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The holy grail of investing is the 10-, 20-, or 100-bagger, the phrase coined by legendary Fidelity portfolio manager Peter Lynch, to describe making 1,000% or more on an investment. Turnaround investments can also be very lucrative, as evidenced by the recovery of McDonald's (NYSE:MCD) and Starbucks (NASDAQ:SBUX) stock prices over the last decade.

Having been fortunate enough to invest in SBUX when its share price was beaten down, I am always on the lookout for turnaround candidates in specialty retail. Admittedly, Build-A-Bear Workshop (NYSE:BBW), and Crumbs Bake Shop (NASDAQ:CRMB), which will be discussed in part 2 of the article, are structurally not as attractive as SBUX. Neither has the scale of Starbucks, or as high profile a brand. Also, retail is not an area which I typically like to invest in because of thin operating margins. That sentiment is shared by many institutional investors as well.

In addition, any investor in these two companies should know that turnarounds take longer than anyone expects, sometimes longer than a year or more. If you invest in these securities, try and have a time frame of longer than six months. Another piece of advice is to allocate only the capital which you can afford to lose. Moreover, placing only a small percentage of your portfolio in these securities would probably be a prudent course of action. Let's take a look at the first turnaround candidate - a cute little company called Build-A-Bear .

Build-A-Bear: Current and Historical Analysis of the Business

Build-A-Bear is the leading company in "making your own stuffed animal entertainment." The concept is based on retail malls, as it appeals to children, teenagers, parents, and grandparents. Build-A-Bear operates 290 stores in the United States, Canada, and Puerto Rico. It also has 58 stores in the UK and Ireland. There are 82 franchise stores using a license internationally, and Build-A-Bear sells products from its web site. The company uses 5 pop up locations and 3 non traditional stores in Major League Baseball stadiums,a zoo, a science center, an airport, and a hospital. The company reports financial results in 3 segments:

  1. Company Owned Stores

  2. Business Partners (Licensing and Wholesale)

  3. Franchise Sales (International)

Build-A-Bear has had poor performance as a public company. Sales from 2007 to 2011 have declined 17.1% from $475 million in 2007 to $395 million in 2011. Operating cash flow has dropped significantly as well, from $56 million in 2007 to $16 million in 2011, a reduction of 72%.

Most Recent Quarter Results

In the first quarter of 2012 (reported May 7, 2012), total revenues were $95.2 million, up 1.6% from the first quarter of 2011. Sales in North America increased 3.6% due to Easter products and promotions. European sales declined 10.1%, with e-commerce sales up 9.1%, excluding the impact of foreign exchange fluctuations. During the announcement, management stated its goals for the 2012 year:

  • Creating and implementing a new store design to improve store traffic. Initially it will be rolled out in 6 stores.

  • Improve store productivity and profitability by closing and transferring selected locations and reducing square footage in others.

  • Making Build-A-Bear into a leading location for gifts.

  • Increasing Build-A-Bear's global identity by opening a net total of 10-12 international franchises.

  • Improve (reduce) the cost structure by an estimated $9 million dollars.

Focus On Improved Marketing Strategies

Build-A-Bear is focused on better results with a variety of marketing strategies designed to improve the customer relationship. Some of these efforts include:

  • A partnership with the Girl Scouts.

  • Tie in with the highly successful Avengers movie to help results with boys.

  • Tie in with McDonald's.

  • A product line for the upcoming 2012 Summer Olympics in London.

  • A new product line involving farm animals.

  • The introduction of the new store design incorporating improved interaction tools for kids.

  • Social Networking efforts and new applications to help attract, retain, and improve customer relationships.

  • The Build-A-Bear Facebook page has over 2 million likes.

  • Increased effort on releasing new digital products, like iPad applications.

Valuation

The main reason for a possible investment in Build-A-Bear is the stock market has put it on sale. The current stock price is $4.23 and the market capitalization is 16.45 (shares outstanding)*4.23=$69.59 million. If we subtract the cash on the balance sheet, the total enterprise value of Build-A-Bear is 69.59-36=$33.5 million.

Over the last three years, cash flow from operations has averaged $20.673 million per year (23.990+22.021+16.010/3). Capital expenditures over the last three years have averaged $11.99 million per year (8.898+13.766+13.318/3). Consequently, the average free cash flow the company has produced over the last three years is $20.673-11.99=$8.379 million.

Based on these averages, there are different ways of calculating what you are currently paying for the business. If you base it on a Market Cap/CFO basis, you would be paying $69.59/20.679=3.36 x cash flow from operations.

If you base it on free cash flow, you would be paying $69.59/8.379= 8.30 x free cash flow.

If we back out the cash and make enterprise value our numerator, these figures get significantly smaller: 33.5/20.679=1.62 x cash flow from operations.

If we use free cash flow as the metric, 33.5/8.379= 3.99 x free cash flow.

If you were not convinced BBW is cheap, let's take a look at two of its competitors :

Kid Brands (NYSE:KID) and Crown Crafts (NASDAQ:CRWS) could be considered competitors in that it sells products to infants and kids.

Here are some key statistics of Kid Brands

(All statistics provided by Yahoo Finance on June 9, 2012) :

Income Statement

Revenue:

248.00M

Gross Profit:

35.85M

EBITDA :

5.64M

Net Income Avl to Common:

-39.12M

Balance Sheet

Total Cash:

878.00K

Total Cash Per Share:

0.04

Total Debt:

48.33M

Valuation Measures

Market Cap :

48.02M

Enterprise Value:

95.47M

Trailing P/E:

N/A

Forward P/E:

4.89

PEG Ratio:

0.47

Price/Sales:

0.19

Price/Book:

0.53

Enterprise Value/EBITDA:

16.94

Here are some key statistics of Crown Crafts:

Income Statement

Revenue:

87.62M

Gross Profit:

20.09M

EBITDA :

9.54M

Net Income Avl to Common:

4.83M

Balance Sheet

Total Cash:

279.00K

Total Cash Per Share:

0.03

Total Debt:

0.00

Operating Cash Flow:

9.44M

Valuation Measures

Market Cap:

53.60M

Enterprise Value:

53.32M

Trailing P/E:

11.33

Forward P/E:

9.57

PEG Ratio:

0.78

Price/Sales:

0.60

Enterprise Value/EBITDA:

5.59

Let's look at Build-A-Bears comparable statistics:

Income Statement

Revenue:

394.76M

Gross Profit:

160.15M

EBITDA:

23.08M

Net Income Avl to Common:

-15.83M

Cash Flow Statement

Operating Cash Flow:

16.18M

Market Cap:

69.59M

Enterprise Value:

33.40M

Trailing P/E:

N/A

Forward P/E:

12.09

PEG Ratio:

5.16

Price/Sales:

0.18

Price/Book :

0.55

Enterprise Value/Revenue:

0.09

Enterprise Value/EBITDA

1.45

A key point to consider is the possibilities for BBW if the business improves at all with respect to margins. Build-A-Bear has revenues of almost $400 million per year, over double the size of the comparable companies I used. A 1% improvement in operating margin results in additional 4 million dollars of profit, which is over 10% of the entire value of the business as it currently stands. Any kind of further improvement means large changes in the results of the business on the positive end. I am not factoring in any kind of top line growth changes at all, just how things change if margins improve slightly.

BBW Total Return Price Chart

BBW Total Return Price

Other Important Considerations

Insiders own 26% of the total number of shares outstanding, with the founder and CEO owning over 10% of the company. A director recently bought over $1 million dollars of shares.

One of the reasons why many retailers have problems is they expand into locations which are poorly placed, and Build-A-Bear suffered from the same issue. They are now trying to fix the problem and it will take a while to correct. Management stated capital expenditures for the year will currently range in the $20-25 million dollar range, which means free cash flow for the year will be very minimal.

I visited a Build-A-Bear store in Las Vegas, NV, and was struck by the fact that the place attracts kids, parents, and grandparents. The store was full of product and it brought a smile to my face watching a little boy choose and hug a teddy bear offered by his parents. Build-A-Bear management has done a commendable job of building a company with a set of values which are inspirational.

There is a story on the web site of a young lady with cancer who chose the name for a teddy bear which is now used by the company for charity donations. Kids from all over the world enjoy this company, and I don't see that changing any time soon. Teddy bears may not currently be a growth industry, but they are not going to disappear either. Investing is not about choosing securities based on heart warming stories. I think there is a place in portfolios for these kinds of situations, and when you feel good about the values of the management and company, it makes it easier to throw down your hard earned dollars.

A few years ago, Crocs (NASDAQ:CROX) had poor performance and the stock cratered to below $1 per share. It has since recovered to over $10 per share. Build-A-Bear could be one of those kinds of situations in a few months' time.

Source: 2 Turnarounds In Specialty Retail Trying To Follow Starbucks' And McDonald's Lead - Part 1