Bed Bath & Beyond: Activist? Does It Matter?

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About: Bed Bath & Beyond Inc. (BBBY)
by: Michael Wiggins De Oliveira
Summary

Activist shareholders are discussed.

Long-term EPS guidance update is not given enough weight.

Capital allocation strategy is questionable.

Ultimately, it's unquestionably undervalued.

This article was originally sent out to my marketplace subscribers.

Bed Bath & Beyond (BBBY) has a lot going for it. Right off the bat, it's very cheaply valued. It has a rock-solid balance sheet. It's very free cash flow generative.

On the other hand, its management team is appalling. Shareholder activists are involved, in the hope of shaking up the business. While I don't expect these activists to succeed, I very much believe that shareholders should be able to clear 50% from the present trading valuation of $2.5 billion.

Activist Shareholders - Does It Matter?

Despite making headlines of owning approximately 5% of Bed Bath & Beyond, the activist don't actually own that much of the common stock, as a significant portion of the common is only beneficially owned via long-dated call options.

Of course, this is not the end of the world, as you will hopefully know that I was highlighting Bed Bath & Beyond meaningfully before the activists became involved, as I feverishly believe the stock is undervalued. Why am I bringing this up?

Because, sadly, despite the enthusiasm and clamoring for changes, I don't trust these activists to have much pull on the board's reshuffling and ousting of CEO Steven Temares.

Put another way, I believe rightly or wrongly, the only realistic strategy toward realizing a gain for present shareholders will be for the company's operational performance to stabilize and deliver evidence of improvement. Now, on this front, I'm willing to invest.

Accordingly, I think there's upside potential in Bed Bath & Beyond because its operations are likely to improve, and it's too lowly valued, offering shareholders a substantial opportunity to profit from its present market cap of $2.5 billion.

Long-Term Guidance

Neither I nor the market is willing to give this management team any benefit of a doubt. The earnings call was as to be expected from Temares and CFO Robyn D'Elia - nothing but evasiveness. However, if we focus on the tangible numbers provided and work with these figures, I trust we'll be in good footing.

The company continues to be highly free cash flow generative, bringing in $592 million of FCF in 2018, making its balance sheet for fiscal 2018 with under $480 million of net debt. Meaning that its balance sheet is rock solid and that Bed Bath & Beyond could fully clear its debt within two years if it so wished.

Capex for 2019 is guided toward $350 million to $375 million, which is an increase of about $35-50 million, but nothing extraordinary.

The big figure which should raise eyebrows is that adjusted EPS is now guided to be between $2.11 and $2.20 for fiscal 2019. Seen as how many, myself included, were expecting around $1.50 just six months ago, this was very positive.

Looking further out than fiscal 2019, and into fiscal 2020, there's the "jam tomorrow" story of double-digit growth rates in net earnings per diluted share.

What this actually means is that most investors will be thinking that over the coming 12 months, investors will be sticking a 10X multiple to earnings, and if forward guidance for fiscal 2020 is announced at an adjusted EPS of $2.32, the stock should rerate to approximately $23, for at least a 30% upside potential, without any heroics of any sort, although I think 10x is inappropriately low.

Capital Allocation

I'm not a dividend investor and consider dividends a horrendous capital allocation strategy, if for no other reason than the fact that dividends get taxed at the corporation level (and potentially at the individual level, too).

However, there are many investors who are dividend-seeking investors and might consider a 3.5% dividend yield appealing, particularly seen as how the dividend will have increased by 6.3% on a year-over-year basis, as well as, increasing by 50% from fiscal 2017 to fiscal 2018.

What I do worship are large share repurchases. This appears to be satisfactory, too. With fiscal 2019 expected to see $225 million set aside for repurchases, a 52% increase over fiscal 2018. And, just 10% off fiscal 2017, when Bed Bath & Beyond was in a much stronger position. Down the road, together with $400 million worth of repurchases, fiscal 2020 EPS is expected to hit around $2.60-2.70 (slide 13), which appears to be disproportionally ambitious.

However, please note that while not discussed on the call but instead highlighted on slide 14, management is essentially highlighting that, presently, its net debt/EBITDA finished at 0.8x and that the company appears to be satisfied with this level of debt and has no plans to use the cash to pay down debt, as they evidently believe that share repurchases are the best use of capital.

Furthermore, I would not be cynical enough to argue this is simply to keep their jobs, because, historically, under Temares, Bed Bath & Beyond has had no issue with strong repurchases either.

In summary, despite having little trust in this management team and the fact that this same management team has in the past been very much capital destroyers, I am still happy to see them returning $315 million to shareholders in fiscal 2019, or 11% capital return yield from the present market cap valuation. And a further $485 million in 2020, or a 32% capital return over the next 24 months.

Valuation

We know that retail is struggling. That is not news to any investor. The table above highlights cash flows from operations (before capex) and P/Sales. With the exception of Wayfair (W), the peer group appears out of favor as a whole.

So, why should Bed Bath & Beyond be worth more? I fail to see why shares should trade for less than 6x FCF? We know that revenue is expected to come down by 5% in fiscal 2019, but then, it is expected to be flat in 2020.

However, management is expecting some benefit on the gross margin of 200 basis points over the next two years and 100 basis points benefit on SG&A, so that by fiscal 2020, Bed Bath & Beyond's operating margin could approximate 3.8%.

In conclusion, Bed Bath & Beyond has a turnaround plan. Very slowly, it is gaining some traction.

Investment Risk

There are three main investment risks here. First, this management team's total ineptness continues to preside. There's literally nothing to inspire hope that the activists will succeed in shaking up the board and getting a new CEO in place.

Secondly, again going back to management, a lot of my thesis is contingent on management delivering upon their fiscal 2020 target of double-digit EPS to approximately $2.60-2.70. If this team were to fail to deliver on their guided operating margin improvement of more than 300 basis points in fiscal 2020, the share price could continue to implode.

Thirdly, the retail landscape is changing at a rapid pace. There's indeed a retail revolution going on. Online competitors are aggressively taking market share. This is not going to abate anytime soon. It will most likely only get worse going forward. Wayfair and others are entrepreneurial-minded, motivated, and succeeding in taking market share, although I should note that Wayfair's revenue has started to slow down, while its debt continues to increase and its free cash flow burn shows no sign of slowing down. I'm not convinced that being at the mercy of creditors makes for a great business model either.

The Bottom Line

I remain optimistic that the present valuation implies that not only it's cheap but also that this management's lack of motivation already is factored into the share price.

If Bed Bath & Beyond continues to deliver strong free cash flow as is expected, there's no rational reason for the company to trade as cheaply as it does. I continue to hold out for $27 per share and will update (my subscribers) as we progress.

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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.