Bed Bath and Beyond Needs To Unlock Value

| About: Bed Bath (BBBY)

Currently trading at 17x EPS, shares of home furnishing giant Bed Bath and Beyond (NASDAQ:BBBY) look incredibly cheap. It’s either that or we should be scolded for our irrational exuberance.

Bed Bath & Beyond operates 760 Bed Bath & Beyond stores throughout most of the United States. The company also owns Christmas Tree Shops, a 31-store giftware and household items retailer, and Harmon Stores, a 38-store health- and beauty-care retailer. The stores' floor-to-ceiling shelves stock better-quality bed linens, kitchen items, and home furnishings. BBBY, which employs 33,000 people, depends heavily on word-of-mouth for advertising to penetrate new customer segments and expand its top line. And with the acquisitions of Harmon Stores [2002] and Christmas Tree Shops [2003] under its wing, BBBY has had no qualms going outside the company to fuel that growth. Internal promotions and every-day low pricing have also contributed to BBBY’s success. Sales have grown at a 19% clip over the last 5 years and free cash flow currently accounts for 8% of revenues.

While BBBY’s P/E puts it at a premium to its 2Y EPS growth rate of 3.4%, the stock is trading at over 15x cash flow, a sign that investors are assigning large value to BBBY's non cash assets. There is much to cheer about, we think, given BBBY’s ROIC (return on invested capital, or simply NOPAT/invested capital) over the last year was more than 23%. In addition, BBBY’s EBITDA margins of 15.1% (120 bps higher than its comp group) are outstanding and should strike a chord with value investors who might also appreciate BBBY’s conservative capital structure.

It is BBBY’s capital structure, in fact, that most interests us. Currently, BBBY has amassed a cash horde of $817M and is debt free. Some its peers like JC Penny (NYSE:JCP), for example, are far more leveraged. This is a significant point of differentiation as it makes the possibility of an LBO event for BBBY all the more plausible. Additionally, the fact that founders Warren Eisenberg and Leonard Feinstein have slowly reduced their holdings to 2% of the company makes a potential deal easier to consummate.

Deal or no deal, BBBY is a in a great position to crack its piggy bank open and return this cash to shareholders either through more share repurchases or a meaningful acquisition. We think that the latter may be a good idea given that BBBY may be entering the maturity phase of its life cycle and thus needs to augment or re-define its value proposition.

Now one could make the argument that if it weren't for the LBO premium that has been priced into the stock for months, BBBY would be trading at a lower multiple. That stands to reason, given that the stock itself has been as exciting as watching paint dry: thus far in 2006, BBBY has returned about as much as a T-bill, whereas the S&P has returned a healthy 12%. A differential of 700 bps is troubling, we think, given BBBY’s bulletproof balance sheet, brand recognition, and EBIT margins.

Besides its capital structure, we like BBBY’s technicals: after the last EPS call, BBBY bounced off of its 200 moving day, a sign that longer term investors were willing to hold onto BBBY amid the quarterly disappointment. In addition, it would seem to us that BBBY is closing a 8-9 month cup and handle pattern (see diagram below), arguably the most bullish chart formation in our coverage universe. In other words, the 1st half of 07 could be a very interesting time for BBBY and its shareholders.


We believe BBBY could trade to the upside in 2007 if management takes it upon itself to unlock all the value hiding in plain sight on the balance sheet. Waning institutional sponsorship (fund managers have been skeptical about BBBY’s growth opportunities), potential market saturation, and the recent options-related dark cloud have all contributed to the stock’s downward price movement. Nevertheless, we believe BBBY could reward patient investors who can stomach the blows that may manifest (higher interest rates in 07 could adversely impact sales next year if home-related spending contracts) before BBBY either sells itself or overcomes investor’s growth-tilted expectations. Ultimately, we believe BBBY could become darling to investors with value appetites.

Bed, Bath, and Beyond is operationally sound, but in a world where management can only decide earnings (the Street assigns the multiple), this "best of breed" name in the home-furnishing space will have to shoot the lights out on an earnings front – or consider “strategic alternatives” – if it wants to truly stand out in an industry that has posted negative returns for the 6M, 1Y, and 3Y periods. We believe the latter scenario is more likely, given the fact that BBBY’s high octane growth days are behind it. It is up to management, then, to generate value creation when the capital markets are not responding: “breaking the piggy bank,” as we have been arguing, is the key to mending the wound BBBY has created between itself and Wall Street and returning value to shareholders that is commensurate with the amount of risk that they are taking as equity investors (we use an 11% WACC, or cost of equity, given BBBY’s presence in retail and the housing space, which experiences high turnover).

On a relative valuation basis, assuming y/y comps grow ~450 bps, we see BBBY fairly valued in the $45-$47 price range, or 15% higher than where shares are currently trading. Time will tell as to whether or not the marketplace agrees on a fair price for this domestics merchandise behemoth.

Disclosure: Author has no position in BBBY.