The Bear Case On Build-A-Bear Workshop

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

Imagine you own a chain of retail stores selling expensive discretionary goods. When you first started out with your novel retail concept, you were wildly successful and the darling of the business world. However, now that you have been in business for a number of years, the buzz has started to wear off.

Your same-store sales have been declining at an accelerated rate for the each of the last three years. And to top it off, the general economy is facing a housing crisis that nearly every expert agrees will negatively affect consumer discretionary spending.

What do you do? Most prudent business managers would get their house in order, rework their brand, and ensure that their company was on solid footing to survive an economic downturn. Well if you are Build-A-Bear Workshop (NYSE:BBW), the operator of specialty toy stores that allow kids to create custom stuffed animals, you take a different tact. Your solution is to:

1) Deny that your store’s popularity is waning. Instead, blame it on “macroeconomic conditions affecting consumers.” This is the primary explanation BBW has for the same-store sales drops it has been experiencing since 2005. Nothing they could do, just a bad economy. Tell this to luxury retailers like Coach (NYSE:COH) and Tiffany (NYSE:TIF), which posted record years in 2005 and 2006. Apparently, with all the money consumers were spending on $2,000 purses and jewelery, there just simply wasn’t enough left to afford $35 teddy bears.

2) Use all your cash flow to build more stores, especially in foreign countries where your store has no brand and is unproven. Through the first nine months of the year, BBW had burned through nearly $37M in cash building out new stores across the U.S. and entering into France. But new stores only seem to be temporarily stopping the bleeding- BBW reported that third quarter revenue grew 8% and earnings 10% over 2006, despite having 71 (35%) more stores open at the beginning of the period! That’s not the kind of return on new stores that any retailer likes to see, but it’s what you get when you deliver a same-store sales decline of 10.1% in 2007, on top of a drop of 5.8% in 2006. And the worst part is, the newest stores appear to be the most unsuccessful. In 2006, sales at stores that were open for less than 3 years declined more than 50% more than older stores.

3) If all else fails, hire an investment banker to “explore strategic alternatives.” BBW hired Lehman Brothers to do just this last summer, but not surprisingly, there have been no takers to this point. And with its dismal same-store sales, it’s not likely that BBW is a mouth-watering PE takeout target in the current credit market. The bottom line is, management realizes that their fad has passed and is trying to cash out while the business still has some value. Unfortunately, they’re unlikely to get bailed out in today’s market. This holiday season, kids, like their parents, want the latest modern electronics like Nintendo’s (OTCPK:NTDOY) Wii or Fisher Price’s digital camera. And ask any young girl (BBW’s target customer) whether they’d rather have a teddy bear or a much edgier Bratz doll. Build-A-Bear is a nice novelty concept, but that’s all. After a customer has had the experience once, the novelty has worn off.

In the interest of disclosing all risks, BBW does have one hidden thing going for it. By early 2008, the company expects to own a 34% minority stake in RidemakerZ, a new mall concept that allows young boys to build custom toy cars. While I’m skeptical that today’s stimulus-seeking boy would rather spend three hours putting wheels on a plastic Mustang than playing Wii, reports say that the store is off to a promising start. This is a potential promising asset that could deliver value for Build-A-Bear down the line.

But RidemakerZ is still an unproven concept that won’t deliver any tangible value to BBW for at least the next 12 months. In the interim, I think we can expect to see more sales declines and destroyed value for BBW shareholders. Analysts are expecting earnings to drop nearly 15% in the fourth quarter.

The company certainly isn’t giving investors any confidence, having ceased activity under its $25M buyback plan. This despite buying back $4M worth of shares earlier this year north of $26/share. And just last month, BBW announced that it was restating its comprehensive income numbers for the first half of the year due to accounting problems.

I see no other near-term catalyst for BBW other than a miraculous buyout by some masochistic PE firm. Unless that happens, I expect the “bear” reality against BBW to take this stock down to the low teens.

Disclosure: SmartGuyAB is short BBW.

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