Bed Bath & Beyond: Fairly Valued At $80, Offering 15 Percent Upside

| About: Bed Bath (BBBY)


Bed Bath & Beyond is fairly valued at $80/share.

Market potential of 1,700 stores.

Recovery in housing market will create tailwinds for the company.

Over the last two years, Bed Bath & Beyond (NASDAQ:BBBY) shares have massively underperformed the broad market as well as the retail industry. Shares have gained only 4 percent in the last 2 years compared to 32 percent gain in the S&P 500 (NYSEARCA:SPY) and 36 percent gain for S&P Retail ETF (NYSEARCA:XRT). For Q3 of FY 2013, the company missed the consensus earnings forecasts by 3 cents. The soft showing in the previous quarter in combination with snowy winter this year forced the management to lower its fourth quarter guidance.

Even though the revenue has grown by 11.5 percent yearly over the last 10 years, revenue by store peaked out at $7.47 million in 2011. The total number of stores growing faster than overall revenue led to the decline in this metric (takeover of World Market Stores). The chart below explains how well and how much capital management has invested in the business for future growth. Management increased reinvestment of the profits back into the future from 2008, restraining its ability to create extra returns over the cost of the capital for several years. Over the last 5 years, its revenue has grown 9 percent yearly whereas the total store count has expanded from 1037 in 2008 to 1520 for FY2013.

(Source: 10 K)

Valuation Inputs

  1. For the next 5 years, I am expecting annual revenue growth of 5 percent and revenue growth convergence to the growth rate of the economy, after the first 5 years.
  2. While my model currently forecasts return on invested capital in the high 20's, as the company reaches saturation levels, its ROIC will converge towards the industry average. This helps in factoring low customer switching costs, increased price competition and decreased pricing power.
  3. Online expansion will help in offsetting the decline in operating margins the company faces due to aggressive promotions in physical stores. Diversifying its store portfolios will also create incremental growth opportunities, and diversify the business risk for the company.
  4. Used pre-tax operating margin of 14 percent (50 basis points lower than current margins).
  5. Using the median of the last 10 years' sales/invested capital ratio of 2.50 in my valuation model to capture the reinvestment requirements of the business.
  6. Converted the operating lease commitments to debt, adjusted the operating income, and invested capital in the business. Also reduced the value of stock options granted from equity holder claims.

With above-mentioned reasons, my discounted cash flow model estimates Bed Bath & Beyond at $80/share. With the stock currently trading at $69.40, gap between value and market price is almost $12/share. This company should be able to create cumulative free cash flow of more than $5.0 billion, enabling it to buy back more shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.