Build-A-Bear Workshop: Turning a Corner

| About: Build-A-Bear Workshop, (BBW)

Shares of Build-A-Bear Workshop (NYSE: BBW, $6.05/share), are slowly getting the attention they are due from the Street as both its core business fundamentals are improving and new growth strategies are being implemented. However, shares are still considerably undervalued despite a recent rally from a low of $4.50/share earlier this month.

Despite these bullish indicators, Build-A-Bear’s shares remain precariously shorted with nearly 1.5 million shares short or 10.8% of the estimated float. Among other things, the shares may be benefiting from shorts scrambling to cover as technical factors suggest the price may have found a bottom.

Last week, Build-A-Bear posted a sizeable adjusted earnings profit of $0.29 per share that easily beat analyst expectations of $0.10 per share (see conference call transcript here). Cash generation, a better indicator in our view of business performance, was also strong at $13.4m for FY09 vs. ($19.2m) in FY08, and left the company with $60m in cash and no long-term debt as of 1/2/10. This amounts to $3.20/share in cash or 53% of the current stock price value. The company also maintains an undrawn credit facility providing $40m of available capital. Total available liquidity, therefore, is over $100m or nearly double the company’s entire enterprise value.

How was management able to achieve such strong results? From a top-line perspective, the company’s consolidated comparable same store sales improved meaningfully year-over-year from a decline of 15.7% in FY08 to 9.9% in FY09. The biggest source of improvement came from the company’s North American operations where declines are clearly moderating. The company continues to show growth in Europe where consolidated sales grew 4.5% year-over-year. Real operating leverage came from management meeting its objective to eliminate $25m of cost savings, and hinting at further opportunities to drive that number higher in 2010.

What else lies ahead for Build-A-Bear in 2010? For starters, management indicated on their conference call that comparable same store sales trend improvement continued into 2010, reaching negative single digit levels in January and February, despite the difficult weather in the past few weeks. These trends were both in stores and online. Through February, sales were flat from last year, even with a few days remaining in the month. These comments were in-line with our observations from recent site visits where we observed strong customer turnout and waiting lines during the Valentine’s Day weekend.

New product introductions and innovation also offer the prospect of driving added sales. For example, the first introduction of the highly popular Zhu ZhuTM pets, a line of artificially intelligent plush hamsters, is currently in 50 stores with strong results and will be rolled out to all North American locations by March 2010 according to the company. Other seasonal promotions for holidays like Easter, when stores will transform to a holiday theme, may drive repeat visits by families and their kids.

Perhaps a more exciting and larger growth strategy is the company’s recently announced agreement with A Squared Entertainment, a global children’s licensing company. Under this agreement, A Squared Entertainment will help the company to create a stronger external licensing program including merchandise that will be sold outside of Build-A-Bear Workshop stores, including DVDs, accessories, apparel, and books, to name a few. In addition, A Squared will develop multimedia entertainment for future distribution online, on air, and on other digital devices. A Squared will also collaborate to produce original programming to expand upon the success of Holly and Hal Moose and will include other Build-A-Bear Workshop properties.

With the worst likely behind it and long-term confidence in their business, the company has decided to increase capital spending by $4m to $12m from last year’s level of $8m for upgrades to infrastructure as well as the opening of 3 new stores, two stores in the UK in the fall and one new format store in the US.

On a relative valuation basis, Build-A-Bear continues to trade at a substantial discount to other toy and mall-based retailers such as (Mattel (NASDAQ:MAT), Hasbro (NASDAQ:HAS), Gymboree (NASDAQ:GYMB), Children's Place (NASDAQ:PLCE), JAKKS Pacific (NASDAQ:JAKK)) despite maintaining a stellar balance sheet and improving trends. For example, the company’s enterprise value to estimated 2010E EBITDA is a meager 1.9x vs. 5.0x for its mean peer group. From a sales perspective, the company’s enterprise value to 2010E revenues is 0.10x vs. 0.90x for the same peer group.

From a technical trading perspective, the overhang of a large selling shareholder has recently ended. According to a recent filing with the SEC, Barney Ebsworth has reduced his holdings in the company to zero. Mr Ebsworth’s firm was an initial VC investor in the company a decade ago, and he continues to remain involved with Build-A-Bear as Director Emeritus.

On the other hand, the company has been a buyer of its own stock as a result of an open $50m share repurchase program. As of the last 10Q filing through November 2009, there was capacity to repurchase an additional $31m of shares.

Also according to filings, BML Investment Partners, another large shareholder, has been purchasing shares around the $5 level. These data points suggest the shares may have recently found a floor price.

At least one analyst has also taken notice of the company’s brightened outlook and potential for valuation expansion. Needham & Company backed its Buy recommendation and affirmed a $13 price target over the coming year.

Given the tangible improvements in the business, increasing investor/analyst sentiment, and an already heavily discounted valuation, the bear thesis in BBW’s share price appears increasingly tenuous.

Disclosure: At the time of publication, Axler was long BBW