Bed Bath & Beyond: No Bottom In Sight

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About: Bed Bath & Beyond Inc. (BBBY)
by: Mike Berner
Summary

Bed Bath & Beyond has trapped value investors over the last few years with the allure of a low P/E and strong balance sheet.

However, operating margins have fallen much faster than anyone anticipated, decimating earnings.

Without any real assets, the valuation relies entirely on future cash flows, which now look dubious.

As long as margins continue deteriorating, there is no bottom for the stock.

For the last six years or so, we have heard over and over again that Bed Bath & Beyond (BBBY) is a value stock. I mistakenly lent my voice to that consensus a year ago when the retailer's valuation looked too low to ignore. Even noted value investor Joel Tillinghast of Fidelity argued that the shares were cheap based on future cash flows.

In the two years I have written for Seeking Alpha, my November 2017 buy case for BBBY has been my worst call by far. Since that time, the stock has plunged more than 50 percent. Shares are at their lowest level in 20 years.

What happened? In two words, profit margins. BBBY's deteriorating margins, now at less than 5 percent, are already below what I considered the "doomsday scenario" with no sign that they will improve soon. Fierce competition has left the chain struggling, even with a booming economy and strong consumer.

Chasing Fool's Gold

BBBY did - and still does - have a few good things going for it. The company is profitable and generates a lot of free cash, $1 billion of which sits on the balance sheet. The company's solid financials and rock bottom P/E attracted many value investors, some of whom speculated that the retailer could be sold to private equity. I myself touted the company as a sum-of-the-parts play based on the value of the company's cash flow and ownership of the Christmas Tree Shops (and That!) discount chain.

However, no one predicted just how fast and far that cash flow would shrivel up. Between 2012 and 2018, BBBY's revenue grew from $9.5 billion to $12.3 billion as the company opened more and more stores, but the operating margin fell from 16.5 percent to just 4.9 percent over the same period. Comparable store sales have also trended negative over the last few years.

As a result, earnings fell from a $1 billion in 2013 to $350 million over the last twelve months. The company also took on $1.5 billion in debt and plowed much of the proceeds into stock repurchases, with little to show for it. Shareholders simply obtained a bigger piece of a shrinking pie, while the company blew its equity on buybacks at a time when the valuation was far higher.

While chains like Macy's (M) at least own valuable real estate, BBBY follows a leasing model. Since 2014 when it took on debt for the first time, liabilities outweigh current assets. Nearly all of BBBY's market value comes from its future cash flows, which now look dubious.

The Seeds of Failure

Although the immediate cause of BBBY's fading fortunes is crumbling margins, the seeds of failure were sown long ago in the company's insular culture and resistance to change.

As Amazon (AMZN) and discounters like Walmart (WMT) and Target (TGT) marched across the retail landscape, BBBY clung to a business model centered around physical retailing in suburbia and ubiquitous coupons. The company has lagged badly in e-commerce, perhaps out of reluctance to cannibalize high margin in-store sales with low margin online sales. Where department stores and 'category killers' like Best Buy (BBY) closed hundreds of locations, BBBY inexplicably continued plowing capital into opening new stores.

Lethargy at the top likely played a role in BBBY's misfortunes. BBBY operates much like a private firm in practice, tightly controlled by management and insiders. Co-founders Warren Eisenberg and Leonard Feinstein, both in their 80s, remain influential as co-chairmen of the board. Steven Temares, 60, a longtime employee handpicked to succeed the founders as CEO fifteen years ago, has remained at the helm despite the litany of failures. As recently as three years ago, Temares earned $20 million in compensation.

In a rare rebuke, Institutional Shareholder Services recommended earlier this year that investors vote against the renomination of board member Victoria Morrison, citing her lack of relevant experience. Morrison submitted her resignation after losing the vote, but BBBY's board rejected her offer to quit. In 2015, Institutional Shareholder Services awarded BBBY a 10 for governance, its worst possible score.

Too Little, Too Late

Lately, the company seems to have recognized the seriousness of its situation. BBBY bowed to investor pressure by jettisoning several elderly board members and cutting executive compensation. Expansion is now off the table, with the company considering closing forty stores after leases expire this year.

Acutely aware of the chain's heavy product overlap with competitors like Amazon, management is trying to inject more differentiation into BBBY's weak product range. On the Q4 2016 earnings call, the word "differentiated" appears more than twenty times.

Still, wholesale change seems unlikely. The same old faces who remain in charge now talk of new initiatives not bearing fruit until 2020. Analysts broadly agree that the company is moving too slowly on e-commerce. Management argues that it is taking the long view of the future, but it is increasingly uncertain whether the company even has a future at all. If BBBY is underperforming in a strong economy and the best consumer environment seen in years, how will it withstand the next downturn?

Retailing is a precarious business that requires a great deal of working capital. Even a temporary downturn in the business can rapidly lead to default if the company does not have enough cash on hand to pay suppliers and landlords.

BBBY may have $1 billion on the books now, but what happens if the company stops turning a profit? The chain owns no real assets, so there is no floor on this decline.

Disclosure: I/we 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.