bed bath beyond (bbby) stock report

Bed Bath & Beyond (Nasdaq: BBBY)

An Analysis and Valuation of Bed Bath & Beyond

By James Cullen, for Wall St. Newsletters Originally Released January 3rd, 2008

Made Public January 23rd, 2008

http://wallstnewsletters.com

Foreword

Numerous economists, market forecasters, politicians and others have weighed in on the odds of a recession in the US - that is, a decline in GDP for two or more consecutive quarters. Whether or not a recession occurs, or is already underway, is a matter of pure speculation. Attentions should be focused on prudent investments and not on divining economic data. There are two approaches frequently advocated in difficult eco-nomic times. The first revolves around chasing growth stocks under the thesis that, as fewer companies grow quickly, those that do will be better rewarded by the market as a whole. The second favors predictable, stable companies - conglomerates, consumer staples, and general blue chip, mega-cap names. Both methods have their place. Certain growth names will perform well, with the obvious caveat that the growth must be for real. Too often, however, I find the growth stories have a high degree of un-predictability, and the stocks are not be cheap. Dogs may chase, but prudent investors should not. With the second strategy, it is difficult to argue against names like Coca-Cola (KO) or Proctor & Gamble (PG) given their enormous economic moats. The stocks, however, simply aren’t cheap at a time like this - both trade around 20x EV/OCF. Still, the idea of buying a consistently high-performing company at a reasonable price should be particularly appealing at a time like this. I will argue that the company in this report may be the most con-sistent high-performer of the last decade, although it trades at less than 60% of the valuation of more well-known firms that are known as “recession stocks.” The Stock Masters offer their Recession Resistance Newsletter free to all Full

Monte subscribers, or just $4 separately.


Consistency of Operations

The market as a whole tends to reward companies with highly pre-dictable operating results. As I mentioned earlier, most mega-cap staples companies (i.e. PG, CL, KO, PEP, MCD) tend to trade at about 25x earnings and 20x operating cash flows. BBBY, on the other hand, trades around 13x earnings and 11x operating cash flows. On the surface, this comparison may seem fairly ridiculous: yes, BBB does have a store base nearing 1,000, but it is still has nowhere near the ubiquity of the aforementioned examples - some-thing I’ll readily acknowledge. At the same time, consider the com-parable performance data over the last decade:

Bed Bath & Beyond has continually maintained gross margins in the low 40% range; standard deviation is 0.70%, lowest of the group above on both a gross and adjusted (coefficient of variation) basis.


Gross Margins over Time

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

BBBY

KO

PEP

MCD

PG

CL


Bed Bath and Beyond has also steadily turned in operating margins in the low double-digits. Again in this case, BBBY has the lowest standard deviation of returns of the group. The next two metrics to consider are about profitability: ROA and ROE. On both fronts, Bed Bath & Beyond has historically done an excellent job delivering results: ROA averages over 16% and ROE averages over 24% in the last decade with little variation. This feat has been accomplished because marginal return on invested capital has held steady, meaning that the company can deploy additional dollars of capital at little or no discount to its current rate of return. See graph, page 9.


Operating Margins over Time

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

BBBY

KO

PEP

MCD

PG

CL


Using return on assets, Bed Bath & Beyond once again has the low-est standard deviation of the group (absolute and adjusted) while having the highest average ROA. Similarly, BBBY has posted an excellent ROE over the past decade:


Return on Assets over Time

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1 2 3 4 5 6 7 8 9

BBBY

KO

PEP

MCD

PG

CL

BBBY Return on Equity

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007


2007 was the first year Bed Bath & Beyond did not post double-digit returns on marginal invested capital. Previously, returns have averaged 21.5% using operating cash flow (OCF) and 19.75% us-ing net income. This datapoint is currently a minor concern, but something worth monitoring going forward. More recent financial data indicates that returns on marginal invested capital are re-bounding somewhat, although they could remain depressed vs. long-run mean over the next several quarters as a difficult spend-ing environment is likely to be realized.


Marginal Returns on Invested Capital

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

1999 2000 2001 2002 2003 2004 2005 2006 2007

OCF

NI

Bed Bath: Financials

Bed Bath & Beyond ended Q2 of FY2007 with $584 million in cash and equivalents and no long-term debt. Because BBBY has a large net cash position on its balance sheet, we will use an Enterprise Value” (EV) approach to calculate many financial ratios. Using mar-ket capitalization would not give an accurate assessment of any relative valuation measures such as Price-to-Earnings (P/E) or Price-to-Book (P/B). By using Enterprise Value, we can get a more holistic picture of BBBY’s financial state. BBBY has an Enterprise Value of $6.93 billion. • BBBY’s last trade as of January 2nd was $28.36 • The 52 week trading range is $27.96 to $43.32 • Because BBBY is a retailer and finances many of its store loca-

tions through operating leases that do not create assets or li-abilities listed on the balance sheet, price-to-book or other book ratio metrics will not be used here

• BBBY trades for 6.65x EV/EBITDA • Trailing twelve month (ttm) Operating Cash Flow was $657.8

million, for an EV/OCF of 10.5x • Capital Expenditures (ttm) totaled $335 million, mainly attribut-

able to new store expansions. While this number may come down slightly in the intermediate term (3-5 years), it looks ap-propriate given the company’s current expansion strategy.

• Adjusted Free Cash Flow (ttm) was $322.8 million


Risks

Investing in equities involves risk. Certain risks are systematic and cannot be diversified away; this “market risk” includes global mac-roeconomic shocks including but not limited to economic slow-downs, recessions and wars. Bed Bath & Beyond also carries spe-cific risks. This includes but is not limited to: • Consumer preference risk. BBBY must identify and react to

changing fashion trends in a timely manner or risk potential sig-nificant adverse results including lower sales and profits as well as losses due to higher markdowns.

• Other operations risk. This includes but is not limited to the cycli-cal nature of retail and effects of that variable.

• Competition. BBBY competes against a number of companies in a fragmented market, some of which may be more well-funded or better positioned than BBBY, including in the ability to respond to consumer fashion preferences. There is no guarantee BBBY will be successful in its operations.

• Growth plans. BBBY relies on new store openings and increasing same-store sales to drive profitability. Should the company be unable to deliver on this strategy, their financial position could suffer.

A complete list of risks can be found by accessing Bed Bath & Be-yond’s latest SEC filings. Additional Note: January 3rd will mark the release of quarterly earnings for the stock, which may result in high levels of volatility — including the chance that BBBY declines significantly on or shortly after the earnings announcement.


Profitability Metrics

One key part of my assessment of a business is its ability to con-vert capital invested into cash. The best businesses have a high Re-turn on Invested Capital (ROIC). ROIC is measured against a com-pany’s cost of capital. A ROIC in excess of cost of capital means that management creates shareholder value for each dollar in-vested in it; a ROIC below invested cost of capital means that man-agement is destroying shareholder value. I believe that this meas-urement of ROIC is superior to other measures of efficiency and profitability such as Return on Assets (ROA) or Return on Equity (ROE) because the ROIC approach equalizes differences in financ-ing structures and focuses on the cash-on-cash yield from a com-pany’s operations. While I prefer businesses with a high ROIC, good businesses also will continue to increase ROIC in excess of the cost of capital. Studies of past stock history also suggest that an in-creasing spread between ROIC and cost of capital is an important driver of a rising stock price.


Bed Bath: Profitability

There are several different measures that can be used to calculate our formula for ROIC. Each specific measure allows us to isolate on specific aspects of Bed Bath’s profitability. • Earnings Before Interest and Taxes (EBIT) allows us to see how

effective at generating profits Bed Bath is before “non opera-tional” costs related to financing structures and tax efficiency are taken into consideration.

EBIT ROIC (ttm) was 33.1%, compared to FY2006 EBIT ROIC of 32.8% and FY2005 at 37.3% • “Owner Earnings” uses adjusted net income, but excludes depre-

ciation and amortization charges and takes into account capital expenditures.

Owner Earnings ROIC (ttm) is 38.3%, compared to 36.9% in FY2006 and 37.0% in FY2005. • Structural Free Cash Flow (SFCF) adjusts net income for changes

in working capital, excludes non-cash charges, and subtracts capital expenditures necessary for continuing operations.

SFCF ROIC (ttm) was 11.4%, compared to FY2006 at 10.4% and FY2005 at 18%. • Maintenance Free Cash Flow (MFCF) takes net income, adjusts

for changes in working capital, and separates expenditures used to grow the company from expenditures required to continue op-erations. We feel this is an appropriate metric because of the current large capital expenditures needed by Bed Bath to open new store locations.

MFCF ROIC (ttm) was 23.25%, compared to 21.6% for FY2006 and 27.0% in FY2005. ROIC has been relatively stable, as one might predict from much of the earlier data. Overall, the company enjoys good returns and cre-ates value with its investments.


Bed Bath: Valuation

We make only one main assumption for this fair value estimate: 1. Bed Bath’s performance will hold steady in future years If we were to put a freeze on all of Bed Bath’s expansion plans and only allow the company to operate from its present store base, what would the company be worth? The valuation then becomes MFCF (see page 13), plus a minor add-back to offset previous in-ventory builds, with growth being something in the low to mid-single digits to represent comps increases. The inventory correction is worth about $30 million, and comps growth of 3% is conserva-tive given that it roughly equals general US economic growth and discounts Bed Bath’s own particular strengths. Cost of capital as determined by the capital asset pricing model (CAPM, diagram at right) is 9.36% using 1–month Treasuries as risk-free, BBBY’s beta of 1.55, and determining the expected market return by taking the S&P 500 earnings yield (from 20.7x earnings and a 2.3% dividend yield). Using those assumptions, I derive a value for the stock of $28.40, or 3.5% below the most recent close. This means that the mar-ket is pricing Bed Bath & Beyond as a company that will

never grow again. This market valuation also ignores the nearly $2 billion in net tangible assets the company has excluding its cash position. Because we have established that Bed Bath creates value through its store investments (page 13), a more realistic fair value is up-wards of $41/share, or 40% above the most recent close - a value that utilizes 8% intermediate annual growth and a 10.7x terminal cash flow multiple, which itself looks to be close to trough and thus on the conservative side.


Bed Bath: Final Word

I believe Bed Bath & Beyond shares are significantly undervalued relative to projected future cash flows. Although no guarantee can be made about the accuracy of such forecasts, using conservative estimates leaves investors a margin of safety to cushion any disap-pointments that may occur. BBBY shares have been taken down by fears of the company’s potential association with the housing mar-ket (see Appendix 1, page 14) and while this may present an op-portunity it also requires a caveat: I have no knowledge of when this seemingly nonsensical correlation will end. There is a very real risk that the performance of the stock will not match the perform-ance of the business (which I anticipate will be good) for an ex-tended period of time. Buying BBBY is a bet on a company with a proven history of perfor-mace; very few companies can boast of the ability to generate a 25% ROE year after year, and those that do typically do not trade at low double-digit earnings multiples. There are stock buybacks authorizing the repurchase of more than $1 billion in shares, but whether or not this will act as a floor on the stock price is currently unknown. With a situation like this where the market looks to be pricing in zero growth, patience will be required. At the same time, the potential rewards for buying such a profitable company at a very reasonable price should make your investment worthwhile. Review the information again with an eye to the January 3rd earn-ings release date.


Notes and Disclosures

• This report is by no means a recommendation to take action for your personal portfolio. It is recommended that you consult your own investment, legal, and/or tax advisor before acting on any information contained within this report. Failure to seek profes-sional, personally tailored advice before acting could lead you to act in a manner contrary to your best interests; consequences include but are not limited to loss of money.

• Equity valuation involves the use of theoretical pricing models and estimates of factors such as future earnings growth and eco-nomic trends, none of which are guaranteed to be accurate.

• At the time of this report, the author had no financial position in BBBY, however, the author reserves the right to take a position (long or short) at a later date.

• This report was prepared independently, and the author has no relationship with BBBY. All opinions, estimates, and/or other sub-jective statements are the author’s own.


Appendix 1

While it is difficult to prove (or disprove) spending correlations be-tween BBBY and housing, consider the following period from early 1998 to early 2003, when housing starts saw no real growth, and the economy saw a recession.


BBBY Income. Statement (Rev - Left, Inc - Right)

0.00

500.00

1,000.00

1,500.00

2,000.00

2,500.00

3,000.00

3,500.00

4,000.00

1999 2000 2001 2002 2003

0

100

200

300

400

500

600

Revenues

Op. Inc.

Net Inc.

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