Why We Worry About Bed Bath & Beyond Heading Into Earnings

| About: Bed Bath (BBBY)

Bed Bath & Beyond, Inc. (NASDAQ:BBBY) reports their fiscal third-quarter earnings release after the bell on Wednesday, Dec. 19, with analyst consensus expecting $1.02 in earnings per share (EPS) on $2.7 billion in revenue for expected year-over-year growth of 7% and 17%, respectively.

Fiscal Q3 comps are expected at 3.5% - 4%.

Last quarter, BBBY reported healthy 12% revenue growth but just 5% EPS growth, although $0.03 of EPS was attributed to a higher than expected tax rate. Normalizing the tax rate, and assuming BBBY earned $1.01 last quarter, versus the $0.98 reported, year-over-year EPS rose 13%. Comps of 3.5% last quarter were a little lighter than expected, given how aggregate home furnishing sales have tracked in the Retail Sales data.

Here is a quick margin table we put together from our internal spreadsheet:

Quarter Gross mgn y/y chg Op mgn y/y chg Net mgn

y/y chg

7/12 Q2 39.8% -1.27% 14.1% -1.98% 8.7% -1.26%
4/12 Q1 40.0% -065% 14.1% 0.43% 9.3% 0.77%
1/12 Q4 42.6% -0.38% 20.2% 1.75% 12.8% 1.53%
10/11 Q3 40.9% 0.04% 15.2% 1.33% 9.8% 1.16%
7/11 Q2 41.1% 0.15% 16.1% 2.16% 9.9% 1.41%
4/11 Q1 40.6% 0.34% 13.7% 1.97% 8.6% 1.41%
1/11 Q4 43% 0.39% 18.4% 1.88% 11.3% 1.24%
10/10 Q3 40.9% 13.9% 8.6%
7/10 Q2 40.9% 13.9% 8.5%
4/10 Q1 40.3% 11.7% 7.2%
1/10 Q4 42.6% 16.5% 10.1%

* Gross mgn = Gross profit margin as percentage of revenues

* Op mgn = operating profit margin as percentage of revenues

* Net mgn = net profit margin as percentage of revenues

* Source - internal spreadsheet from earnings reports, SEC filings

As the reader can quickly tell, BBBY's margins have deteriorated since the beginning of 2012, starting with gross margin and ultimately trickling down to net margins. BBBY has maintained sales, general and administrative expenses (SG&A) as a percentage of revenues in the 25% - 27% range, so the retailer hasn't cut operating expenses to try and prop up the operating margin.

Next, we'll look at cash-flow data for BBBY:

Quarter end 4Q trail CFO y/y growth

4Q trail


y/y growth 4Q trail FCF y/y growth
7/12 Q2 $1,085 -2% $280 31% $805 -10%
4/12 Q1 $1,181 14% $253 28% $938 11%
1/12 Q4 $1,225 24% $243 33% $982 22%
10/11 Q3 $1,166 21% $228 30% $937 19%
7/11 Q2 $1,106 17% $213 27% $893 15%
4/11 Q1 $1,047 13% $198 23% $848 11%
1/11 Q4 $987 9% $183 19% $804 7%
10/10 Q3 $967 $176 $791
7/10 Q2 $946 $169 $778
4/10 Q1 $926 $161 $765
1/10 Q4 $905 $154 $751

* Source - internal s/sheet from SEC filings

* 4Q trail CFO = 4-quarter trailing cash-from operations

* 4Q trail capex = 4-quarter trailing capital expenditures

* 4Q trail FCF = 4-quarter trailing free-cash-flow

Like the margin table above, you can see in the recent trends that BBBY is oh-so-slightly starting to fray a little bit at the edges, and in effect, they could be a victim of their own success as it is clear that most of BBBY's metrics peaked in late calendar 2011, early 2012, and have faced very tough compares in fiscal 2013.

Let's take a closer look at capex:

Quarter end

4Q trail capex

% of rev's

4Q trail capex

% of CFO

7/12 Q3 3% 26%
4/12 Q2 3% 21%
1/12 Q1 3% 20%
10/11 Q4 2% 20%
7/11 Q3 2% 19%
4/11 Q2 2% 19%
1/11 Q1 2% 19%
10/10 Q3 2% 18%
7/10 Q2 2% 18%
4/10 Q1 2% 17%
1/10 Q4 2% 17%

* internal spreadsheet

Capital expenditures are vital to maintaining the economic moat of the business and are management's best indicator of what they consider to be future growth opportunities. For a retailer like BBBY, "capex" is typically new store openings, and it is becoming clear (and this could still be temporary) that BBBY has maintained the pace of new store openings, even as cash-from operations (CFO) has begun to fade. You can see in the third column how capex is becoming a bigger percentage of cash-flow.

Finally, we use two spreadsheet calculations from the cash-flow statement to help us discern the trend or correlation between cash-flow and net income (basically an earnings quality test), and then how cash-flow/free-cash-flow covers potential future dividends and share repurchases, which tell us whether a company can continue to return capital to shareholders, and the potential for increases and/or the threat of decreases to shareholders.

Quarter end 4Q trail CFO 4Q trail net inc CFO / Net inc 4Q trail FCF Div / share repo's FCF cov of div/repo
7/12 Q2 $1,085 $1,011 1.07(x) $805 $1,114 0.72(x)
4/12 Q1 $1,191 $1,016 1.17(x) $938 $1,166 0.80(x)
1/12 Q4 $1,225 $990 1.24(x) $982 $1,218 0.81(x)
10/11 Q3 $1,166 $922 1.26(x) $937 $1,085 0.86(x)
7/11 Q2 $1,106 $882 1.25(x) $893 $953 0.94(x)
4/11 Q1 $1,047 $834 1.25(x) $848 $820 1.03(x)
1/11 Q4 $987 $791 1.25(x) $804 $688 1.17(x)
10/10Q3 $967 $734 1.32(x) $791 $539 1.47(x)
7/10 Q2 $946 $697 1.36(x) $778 $391 1.99(x)
4/10 Q1 $926 $650 1.42(x) $765 $243 3.15(x)
1/10 Q4 $905 $600 1.51(x) $751 $95 7.92(x)

* Source - internal spreadsheet

Currently, BBBY doesn't pay a dividend, and if the cash-flow data is any indication, the share repurchase program might be downsized or not continued or suspended temporarily, given the dwindling free-cash-flow. (With the balance sheet cash and still positive free-cash-flow, BBBY doesn't have to do anything drastic regarding the share repo program, but it looks like they are already repurchasing fewer shares, even with the stock trading at lower prices. How many companies have we seen that from?)

One 2012 event we haven't talked about is the CostPlus acquisition, and perhaps, BBBY wanted to spend some of their ample balance sheet cash ($669 ml cash paid for CostPlus per the latest 10-Q) on "buying" rather than building square footage. Whole Foods (NASDAQ:WFM) did this in 2007 when their store build-out started to hit extreme levels, and investors were wondering if they were getting into the real estate development business, rather than the specialty/organic grocery business. Whole Foods bought Wild Oats, and greatly improved store productivity and cash-flow without all the store development.

Can BBBY convert the CostPlus brand and square footage into the kind of productivity BBBY has gotten from their own stores? The CostPlus numbers were just incorporated into BBBY's results last quarter, so the next few quarters we will see what BBBY has in store for the acquisition.

Bottom line on BBBY: While we aren't shorting the stock, we do not want to own the stock in front of earnings, given the fraying of just about every key financial metric. Capex is obviously pressuring the cash-flow statement, so CostPlus could actually have a beneficial impact on cash-flow if BBBY slows their own store growth for a bit.

Our primary quality-of-earnings metric, the CFO coverage of net income, while not yet in the red, has narrowed substantially to where it is just barely breakeven. (Last chart, third column).

To be clear, we think that Bed Bath & Beyond:

1.) Has an exceptional management team that has executed superbly in the worst housing depression since the 1930s;

2.) If you put the housing peak right around the date of Hurricane Katrina in August 2005, BBBY has had a total return of over 70% (as measured to its July peak near $73 per share) while other housing related stocks were down 50% - 75% or more;

3.) Some of the stocks weakness of late could be longer-term investors booking gains and swapping BBBY for homebuilder stocks or a entering into another housing-related relative earnings strength play;

4.) BBBY still has $775 ml in cash on the balance sheet as of July '12 and after the CostPlus expenditure, and no long-term debt on the balance sheet, so the retailer still has plenty of liquidity and financial flexibility should it be needed;

While metrics have deteriorated, they are not yet alarming. We would love to buy BBBY between $45-$50, but the stock may never see those levels.

The attached weekly chart puts the stock in a technical no-man's land, where it could rally back to the 50-week m/a or sink to the 200-week m/a. The chart is very oversold though (a positive for patient investors).

We think the company may slow new store openings and temper the share repurchase program as it digests the CostPlus acquisition, and as it adjusts to a lower-comp environment.

Retail too has been weak of late, some of it's seasonal-related (retail stocks typically trade poorly during December to mid-January) but there has been weakness at the lower end of retail too.

Let's see what Wednesday evening holds.

Disclosure: I am long WFM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Home Furnishing Stores, , Earnings
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