Bed Bath & Beyond: Short On Clarity, Long On Opportunity

Summary

• Bed Bath & Beyond's net margin has likely bottomed and guidance above current levels could send the stock upward.
• The company's sales trajectory should be flat to positive over the long term due to its successful and rapidly growing online business.
• One main reason for the attractive valuation is the lack of clarity/communication from management.
• Considering the attractive financial metrics/valuation and lack of clarity, a transformational transaction is certainly possible.

Bed Bath & Beyond (BBBY) is a retail stock investors should consider despite the company's recent profitability compression and poor results.

The company is still nicely profitable despite all of its recent challenges from Amazon (AMZN) eating up market share to foot traffic declines in its brick and mortar business. Much of the recent margin pressure is due to management investing for the long term success of the company while ignoring the short term impact on profitability to some extent. Without a capital markets day, company road shows or even clear strategy discussions on results calls, investors are left largely in the dark in terms of where the company's current strategy is meant to lead in terms of margins, growth or number of store locations. While clearly a challenge, the lack of clarity can also be viewed as an opportunity as it potentially pushes the stock price down despite the underlying business being well positioned for the long term. In the meantime, the attractive valuation offers investors some protection on the downside while the company works through its challenges.

Purpose of this article

We published an article on Bed Bath & Beyond in September of 2017 which reviewed possible top and bottom line outcomes for the company. This article will offer a quick update of our projections and investment thesis from that piece as well as a discussion regarding management's communication style and its potential impact on the investment case. We will also incorporate some key items for the upcoming quarterly/yearly results (scheduled for April 11th) such as tax changes, potential transformative transactions and the earnings trajectory.

An update on the top line

In September of 2017, we offered an analysis of the company's revenue trajectory and the mix between brick and mortar versus online sales. We offered a base case demonstrating why the company should be able to keep the top line relatively flat for several years before returning to reasonable growth. The core of the argument is that the rapidly growing online business will offset weakness in brick and mortar and eventually lead to overall sales growth as it becomes a larger and larger chunk of the business.

Not much has changed from our original projections. Online sales continue to grow in excess of 20% and are now above 15% of turnover. Sales are essentially flat year over year with low single digit declines in stores offset by growth online and some non-comp sales, including One Kings Lane, PMall and new stores. We have tweaked our growth projections which you can see in the table below. Our estimates consider company top line guidance for fiscal 2017 (shown as 2018 in the table below) including a low single digit percentage decline in comparable sales for the full year and consolidated net sales for the full year that are relatively flat to slightly positive including a slight benefit from the 53rd week.

Source: Estimates from Oyat Advisors, USD millions

The end result is that the top line continues to be steady while the company transitions to more online sales, and the low single digit declines in existing stores should be quite manageable and shouldn't result in a negative shock to the top line going forward.

Looking just at the top line, it seems quite reasonable to assume stability or even reasonable growth going forward. Using Benjamin Graham's P/E base of 8.5x for a no growth company and current company guidance for $3 per diluted share, shouldn't Bed Bath and Beyond be trading at $25.50 or higher?

Of course, the bottom line is where most people are focusing currently.

An update on the bottom line

In our September 2017 article, we reviewed a number of scenarios regarding margin levels Bed Bath & Beyond could achieve. But perhaps it's not most important to discuss what margin levels the company could achieve over the long term but rather where the margins will bottom now. The main reason the stock has been punished recently is that the net margin has declined significantly and management is not providing any clarity on where it may stabilize. Consequently, if investors get comfort that margins have bottomed, the stock will likely recover significantly before needing to inch back up to more attractive levels. So we will focus this discussion on why we think we are near a margin floor and why the valuation is still attractive even at current lower margin levels.

Our original article mentioned a "Walmart Scenario" where net margins stabilize near Walmart's longer term average net margin of around 3.4% (Bed Bath & Beyond's long term average is closer to 8%). This is also the approximate margin level implied by current guidance. We don't see any reason why the margin should fall materially from this low level. There are several reasons we believe margins have essentially bottomed including the following

The first argument stems from analysis of the peer group. It is comforting to see that other decent quality companies in the industry can achieve net margins of 3% or significantly above even given current challenges. Even commodity focused companies or companies facing heavy pressure from the shift to online purchasing achieve a reasonable net margin. If we give BBBY some credit for historically being an above average profitability company and having a functioning supply chain, it is realistic to assume BBBY will not drop below the 3 - 3.5% threshold for net margin.

More importantly, the current margin level contains just about as many negatives as we can think of. Said a different way, we just don't see where incremental margin pressure will come from. The company's fiscal 2017 results will include negative impacts from items such as:

• The investment and ramp up of a large new distribution facility in Las Vegas and a new customer contact center near Orlando.
• Elevated spend on technology projects including investments in digital capabilities and new in-store systems.
• Under-scaled online business and a shift to online in general.
• Hurricane impacts
• High couponing and advertising spend levels
• Restructuring charges related to the accelerated realignment of store management structures
• High tax rate (compared to the new 21% US corporate tax rate)
• Consultancy fees (the company mentions Accenture for example)

The current margin level simply has a lot of negatives included already, and it's hard to see where material incremental negatives will come from. In terms of capex, management has actually been quite clear that it should plateau around current levels, so we don't see why incremental margin pressure should come from unexpected additional investments. Around half of fiscal 2017 capex will end up going into technology related projects to support omnichannel capabilities which should improve the efficiency of fulfilling online orders when combined with investments in supply and distribution like the new Las Vegas facility. After many quarters of elevated spend and technology investment, a plateau has likely been reached and efficiency gains should be expected going forward.

The online business has been in a ramp-up phase and is still growing in scale. The larger the scale, the more likely it is that margins improve. The company has also been busy tweaking shipping and distribution including new distribution centers and direct from vendor shipping which should all help improve the online margin in the coming quarters. There is surely still plenty of inefficiency in the online business, but we see little to no reason that the margin should face additional pressure going forward and efficiency gains from scale and technology should at least offset any pressure from cannibalized brick and mortar sales.

One-off impacts such as hurricanes and management structure realignment will hopefully not resurface. But even if they do, they won't be an incremental negative. And there has already been quite some attention given to the high level of couponing and advertising spend as well as the optimization of free shipping thresholds. These items may or may not continue going forward, but it is hard to imagine them increasing significantly from already elevated levels meaning no incremental margin pressure should be expected.

When we add in the impact of a significantly lower tax rate going forward, it certainly is hard to imagine that net margins will go lower from current levels.

Where could we be wrong? It is possible that the fall in brick and mortar foot traffic accelerates. Currently, the low single digit decline in stores is slow enough for management to handle through gradual refurbishments or resizing or simply through lease re-negotiations or terminations as they come due. There shouldn't be a need for drastic restructuring or store closures, and it is unlikely there will be a big shock to margins if things continue around the current rate. A steeper decline than expected in brick and mortar could complicate things however. While this is a risk, the challenges in brick and mortar can also present opportunities for margin improvement. For example, investors may be underestimating the potential positive impact from improved leasing conditions due to pressure on landlords. Bed Bath & Beyond's CEO has himself commented on the fact that they are seeing occupancy cost opportunities come about as retailers go away and there is pressure in the landlord community to fill space. We can also reference comments from other large retailers suggesting material savings are ahead such as these comments from Starbucks.

Our conclusion is that the net margin will essentially be stable at worst and likely better over time.

Put it all together and the valuation is attractive

We have supported the arguments that the top line will essentially be flat or up over time while the net margin has bottomed and may even improve. We believe the margin has significant upside potential over time, but let's stick with the discussion about how things look if we simply stabilize things where they are now.

A flat top line and a flat bottom line would lead us back to Graham's P/E base of 8.5x on $3 of earnings per share or a minimum share price of $25.50. That price already provides some upside, but perhaps not the margin of safety some investors want. We prefer to model the company using conservative estimates while using multiples as a double check. A model which uses the top line projections presented earlier in this article combined with stable margin levels already gets us to more than 35% upside. If we drop the tax rate to 24% (conservative compared to the new 21% headline rate) and allow that to improve the net margin with no other adjustments, we get to more than 75% upside. We believe there is margin improvement potential over time and as such could even argue for more return potential.

A note on the balance sheet

We would not entertain such an investment if we did not have confidence in the balance sheet. By most measures, Bed Bath & Beyond has a good balance sheet with reasonable debt related multiples such as a Net Debt to EBITDA multiple around 1x. We draw additional comfort from the fact that the majority of the company's debt is fixed rate and not due for a long, long time. The graphic below shows the maturity for a large chunk of company bonds in 2044!

Source: Thomson Reuters Eikon

So why aren't investors piling in?

The short answer might simply be fear. Retail is changing and risk is elevated which is scaring investors away from companies that haven't stabilized profitability and growth yet. But the real answer likely has more to do with the fact that management is doing essentially nothing from a communication perspective to relieve that fear. The company is quick to tell investors that it's investing heavily in new technology and new distribution while working on numerous initiatives to improve attractiveness to customers. But it does not share any detail on what that will mean for long term margin levels or at least what the company views as an acceptable return level to achieve for the company. Investors are left to decipher for themselves what items are temporary in nature and which ones are permanent. What is the expected margin level of the online business considering all the new investment in the area? Is the margin profile for brick and mortar changing forever or are current challenges being overcome? The company must have some estimates for return on the various investments it's making and what their ultimate impact should be on margins. How else can they determine if the investments make financial sense? We doubt that management has suddenly abandoned its long standing financial discipline and focus on profitability, but it's hard to tell what direction things are headed currently.

The lack of transparency is quite dramatic. There are no investor days or road shows or investor conferences. We think that would be just fine actually, if the company would at least provide sufficient information with its normal quarterly or annual reporting to help us gage the potential profitability outcomes of the company or financial reasoning behind material investments. For example, there is no indication of where online margins should ultimately be relative to historic brick and mortar margins or even information regarding online related fixed costs versus sales. It is even still quite difficult to get information regarding the amount of online sales or the current growth rate.

Without more transparency, investors will likely find it hard to get past the declining profitability and prefer to avoid the name. While we fully understand that strategy, we also see the lack of transparency as an opportunity. The lack of transparency gives rise to a situation where a company can trade at such an attractive valuation while the underlying business fundamentals are doing just fine. When looking at cash flow, ROE, online growth, the balance sheet and still acceptable profitability levels, we tend to believe that is exactly what is happening right now.

On a side note, we do find it hard to ignore that the CEO is significantly over paid currently and that he apparently dominates management and consequently management's communication style. The CEO also earns a large multiple of what the other officers earn such as the CFO which is likely a symptom of his dominance. That might be leading to the inability of the CFO to push through any improvements in investor communication, even if that is not necessarily the CFO's strength. For better or worse, investors are left to figure things out on their own.

Is there something else going on?

The lack of transparency naturally leads to speculation about whether there is something going on behind the scenes. We can imagine two possible or even likely transformational events that could occur.

The most likely is perhaps that the company wants to take itself private. If the company wants to go private, it might explain why it is not giving investors any more information than it has to. It even avoided most discussions around the highly positive tax changes. The other option is that the company will be taken over. In this case, you'd think that the company would want to be more transparent about positive developments such as the tax changes or potentially give more comfort as to where margins will plateau.

In the end, it is all speculation. But besides the attractive cash flows and attractive valuation that might inspire a transformational transaction, we can mention a couple curious items. The first is that the company filed an 8-K recently which addresses the CFO's employment conditions. It wouldn't be farfetched to think there will be a change in the position or something more transformational, but it doesn't necessarily mean anything. An excerpt is below:

Item 5.02 Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain Officers; Compensatory Arrangements of Certain Officers

On November 28, 2017, Bed Bath & Beyond Inc. (the "Company") entered into an amendment to its employment agreement dated October 6, 2014 with Susan E. Lattmann, Chief Financial Officer and Treasurer. The amendment, effective as of November 1, 2017, removes the requirement in the agreement that any severance payable to Ms. Lattmann be reduced by any monetary compensation earned as a result of her employment by another employer or otherwise. The amendment also adds a trigger for severance payments in the event of a "constructive termination," defined as the Company's relocation of Ms. Lattmann's place of employment by more than twenty-five miles, or the Company's material breach of one or more terms of the employment agreement. The amendment reduces the period of required post-employment non-competition from two years to one year, but provides the Company with the ability to extend the period of non-competition for an additional year provided the Company also extends severance payments for such additional period. Further, the amendment adds a requirement that Ms. Lattmann deliver a formal release of all claims prior to, and as a condition of, her receipt of any of the severance payments or other post-employment benefits described in the agreement, as amended.

Source: Company 8-K

The other item is the change in share buybacks. If we look at the amount of share buybacks over recent quarters, we can see a big fall off in the fiscal 2017 third quarter. That's a bit of a surprise considering the low share price and still attractive cash flow of the company. The answer might be that the company is a poor capital allocator or simply thinks that share buybacks are suddenly no longer attractive, but the answer might also be that there is a potential transformative transaction in the near future that would prompt the company to stop or adjust its share buybacks. Management likely can and has only answered questions on this topic very generally which leaves the door open to speculation. If you look at the chart below, you can see that the company did indeed slow its purchases in the Q3, but the reduction does seem to follow the pattern set in 2016 and follows a general reduction in the first couple quarters of fiscal 2017. It will be interesting to see what happens in the Q4.

Source: Company 10-Qs

It's not clear, but Bed Bath & Beyond is a buy with a bonus

Bed Bath & Beyond is a value creating company which has historically enjoyed above average margins. Recent transformation of the retail industry through a shift to e-commerce and the rise of powerful competitors such as Amazon has pressured the company's business model and profitability levels. Bed Bath & Beyond is responding to industry challenges by building up a fast growing and successful online business while investing in the future strategy of the company. The need for large and concentrated investments in the short term to support the viability of a business in the long term often scares off increasingly short term focused investors as profitability suffers. But Bed Bath & Beyond's success in the online space demonstrates the company's ability to come through the retail transformation with a competitive and growing business model. There may be a lower normal for Bed Bath & Beyond's profitability going forward, but it is unlikely that margins fall materially from current levels. Even at current margin levels and low to no growth, the company has an attractive valuation with significant upside and should be seriously considered by long term investors. Investors have to accept the lack of transparency from management but are at least compensated with a speculative bonus in the form of a potential transformational transaction.

Analyst’s Disclosure: I am/we are long BBBY. 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.

The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.