Description

Thesis:
SELL.  Trading at a premium to its peer group and at peak multiple, Bed Bath & Beyond (BBBY) is a sell at $68.05, or 15.7x FYE Feb. 2013 P/E and 8.4x FY’13 EV/EBITDA.  In short, BBBY is facing a long term structural and secular decline in its business due to the disruption created by online players such as Amazon (AMZN) and casa.com (a recent launch by an AMZN subsidiary.)  BBBY is also seeing increasing competitive pressures from more focused ecommerce strategies from other players such as William-Sonoma (WSM), Pier One (PIR), Target (TGT) and Macy’s (M). Further, BBBY’s online presence is significantly weaker than its competitors and must use 2012 to invest in the ecommerce business which will compress already peak margins.  Additionally, BBBY has been over-earning over the last several years from a combination of the bankruptcy of Linens N’ Things as well as the exponential growth of a couple of non-recurring exclusive consumable product introductions (e.g. Keurig by GMCR and the Soda Stream Soda Maker by SODA – both of which will soon see wider distribution and competition.) Given the increasing competitive environment, peak operating performance, maturing store base and necessary investment spending leading to lower growth and margins, BBBY should trade in the near-term at 6.5x multiple of EBITDA or $54 per share, about a 20% decrease from the current price. In the longer term, BBBY’s margins should decline to the mid-single digits as it converges to  AMZN over time.  However, in the intermediate term, with increased completion and moving to a more normalized growth rate, estimated margins could be closer to the low double digits (10-11% range – a similar decline percent to what happened to Best Buy’s margins.)  In this scenario, the stock would be worth in the low $30s or almost 50% downside.

Business Description:

Founded in 1971, Bed Bath & Beyond (BBBY) is a home furnishings and décor retailer with over 1,000 stores in North America.  Its largest concept is its namesake with just under 1,000 stores.  Other concepts include Harmon, Christmas Tree Shops and buybuyBaby with 45, 71 and 64 stores, respectively.  Of those concepts, buybuyBaby is the only concept seeing any significant square footage growth and could have a store base potential of about 200 stores while Bed Bath & Beyond is expected to have 1,300 stores. 

Why now?:

Currently, BBBY is at peak margins of over 16% and there are already signs of long term stressors to margins in the form of competition and mix shift.  Additionally, many analysts believe that BBBY’s past comparable store sales performance is a barometer for future performance although a lot of those sales were positively impacted by the closure of key big box retailer, Linens n’ Things and before the proliferation of online/mobile competitors.  BBBY is competing in a new era where it is no longer the leader and must catch up. Comparable store sales also benefited from the one-time inclusion of exclusive consumable products from GMCR and SODA, both of which BBBY has already started anniversarying. Additionally, GMCR and SODA have already seen their own sales slow down significantly as household penetration rates are slowing down.

Variant Perception:
Despite cracks in the margin and the launch of what will likely be a formidable online competitor, casa.com (owned by AMZN), BBBY is up 20.6% year to date vs. 10.6% for the S&P 500 as of the close of trading May 3, 2012.  Of the 28 analysts known to cover BBBY, only 1 analyst is willing to look out longer term and see the secular and structural change that is taking place in this industry.  In its short life, the internet and online players have severely disrupted multiple industries once led by big box category killers from books to gaming to consumer electronics.  Even apparel is currently facing challenges from the online space.  Urban Outfitters, Inc. (URBN), an apparel retailer with strong brand characteristics in a niche market also recently indicated for the first time that they will need to spend significantly to invest in their online presence as their unique store environment was not enough to drive sales/traffic/conversion as it was in the past. Bottom line – the retail industry is changing.  The weak players in each segment will/have failed, but the remaining players continue to struggle and lose market share to the internet. With the rise of mobile, this destruction is likely to be even more rapid.   It is naïve to believe that home furnishings and BBBY will not suffer the same fate as, for example, Best Buy (BBY) with electronics and Barnes n’ Nobles (BKS) with books.  While there remains that customer who might want to touch and feel the product, at the end of the day, price and convenience matter and BBBY could end up being more of a show-room, not unlike BBY is for consumer electronics.

Investment Highlights:

Increasing Competitive Environment

Growth in E-Commerce Competitors –Lead to Loss of Share

BBBY is facing an increasingly significant competitive threat from online-only players as well as brick and mortars competitors who have already made strides in their online investments.  Amazon, the leader in online retailing, is one of the most significant threats to BBBY, particularly as it continues to expand into new categories through its Quidsi.com division, as well as through its main website, www.amazon.com. The latest area is into home furnishings/home décor market through www.casa.com, which launched in February of 2012. At the initial launch, www.casa.com had over 35,000 products and will be adding selection throughout the year.  There is free shipping on orders over $49 and the site shares a shopping cart with other Quidsi sites including the popular Diapers.com, Soap.com, Beauty.com, Wag.com and Yoyo.com.   At launch casa.com provided 20% off an item (basically BBBY’s promotional tool.)  Management recently acknowledged that casa.com could be a significant threat. Amazon is estimated to currently have 1-2% of the home furnishings market but has already made inroads in certain subsectors, such as small appliances (despite it being a major category for BBBY)  where it has about a 6% share and growing versus less than 5% for BBBY.

In addition to Amazon and other online only players, BBBY is facing competitive pressure from other brick and mortar retailers as they ramp up their online presence.  William-Sonoma (WSM) has been heavily invested in their online presence with over 30% of their sales from this channel (grew from 34-38% of total sales in 2011).  WSM’s ability to continually grow online sales indicates that consumers are willing to use this channel (versus an in store experience) for home furnishings/décor.  WSM reiterated their focus to serve their customers anytime/anywhere and stated on their last conference call that they will continue to spend heavily (capex increased to $220M from $130M plus an additional $20M on SGA, which will cost them 30-40bps in GM ) by developing a new ecommerce platform to improve customer experience and conversion. Additionally, WSM is expanding international shipping from 75 countries to 99.  Other players, such as Pier-One (PIR) have also recently improved their ecommerce platforms and added services such as ship to store for pick-up. 

BBBY also faces competition from department store players, such as Macys (M) and jcpenney’s (JCP) as well as mass merchants, such as Target (TGT), who have increased their penetration in the home area.  For example, home is 15% of sales at JCP and, led by new CEO Ron Johnson from Apple, it has recently taken a 16.6% ownership stake in Martha Stewart Omnimedia (MSO) and plans to roll-out an exclusive line of Martha Stewart branded home items in early 2013.   Other retailers have also focused on exclusives or private label, such as the Charter Club at M to drive traffic and conversion. Additionally, these merchants are often very promotional, another negative for BBBY.

Growth of SmartPhones – If You’re Not Online, You’re Not in the Market

Smartphone proliferation has been growing rapidly in the last few years with the launch of the Apple’s iPhone.  Nearly 42% of US mobile subscribers now use smartphones and mobile media usage (browsing mobile web, accessing applications etc) saw rapid growth and increased penetration.  As the phones become more user friendly, they have increasingly become a method of consumers to perform retail research while inside a store or immediately before a purchase.   According to comScore in a study of over 30,000 mobile phone users last year, there are over 90 million smartphone users in America and, of those, two-thirds used smartphones for shopping-related activities.  BBBY is just now using 2012 to really invest and develop their ecommerce platform and distribution capabilities, putting them at a disadvantage to competitors and it run the risk of losing sales if their ecommerce platform is not competitive. 

Peak Margins – Will See Compression

BBBY is currently operating at peak operating margins (if you look over the last ten years), with operating margin at just over 16%.  There are a number of factors, described below, that will be putting near term and longer term pressure on the gross margins.  The long term margin rate likely resets at a lower level of the mid-single digits as it converges to Amazon’s margins.

Increased Promotional Environment

Management has already seen slight margin compression via gross margins after the fourth quarter of 2011 due to increase promotional activity. Despite retailers trying to tame customers’ desires for promotions, the market remains promotional, particularly during key holidays such as Christmas/Post-Thanksgiving.  One of BBBY’s most consistent promotions is its 20% off coupon (for one item). That helps to drive sales and also additional higher margin impulse buys. In Q4, however, couponing negatively impacted gross margins by 40bps. While this sometimes allows BBBY to have a price advantage over competitors on like for like items, that advantage is often eroded, particularly in the online channel, due to shipping costs.  As online players increase their penetration into the home furnishings/domestic goods space, it is likely that we’ll see an increase in promotions in the category. 

Strong Economically Irrational Competitor

While most retailers, BBBY included, must manage their investment spend and growth with an eye towards maintaining/protecting margins, one main competitor, AMZN, does not seem to be held to that same standard.  This is not an insignificant point because AMZN is able to take the hit on margins to fight for market share/sales in any category while its competitors such as BBBY would be punished for following suit.  Amazon’s stock is currently trading at over 80x P/E so clearly it is not being penalized for its investment spend which makes it a formidable and, perhaps, an economically irrational competitor.

Increased Investment Spend

Going forward into 2012, BBBY will be making significant investments to bolster its online presence which includes building out an 800,000 square foot distribution center in Georgia, approximately $30M in cost, as well as reworking/redesigning its webpage, which the company has stated will be dilutive to earnings by $0.09 and which I estimate will compress margins by approximately 30-40bps (if you compare to what WSM’s says its spending impact would have on margins). This is not going to be a one-time cost.  Another indirect cost and margin compression of an online strategy will be the impact of “Free shipping” which BBBY will need to implement particularly to compete with Amazon/casa.com.  Maintaining and continually innovating the ecommerce site/platform will likely reset costs at a slightly higher level versus historical numbers (where it wasn’t much of a priority.)   Also, other bricks n’ mortar retailers, such as Target, have sometimes seen disruption when relaunching their websites, which could negatively impact sales/conversion during that period.  Currently BBBY is a decentralized organization and might find fulfillment of online orders to be more difficult than initially expected which would present itself as poor customer service/delay in receiving the product.

BBBY is likely still in the early stages of this development and is clearly still looking for the right people for this roll-out – on the “Careers” section of its website, the firm is hiring what appears to be a number of key positions including a web planner, director of CRM, Content Development Manager, and Ecommerce Merchandise Coordinator.

Product Mix Shift

Along with the introduction of the Keurig system has come the increased penetration of coffee and other consumables as a portion of BBBY’s total sales/inventory.  While management is reticent to talk about their merchandising strategy, a rise in consumables, as evidenced by other retailers, is usually accompanied by a decrease in margins as those goods are lower margined versus other products.  Management already cited this product mix shift as a reason for some of the margin compression in Q4 and this will likely grow over time, possibly resetting total gross margin to a new lower rate.

Ecommerce Leads to Reduction in Higher Margin Attachment Purchases

Besides weakening sales, the growth of the online channel reduces margins.  BBBY, like BBY, sells many smaller high margin items (impulse buys) when consumers come into the stores to make larger purchases e.g. for a Keurig machine or a flat panel TV.  As consumers move to the online channel, they will use their coupons for the specific item, such as the coffee machine and are less likely to add higher margin items to their cart at check-out, the way they might if they actually visited a store location.  Although we are in the beginning stages for BBBY, BBY saw continued margin erosion as the competitive environment heated up and sales move online. 

Pricing as Key Driver of Conversion – Merchandise/Experience Not Differentiated Enough

The internet and online shopping capabilities allow customers to quick learn and understand products but also find out where it’s selling for the best price.   While in-store customer experience might still be important to some customers, the growth of the Internet, especially after the Great Recession, have kept consumers focused on price as a main sales driver particularly on national brands where a retailer may not have exclusivity.  BBBY believes that its steady comparable store sales gains in the last few years were due to its focus on the customer and the customer experience.  Further, it believes that continued focus on that experience will continue to drive visits and conversion, but I believe that times have changed that that the “experience” alone will not be compelling enough to drive continued and steady comparable sales gains.   BBY said something similar in its 2011 annual report and it has declining sales and margins to show for it.

 “ We believe our dedicated and knowledgeable people, store and online experience, broad product assortment, distinct store formats and brand marketing strategies differentiate us from our competitors by positioning our stores and Web sites as the preferred destination for new technology and entertainment products in a fun and informative shopping environment.”

In February 2012, comScore noted that, “Consumers remained cautious spenders overall, but increasingly turned to digital commerce due to two prevailing factors: price and convenience. TotalU.S.retail and travel-related e-commerce reached $256 billion in 2011, up 12 percent from 2010.”     This does not bode well for BBBY.

While BBBY does not disclose the exact amount of branded versus private label merchandise it carries, management recently stated that it is essentially a national brands warehouse, and thus, I have estimated private label/exclusives to be in the low to mid-teen levels, lower than competitors such as WSM or CPWM.  This puts it in a more vulnerable position to lose market share based on price unless it’s willing to be more promotional, as at least 85% of its inventory is available in other locations, increasing the risk of further margin compressions.

Newer/Younger Concepts Are Drags on Margin

BBBY has three younger/new brands including Harmon, Christmas Tree Shops (CTS) and buybuy Baby.  These concepts are lower margin than the core BBB stores and as they become a larger part of the store base/revenue base, it will lower margins on a permanent basis.  Although management hasn’t clearly stated how big each of the concepts can be, it is likely that Harmon and CTS are 100 stores or less concepts and buybuy Baby could have maybe 200-250 stores. Altogether this crop of new stores, even if they experience great success, will likely be too small to really move the needle and alleviate the structural and secular headwinds the core BBB concept faces.

Anniversarying A Weakening Keurig – Key Traffic Driver

One of the largest contributors to BBBY’s recent comparable store sales performance has been the Keurig coffee system by GMCR.  BBBY had the exclusive on the Vue which boosted comparable store sales by approximately 100-200bps.  GMCR is itself, facing huge competitive pressures from Starbucks (SBUX) and private label single serve coffee makers.  To maintain its sales momentum it will have to increase distribution of its product which will negatively impact BBBY who will no longer have the exclusive on the Vue system and who will be anniversarying that product in the store.   Comps will likely then decelerate on a year over year basis and sequential basis unless BBBY is able to find another item/product line to same the same conversion.

GMCR reported their quarter on Tuesday May 2, 2012 after the close where its management seemed surprised by the slowdown in its sales growth rate.  Additionally, it is facing patent expiration in September 2012 and will likely see even more direct competition, a negative for BBBY in terms of having GMCR/Keurig as an incremental lift to comparable store sales. Management is notoriously tight-lipped but with the impact of Keurig weakening, BBBY may have to promote more to maintain its strong comparable store sales number. 

Maturing Domestic Retail Business

BBBY has repeatedly stated that it believes that the North American store potential for its core Bed Bath & Beyond concept is 1,300, a huge 31% increase from the current store base of 995.  This seems optimistic particularly in light of the growing online threat and increased penetration/focus on the home category from players such as department stores and mass merchants. Additionally, it is doubtful that there remain that many additional prime locations for such a large store footprint.  Looking at BBY as an example of a once formidable standalone category killer who grew its store base rapidly to a tune of 1,100 stores, and who also profited from the demise of a key competitor (Circuit City (CC) versus Linen n’ Things (LIN) for BBBY), it is apparent that it had/has too many stores and is forced to close them to improve the chain’s productivity.   As recently as February 2012, BBY announced that it was permanently closing 50 locations, as it struggles to come up with a plan to compete with its more nimble competitors. 

Big box retailers like BBBY and BBY grew and thrived in the era before the Internet, when consumers needed a large format to experience an array of merchandise and when it was difficult to comparison shop on price unless at a physical location.  As online continues to disrupt the home furnishings industry, BBBY will likely find that its current format and size (in terms of number of stores and store size (the average store is~30,000 square feet, but many are much bigger)) will be too large and unwieldy and it will be forced to downsize, thus lowering revenue growth (unless it can shift those sales online.)

Valuation

Trading at a premium to its peer group and at peak multiple, Bed Bath & Beyond (BBBY) is a sell at $68.05, or 15.7x FYE Feb. 2013 P/E and 8.4x FY’13 EV/EBITDA.  Given the increasing competitive environment, peak operating performance, maturing store base and necessary investment spending leading to lower growth and margins, BBBY should trade in the near-term at 6.5x multiple of EBITDA or $54 per share, about a 20% decrease from the current price. In the longer term, BBBY’s margins should decline to the mid-single digits as it converges to  AMZN over time.  However, in the intermediate term, with increased completion and moving to a more normalized growth rate, estimated margins could be closer to the low double digits (10-11% range – a similar decline percent to what happened to Best Buy’s margins.)  In this scenario, the stock would be worth in the low $30s or almost 50% downside.

Near Term Valuation

We are fortunate to have a roadmap of how BBBY’s situation will play out, thanks to the pain and suffering of BBY and BKS, among others.  BBY, which once traded as high as 9x EV/EBITDA (where BBBY is trading today) is now trading around 4x EV/EBITDA.  BBY is in the later stages of the cycle, where it has already seen significant market share loss to online competitors and where its cavernous stores really no longer meet the needs of its customers.  It is now seeing more significant cuts in margin, down more than 20% from the peak (from 6.% to 4.2% and declining.)   Given that BBBY is in the earlier stages of this downward cycle, its strong financial position and that its competitors are trading at multiple of just over 6x 2013 EBITDA, BBBY would be valued at 6.5x 2013 EV/EBITDA (until the structural issues become more evident.)

The Long Slow Bleed

The obstacles facing BBBY are not temporary; essentially BBBY will see a slow bleed of its margins as the online competition becomes fiercer. As mentioned above, AMZN, the central competitor, is an economically irrational competitor who can literally compete without concern for margins. AMZN’s current EBIT margin of under 2% may increase to 4-5% (as the investment cycle slows down). BBY is already seeing its margin compress and converge to the AMZN average margin and is down about 23% from peak margins and will likely continue to decline over 40% from its peak.  Haircutting that decline and applying it to BBBY’s peak and current margins of over 16% gets to an intermediate term margin rate of 11%, down about 500bps from current margins. However, if AMZN’s total margin is even 3% (perhaps 4-5% normalized given AMZN’s current investment spend), it is likely that in the future, BBBY’s margin will be even lower than the 11%, to the mid to high single digits.  Looking at this year’s revenue with an 11% EBIT margin, and applying a premium to BBY’s multiple (so using a 5-6x EV/EBITDA multiple) gets to a share price in the low $30s, close to 50% decline from the current price.

Risks:

• Near-Term Risks:

• BBBY is a well-managed company with a strong balance sheet – it has no debt and generates  a lot of cash. FCF yield is over 5% and management is committed to its share repurchase program.  Due to  this financial strength, BBBY will be able to withstand some reduction in sales and margins in the near term, but like BBY, over time, it will find it more and more difficult to manage the deleverage from a shortfall in sales and an increase in competition.
• A housing recovery  could continue to benefit BBBY via higher comparable store sales.
• Continued  sand-bagging of guidance, where the company always “beats and raises” will help the stock price in the near term.  SGA is tightly managed and will help BBBY gain some near term leverage on this line item.

Catalyst

Catalysts:

• Weakness in macro environment led by weak jobs numbers, housing turnover, etc
• Continued evidence of promotional environment
• Increased spending over current numbers to complete ecommerce platform or delay of ecommerce platform
• Margin deterioration from increased online and brick-and-mortar competition
• Decelerating comp growth from slowing exclusive consumable product categories