and kitchen textiles) and home furnishings (e.g. kitchen and table top items, housewares, furniture, wall décor and consumables). It operates several established retail chains, including Bed Bath & Beyond (BBB); Christmas Tree Shops (and derivatives); Harmon (and derivatives), which sells discount beauty supplies; buybuy Baby (bbB) (baby and toddler products); and Cost Plus World Market (home furnishings). Its newer, mostly online retail concepts include Of a Kind, One Kings Lane,, Chef Central and Decorist. In addition, BBBY’s Linen Holdings serves institutional customers in the hospitality, cruise lines and healthcare industries. The company also has an interest in a joint venture that operates Bed Bath & Beyond stores in Mexico.

The company competes against department stores (e.g. Macy’s, Dillard’s and Kohl’s), mass merchandisers (Wal-Mart and Target), specialty chains (lWilliams-Sonoma) and online retailers (Amazon). Customers have continued to shift more of their total purchases online, where it is easier to comparison shop and obtain the best price.

Strategic challenges and management’s response.
Overcapacity in the retail industry and the continued growth of online shopping have put significant pressure on BBBY’s net sales and profit margins. Management has responded by developing strategies to address every potential opportunity to improve profitability. These include:

  1. Revenue growth initiatives.
    1. Core Bed Bath and Beyond retail.
      1. Focusing on delivering value, personalized services and enhancing customer experiences.
      2. Improving pricing strategies over time and customer engagement (e.g. Beyond Plus)
      3. Adding new product/services with higher growth potential (such as decorative furnishings and home design services)
      4. Deliver a better omnichannel experience (by enhancing online/mobile offerings and digital/store integration).
      5. Roll out of “Next Generation” stores to boost customer traffic.
    2. Other company retail chains.
      1. Sharing best practices and product/sales ideas across all BBBY nameplates.
      2. Adopting relevant parts of the BBB playbook.
      3. Adding new stores.
      4. Acquiring new retail (adjacent) concepts, especially in digital.
  2. Gross margin improvement
    1. Deleveraging gross margin by lowering fixed costs and/or converting fixed costs into variable costs.
    2. Developing new product and pricing strategies for various customer segments (e.g. frequent shoppers, occasional shoppers, bargain hunters, impulse buyers, etc.).
  3. Lowering SG&A costs.
    1. Deleverage SG&A expenses by lowering fixed costs and/or converting fixed costs into variable costs.
    2. Reducing lease expense and/or closing stores.
    3. Improve advertising effectiveness (in part by continuing the shift to digital advertising).
  4. Reducing working capital requirements mostly by managing inventories more effectively.

BBBY’s mission is “to be trusted as the expert for the home and heart-felt life events.” Heart-felt life events include weddings, child births, going to college, moving to a new home, etc. Most notably, this mission does not require the company to be the price leader in its product and service offerings. In fact, it implicitly anticipates that consumers will be willing to pay a little more to obtain the best value and especially products and services that meet their individual wants and needs. To position the company for long-term success, management has four broad areas of focus: assortment, services, experience and operational excellence.

Decorative Furnishings. BBBY wants to become the trusted expert for whole home decorating. To achieve this objective, it is expanding its online assortment of products with an eye toward increasingly differentiating its offering from competitors over time. It is seeking to offer quality, value and competitive pricing in this category, with an easy and convenient shopping experience. Increasing customer awareness is just one of the challenges that the company faces in building this segment of its business.

The effort to grow the DF business is being led by Debbie Probst, who came to BBBY with its acquisition of One Kings Lane in 2016. One Kings Lane promises to help you “create the home you love everyday [sic].” Besides offering a wide variety of merchandise (e.g. furniture, rugs, lighting, art, mirrors and wall decor), it invites potential customers to meet one-on-one at no cost with a designer at its studios in Southamption, NY (on Long Island) and New York City (SoHo), which will open later this year. It also offers a virtual design studio and serves design professionals.

BBBY has significantly expanded the number of DF stock-keeping units (SKUs) that it offers on its websites. It is also adding its own proprietary brands in this category (and in others) for launch in fiscal 2019. (BBBY added branding expert JB (Johnathan) Osborne, co-founder and CEO of Red Antler, to its Board of Directors in April to assist in its private label initiatives.)  The effort to grow decorative furnishings is supported by a cross functional team of buyers, planners, merchandisers, operations specialists, data analysts and dedicated marketing support. BBBY is investing in 3D and other technologies to improve product presentation on its DF websites. It is also launching in-store pilots to boost customer awareness and sales of its DF product lines, especially furniture.

Decorist, which was acquired by BBBY in 2017, offers professional online interior design services for homes and offices for a fee, with showrooms in San Francisco and Seattle. It seems to be a natural fit with the effort to grow the DF business.

Although it is still early days, BBBY reported that its sales of DF products and services at BBB and bbB increased 21.5% in the 2018 first quarter vs. a year ago. Management says that customer engagement with DF products on the BBB and bbB websites is up strongly over last year. The online DF business has significantly higher average order volume (AOV) than the BBB and bbB websites.

Next Generation Store. BBBY is taking advantage of an increase in near-term lease renewals to improve its real estate footprint. In many cases, it is renegotiating lease terms to reduce rents (both temporarily and permanently) and extend maturities. Given its gross margin deleveraging objective, BBBY ought to pursue lower base rents with a higher contingent rent component (i.e. tied to the level of store sales), but contingent rents were immaterial in fiscal 2017 and management has not said whether it is seeking such a change. Alternatively, temporary rent reductions should give BBBY a greater incentive to upgrade to its next generation store prototype. Sometimes, BBBY will seek to exit a lease to move to a better location. If the company cannot get the terms that it wants, it is also prepared to close stores.

The company’s next generation stores offer a new assortment of products designed to increase shopping trips, the number of transactions and transaction value. Next generation stores will have more scarcity product, including seasonal items, DF, treasure hunt and deep value products. They will also offer more food & beverage and health & beauty care consumables.

To date, BBBY has completed four remodels to the next generation format and plans for 15 more to be completed later this year and another 20 by the end of Spring 2019. At the four remodels completed date, the company has seen strong transaction growth, especially in newly offered merchandise categories. Although core department space has been reduced by 10% at next generation stores, sales of core merchandise are still outperforming the rest of the BBB chain.

Although the next generation stores are an important component of the company’s competitive strategy, BBBY may still need to find a way to become more competitive in its every day pricing of core products without further eroding gross margin, if possible. Although many of its customers shop at its stores because of the wide assortment of products offered in core categories and the perceived higher quality of its product offering, many of those who buy elsewhere are driven to obtain the lowest price. Online retailers make it much easier to comparison shop. To some extent, winning the sale may be a question of finding the proper balance. Customers may be willing to pay more for the wider assortment and better quality but not much more.

Beyond Plus. BBBY’s recent steps to boost engagement with its customers and increase foot traffic at its stores are driven in large part by its desire to reduce its reliance on coupons to generate sales. Initially designed to bring more traffic to its stores, the once ubiquitous 20% off coupons (which are now available mostly online) were also meant to match the pricing of rivals, such as Amazon and Wal-Mart, in an increasingly tough competitive environment.

It is therefore somewhat surprising, at first glance, for BBBY to embed 20% discounts in a new loyalty program called Beyond Plus. With Beyond Plus, customers receive 20% off on all purchases for an annual fee of $29. The annual fee makes the program similar in concept to memberships at warehouse clubs.

Given BBBY’s other strategic initiatives, I expect that BBBY will use the current structure of the Beyond Plus program as a loss leader to encourage sign-ups. Over time, I anticipate that the company will seek to convert Beyond Plus to a traditional membership/loyalty program, making special offers to these customers – e.g. notices of special product buys or perhaps sales on brands or product categories or closeout specials – and gradually wean them off of the 20% discount on all purchases.

Digital. With the shift in consumer shopping preferences toward digital channels, BBBY is investing heavily in technology. 80% of its capital expenditures in recent years have been technology-related. The company is steadily improving the presentation, content and functionality of its customer facing digital channels, including search and navigation capabilities. It is using technology to enhance the full omnichannel shopping experience including online/mobile ordering with store pick-up, online purchasing with in-store returns, online scheduling of appointments for design and registry services, customer DIY online design services, online 3D product displays and in-store technology to make available an expand product assortment, present product ideas and answer questions.

BBBY’s digital programs also utilize the full range of marketing communications, online and off-line, including email, SMS, social media, search, display advertising, affiliate programs, newspaper advertising, inserts, catalogs and post cards. The company is also increasing its use of third-party data to tailor and personalize its marketing communications.

BBBY’s working capital reduction initiatives are also dependent upon the effective deployment of technology. The company plans to reduce in-store inventories while making a wider assortment of products available online. For example, it added 78,000 DF SKUs to its digital channels in fiscal 2017 and another 24,000 DF SKUs in 18Q1. One challenge with such a big expansion in SKUs is to organize product presentation to enhance customer shopping experiences and prioritize product marketing without overwhelming customers or burying them in detail.

Guidance.  Management anticipates 2018 net earnings per diluted share in the low- to mid-$2.00 range. Its three-year financial goals include: 1) achieving comparable sales growth in fiscal 2018; 2) moderating the declines in operating profit and EPS in fiscal 2018 and 2019; and 3) achieving EPS growth by fiscal 2020.

On the 18Q1 conference call, management said that it expects for full year fiscal 2018 that net sales will be flat; comparable net sales will be down by a low-single-digit percentage, but this will be offset by growth in digital net sales; further deleveraging of gross margin and SG&A expenses (i.e. reducing fixed costs outright or converting them to variable costs); continuing “one-time” or temporary expenses, such as store closures and restructuring costs; depreciation and amortization expense of $315 million to $325 million (compared with $313.7 million in fiscal 2017); capital expenditures of $375 million to $425 million (compared with $375.8 million in fiscal 2017); and an effective tax rate of 26%-27%, down from 38.9% in fiscal 2017.

After incorporating those assumptions into a financial projection model for fiscal 2018, I calculate that the company will not be able to achieve its goal of moderating the decline in operating profit unless diluted earnings per share comes in at the high end of its guidance range (i.e. nearer to the mid-$2.00s). A projection of $2.25 for fiscal 2018 diluted EPS implies that operating profit will decline 37.4%, worse than fiscal 2017’s 32.9% decline.

The three-year targets given above, including moderating the decline in operating profit, are goals and not guidance. The market may very well ignore a missed operating profit goal, as long as BBBY meets its EPS guidance. I think that investors and analysts will also be more focused on the company’s goal of achieving comparable sales growth by the end of fiscal 2018. Failure to achieve this objective could hurt BBBY’s stock price, especially if the decline in comparable net sales remains in the mid-single digits.

The company’s three-year turnaround goals seem appropriate given the current state of its various programs. Both DF and Beyond Plus are still in their early stages. Similarly, with 15 more conversions this year and 20 more planned by the end of Spring 2019, the Next Generation Store rollout will not likely be completed until 2020 at the earliest, although the rollout should begin to have an impact on the company’s overall financial performance by the end of fiscal 2019.

Nevertheless, there are other factors which are likely to affect BBBY’s nearer-term performance. For example, bbB is benefiting from the shut down of Babies ‘R Us and that positive impact should continue for the next several quarters at least. More importantly, BBBY is pursuing improved operating and financial performance across many different fronts and the cumulative impact of even small gains in each of these initiatives could be meaningful sooner than anticipated, perhaps even by the end of the current fiscal year.

Furthermore, the strong recent relative stock performance of the retail sector may anticipate stronger consumer spending. So far, the market seems to have ignored that potential positive benefit on BBBY’s fiscal 2018 performance.

At the current share price of $19.87 (close on 7/13/18), BBBY is trading at 8.8 times the $2.25 midpoint of management’s diluted EPS guidance range for fiscal 2018 and 9.9 times my projected diluted EPS of $2.00 for fiscal 2019. It is also trading at 1.0 times book value (or 1.3 times tangible book) and 5.6 times trailing 12-month free cash flow per share.

By any measure, that is cheap. In comparison, its self-identified peer group (AAP, AZO, DKS, DDS, DG, DLTR, FL, GME, GPS, KSS, LB, M, JWN, ODP, ORLY, ROST and WMS) trades an average of 14.8 times trailing 12-month EPS, 13.4 times anticipated 2018 earnings and 12.7 times projected 2019 earnings.

Applying a forward multiple of 15 to BBBY’s projected EPS of $2.00, under the assumption that its valuation will return to the peer group average when the market projects forward EPS growth, suggests an 18-month target price of $30 per share. That would translate into a gain of 50% from the current share price.

Current forward multiples for BBBY seem to imply that the company’s earnings are near a permanent state of decline. The market seems to be saying that the drop in BBBY’s profitability is all about price competition and assigns a very low probability to management’s ability to stabilize the company’s financial performance and return eventually to profitable growth.

Although it does seem that the turnaround will take time, I believe that there is a good chance that management can be successful here. BBBY’s Board of Directors expressed some confidence in its ability to right the ship earlier this year by raising the annual dividend by $0.04 to a rate of $0.64 per share. At that rate, the stock has a 3.2% dividend yield, which is still attractive despite the recent rise in short-term interest rates. The dividend provides investors with an acceptable return while management executes its turnaround strategy.

BBBY’s stock reached a new low of $16.39 on May 9, about a month after the company reported a disappointing fiscal 2018 outlook. It then rallied to an intra-day high of $21.35 on July 9, before pulling back to the current level.   On a short-term basis, the stock looks like it may retest the May 9 low. If it does that successfully, I will be watching to see if it can break through medium-term resistance in the range of $21-$24 per share, seen more clearly on a weekly chart. A longer-term chart suggests that the stock is just now leaving oversold territory and could be poised to stabilize and recover from here.

July 21, 2018

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

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