Recent Observations on Bed Bath & Beyond

The investor optimism that followed the October 2019 appointment of Mark J. Tritton as Bed Bath & Beyond’s CEO and continued after the company gave a preliminary upbeat assessment of its performance early in the Christmas selling season gave way to disappointment initially when it withdrew fiscal 2019 guidance in January and especially following the company’s update on its fiscal fourth quarter performance on Feb. 8.  Since reaching a peak of $17.79 on Dec. 18, the stock has fallen $8.30 or 52% to $9.49 on March 5.  Most of that decline occurred right after the fourth quarter update announcement. Most recently, the stock has been caught in the coronavirus market sell-off.

Recent Developments

Prior to the update, management had said on its fiscal third quarter earnings call in January that, adjusted for the 2019 calendar shift that took away a week of post-Thanksgiving holiday sales, the decline in that quarter’s comparable sales would have been 3.6% (rather than the 8.3% actually reported).  The company also reported that comparable store sales during the busy Thanksgiving to Cyber Monday period rose 7.1% from the prior year.  This news raised hopes for a meaningful improvement in fourth quarter sales.  Yet at the same time, management withdrew its full year fiscal 2019 guidance which was a prelude to the disappointing fourth quarter results.

In the fourth quarter update, BBBY reported that comparable sales during December and January, the first two months of the fiscal fourth quarter, fell 5.4%, due to a decline in store traffic, inventory management problems and increased promotional activity and markdowns.  Comparable store sales fell by a low teens percentage, but this was partially offset by a 20% increase in sales through digital channels.

If that 5.4% comparable sales decline continued through February, the final month of the quarter, the quarterly decline would represent a modest sequential improvement from the declines of 6.6%, 6.7% and 8.3% in comparable sales reported in the three successive earlier quarters of this fiscal year.  Even so, that is nothing to celebrate.

Since Mr. Tritton’s arrival, BBBY has made several announcements that provide some clues about its strategy going forward:

In December, BBBY sacked five corporate executives:  its Chief Merchandising Officer, its Chief Marketing Officer, its Chief Digital Officer, its Chief Legal Officer and General Counsel and its Chief Administrative Officer.  A sixth, the Chief Brand Officer, had already resigned.  The company will seek replacements to fill these positions, except that it will combine the roles of the Chief Marketing Officer and Chief Brand Officer and will not replace the Chief Administrative Officer.  On March 4, BBBY named Joe Hartsig as Chief Merchandising Officer and President of Harmon Stores Inc.  These recent personnel moves appear to be taken with an eye toward reducing operating costs.

In early January, the company announced that it had completed a sale-leaseback transaction with an affiliate of Oak Street Real Estate Capital for 2.1 million square feet of commercial space, including retail stores, a distribution center and its Union, NJ headquarters.  It received more than $250 million of proceeds in the transaction, which it will deploy either by reinvesting in the business, buying back shares or reducing debt.  BBBY has not yet disclosed the implicit interest rate for this financing.  Two previous BBBY sale-leasebacks have annual interest rates of 7.2% and 10.6%.

In February, BBBY agreed to sell PersonalizationMall.com to 1-800-Flowers.com for $252 million (before tax).  The transaction is expected to close during the fiscal 2020 first quarter.  On a recent conference call, management said that PersonalizationMall.com’s profit margins were above the company average, but the business was not material to BBBY’s consolidated results.

In the announcement, the company said that it was focusing on its “core” home, baby and beauty businesses.  That suggests that other businesses – such as Cost Plus World Market and Linen Holdings (a seller of bed, bath and table linens and other textile products to institutions) – are candidates for sale.

PersonalizationMall.com will still provide product and personalization services to its Bed Bath & Beyond and buy buy Baby customers; so even though it provides an ancillary service that enhances BBBY’s core business, the company decided to cash out.  Perhaps then other ancillary BBBY businesses, such as Decorist, One Kings Lane and Chef Central may be candidates for sale, especially if Mr. Tritton adopts a strategy that is materially different from the one that the company had been pursuing prior to his arrival.

BBBY also announced that it would allocate $1 billion of capital in fiscal 2020 for share buybacks, debt reduction and reinvestment.  Returns to shareholders (both share repurchases and dividends) and debt reduction are expected to total $600 million; while capital expenditures are budgeted for $350 million to $400 million. In fiscal 2019, the company will likely incur $275 to $300 million in capital expenditures and pay $86 million in dividends. Stock buybacks in the first three quarters of fiscal 2019 totaled $99 million, of which $81.5 million were completed in the first quarter.

The company will fund its fiscal 2020 capital program primarily with the $900 million of cash and short-term investments on hand at the end of the fiscal 2019 third quarter, the $250 million in sale-leaseback proceeds and the $252 million from the sale of PersonalizationMall.com.  Altogether, that suggests the company could end fiscal 2020 with $400 million or so in cash, if it does not generate (or use) cash during the year from additional asset sales, the planned inventory liquidation or changes in cash flow from operations.

Observations

Over the past five years, BBBY has suffered a sharp erosion in its operating margin, driven in large part by same store sales that have been declining at an increasing rate.  Its operating margin has fallen from 11.7% in 2016 to only 0.4% in the 12 months ended November 30, 2019.  That decline was driven by a 580 basis point (bp) drop in its gross margin, from 38.2% to 32.4% and a 550 bp increase in its SG&A expense ratio, from 26.5% to 32.0%.

By comparison, the average specialty retailer, according to S&P, currently has an operating margin of about 9%, with a gross margin of 30% and an SG&A expense ratio of 21%.  Some specialty retailers show a higher gross margin with a proportionately higher SG&A expense ratio.  Others with lower gross margins are able to run with a lower SG&A expense ratio.  Assuming the differences in gross margin and SG&A expense ratios are not due to differences in accounting policies, the trade-off may reflect in part variations in the value proposition provided to the customer, including the level of service.

In order for BBBY to return to a mid- to high single-digit operating margin, it must work on both improving gross margin and reducing SG&A expenses.  Gross margin is the most obvious target.  Over the past year, there has been much talk about changing the company’s dysfunctional pricing policies, including its extensive reliance on promotions and discounts, including those 20% discount coupons.  Gross margin might also be improved by increasing sales volumes.  Reducing SG&A expense, on the other hand, will probably be more difficult, because the company’s average sales per square foot of retail space, currently running around $260, is well below the range of $400 to $800 per square foot that I estimate for a handful of S&P 1500 specialty retailers.  Here too, a sales boost would reduce the SG&A expense ratio because a significant portion of SG&A expenses are fixed.

The decline in comparable store sales has been blamed upon loss of market share to Amazon; but all retail has become more competitive.  Both Wal-Mart and Target have undoubtedly sharpened their pencils in their bed and bath product lines.  Other retailers, like Home Depot, have moved into the space to sustain their growth.

A Home Depot email advertisement

The slide in sales has exposed some of the weaknesses in BBBY’s operating model.  Up until now, the company has operated with heavy inventories, well in excess of the average retailer.  For at least the past five years, its inventory turnover has averaged 2.7 times, well below the average 4.0 times for specialty retailers, according to my estimates from S&P data.  BBBY’s plan to reduce inventory by $1 billion or 40% within 18 months, announced at the end of the fiscal 2019 second quarter, would raise its inventory turnover to the industry average, assuming no loss in sales.

But it remains to be seen whether the company reduce inventory so significantly without hurting sales.  BBBY reported recently that sales in both the third and fourth quarters of fiscal 2019 were hurt by out-of-stocks, especially on best-selling products, after the company began to take down its inventory levels.

I experienced this problem first-hand before Christmas, when I visited the Iselin NJ store to purchase a coffee maker.  The model that I preferred, the Cuisinart Coffee Center, was on display but not in stock.  I was told by a salesperson that I could pick one up at the North Brunswick store, 12 miles away.  I did not make the trip.

The aim of the inventory reduction program is to liquidate aged merchandise and cut duplicative SKUs from the company’s stores and distribution centers.  A recent WSJ article highlighted the effort by Mr. Tritton to “declutter” the stores and eliminate the “purchase paralysis” that customers get when exposed to too many items in overcrowded stores.   According to the article, Mr. Tritton aims to eliminate the piles of merchandise up to the ceiling in large part by eliminating SKUs – for example, by reducing SKUs for can openers from 12 to 3.  He also intends to expand BBBY’s private label offerings.

A Bed Bath & Beyond Store
A Bed Bath & Beyond store

Personally, I think that the expansion of private label products has promise.  In that same Iselin, NJ store, I bought a large, private label stainless steel roasting pan before Thanksgiving at a price of $35, about half the price of a comparable branded roasting pan.  The private label roasting pan was featured prominently on a promotional flyer that I received from the company in the mail.  I was happy with the purchase.

I bought other items at the store on that shopping trip and had a 20% discount coupon from my Beyond+ membership.  I did check to see whether the 20% discount was applied to the roasting pan.  If memory serves correctly, it was not.  If the 20% discount had been applied, the cost of the purchase before tax would have been $28, which (wearing my shareholder’s hat) would have been unnecessary windfall, since I was happy with the purchase at $35.

The application of the 20% discount on top of an attractive promotional price is, I believe, an example of what management has called “stacking.” Although it said that the practice continued in the third and fourth quarter, it has pledged to “destack” its promotions.  I think that it is only prudent, but some customers, especially those that rely heavily on those 20% discount coupons, may not be happy about it.  In order to accomplish this without alienating those customers, the company will have to communicate clearly that certain promotions are such a great value, they cannot be eligible for the 20% discount.

Expanding private label appears to be a key part of the company’s strategy under its new management team and new Board of Directors.  As noted, the company intends declutter the stores by reducing inventory (including reducing SKUs).  It also intends to beef up its website and offer customers the ability to buy online pick-up in store (BOPUS).

BBBY already offers customers the BOPUS option for merchandise on hand in its stores.  Customers can also buy online and have the merchandise sent directly to their residences by paying the shipping cost. It seems unlikely that BBBY will get much of a sales boost by adding a BOPUS option for merchandise not currently in stores; but it could very well help the company achieve its goal of operating with leaner inventories.

If taken to the extreme, this new strategy of making substantial cuts to in-store SKUs would, in my opinion, represent a significant departure from the company’s current customer value proposition.  Under the previous management, BBBY had sought to differentiate its business by offering customers a wider selection SKUs within major product categories.  This satisfied two categories of customers:  (1) those who are willing to pay a premium to obtain personalized home furnishings (e.g. the “perfect” color, pattern and length of curtains) and (2) those who come to the store not knowing exactly which brand or model they want, but know that BBBY offers a wider selection in each product category than say Wal-Mart.  Indeed, the company’s next generation lab store emphasizes wide product selection and personalized services.  In this way, BBBY sought to differentiate itself from Amazon, Wal-Mart and Target, taking customers’ focus away from obtaining the lowest price.

Mr. Tritton’s strategy, which is currently being tested in three BBBY stores, would seem to position the company to compete more head-to-head with those retail behemoths, with presumably (high-quality) private label merchandise as the main differentiating factor.  Of course, BBBY cannot ignore the competitive threat posed by those retailers; but neither is it likely to be able to compete successfully directly against them.

The improved online presence and BOPUS capability should help raise BBBY’s appeal to younger shoppers (e.g. millenials), who prefer to do much of their shopping online and who may not require seeing and touching the product in store before making the purchase.

In my view, BBBY should seek a balance in the breadth of its product offerings and its value proposition in order to appeal to the broadest range of customers.  In some product categories, it must have a wider selection in store, which probably requires carrying high in-store inventories.  In others, like can openers, it probably can limit the in-store selection without alienating customers.  Finding that balance may take time and it may also require tailoring the in-store product mix to appeal to local tastes.  With BOPUS and an expanded distribution capability, it might be possible for the company to reduce in-store inventory while still maintaining a broad product selection, but that will probably also raise (fixed) operating costs.

Besides the revamping of its in-store inventories, website and distribution network, BBBY, as noted above, has established a $1 billion capital program for fiscal 2020 with $600 million targeted to dividends and share buybacks and $400 for capital expenditures.  With its current annual dividend requirement of $86 million, it has $514 million available for share buybacks or possibly a dividend increase under the fiscal 2020 program.

I question whether buying back stock is appropriate for the company at this time.  BBBY’s operating and financial performance deteriorated markedly in fiscal 2019. Comparable store sales will likely decline by 6% or so for the full year, much worse than the declines of 0.6% in fiscal 2017 and 1.3% in fiscal 2018.

The decline in sales has taken a toll on BBBY’s profitability.  Net earnings for the first nine months plunged from $116.6 million in fiscal 2018 to a net loss of $548.4 million (including $441.4 million of goodwill and intangible impairments) in fiscal 2019.  EBITDA, according to my calculations was nearly halved from $426.4 million to $247.5 million.  Free cash flow, which I define as cash flow from operating activities plus or minus cash flow from investing activities, excluding the changes in investment securities declined from $413.0 million to $68.9 million.

Although the sale-leaseback transaction and the sale of PersonalizationMall.com will add $500 million to the $900 million of cash and short-term investments on BBBY’s balance sheet, putting the company in what clearly looks like an excess capital position (with possibly more asset sales to come), it is not clear when the new management team will be able to stabilize its sales, profitability and cash flow.   Under these circumstances, and given the now elevated risk of recession, I believe that it would be prudent for BBBY to hold on to that excess cash until it is certain that a turnaround has taken hold.

Despite these risks, I believe that BBBY has a viable franchise. As long as the economy does not slide into a deep recession, it should be able to tweak its business model sufficiently to stem the slide and eventually rekindle growth in sales and profits.  The stock looks expensive based on consensus forward adjusted (Non-GAAP) earnings estimates; but cheap on enterprise value-to-EBITDA multiple basis.  Modest growth in sales transactions, better gross margin management and some belt tightening in SG&A expenses could produce a meaningful improvement in profitability over time.

Mr. Tritton will one way or another address the questions that I and others have raised about the company’s revised business and financial strategy at an upcoming investor meeting currently scheduled for May.

March 6, 2020

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
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