Description

Build-A-Bear Workshop (BBW)

BBW is a specialty retailer of make-it-yourself stuffed animals primarily for children ages 3 to 12 years old located mostly in malls in North America and Europe.  The company has 291 company-owned stores in North America, 54 company-owned stores in Europe, and 65 franchised stores internationally.  Stores average about 2,800 square feet.  The company is the 9^th largest toy retailer in North America.  BBW has a current market valuation of about $150m ($7.50 per share x 20m shares), no debt, and $53m in net cash for an Enterprise Value (EV) of $100m.  BBW generates very substantial amounts of cash flow.  Cash from operations (CFO) was $56m in FY07, $24m in FY08, and $24m in FY09.  LTM CFO has risen to $34m and LTM capital expenditures are $8m. 

We expect BBW to generate free cash flow of approximately $18m to $20m in FY10 for an unleveraged FCF yield of 18% to 20%.  We think BBW is in the early stages of a turnaround which could drive profits and free cash flow higher over the next few years.  BBW has a very solid balance sheet with a net cash position of $53m as of 4/3/10.  Due to strong free cash flow generation we expect this net cash position to grow during FY10 and FY11 (mostly in Q4 which is the major quarter for EBITDA and cash generation).

BBW sells a discretionary product and has struggled with sales during the economic downturn.  Comp store sales have been in a long slide with comps for North American stores of -9.9% in FY07, -14% in FY08; and -13% in FY09.  BBW undertook an aggressive expansion plan opening 35 stores in FY06, 50 stores in FY07, and 25 stores in FY08 and paid the price with awful comp store sales and financial results.

During FY09 CEO Maxine Clark (largest shareholder with 13%) and her management dramatically reduced overhead (by $25m) and capital expenditures (by $14m) to build cash and maintain a strong balance sheet.  They also implemented a focused strategic plan (see below) which includes product innovation, cost engineering, and tighter integration of product launches, marketing, and store operations.  Pricing has also been shifted to more of the value-orientation which today's consumer requires.  The result has been gradually improving comp stores sales results - it would have been hard for them to get much worse - and a possible glimmer of hope in Q1 of FY 2010 with positive comp store sales in North America (+1.9%) for the first time in 17 quarters.

We think BBW's franchise is unique and viable and reaches a large and attractive customer base.  We think that management has at least stabilized the steep sales declines with its cost reductions and more focused strategy.  We believe BBW is being heavily discounted by the market.  We think BBW could achieve EBITDA for FY10 of $30m without a dramatic economic recovery.  BBW currently trades at about 25% of LTM revenue, 3.3x our estimate of FY10 EBITDA and an 18% to 20% FCF yield on our estimate of FY10 FCF of $18m to $20m.

Strong Free Cash Flow

BBW has modest working capital needs with few receivables and high inventory turns.  The Company does close to $400m in annual sales with $45m to $50m of inventory (see Quarterly Balance Sheets below).  Since FY09 management has sharply curtailed new store growth (only one or two new stores expected in FY10) to optimize the comp store sales and profitability of the existing store base.  Capital expenditures have come down significantly from $32m in FY 07 and $22m in FY08 to only $8m in FY09 and $12m estimated in FY10.  With D&A expense estimated at $28m for FY10, BBW is generating significant amounts of free cash flow.  Cash from operations was $56m in FY07, $24m in FY08 and FY09 - despite the slow economy - and we expect $30m to $32m for FY10.  Our free cash flow (cash from operations less capital expenditures) estimate for FY10 is $18m to $20m or almost $1 per share.

Strong Balance Sheet and Growing Net Cash Position

The Company's net cash position has been consistently improving on a year-over-year basis (see Quarterly Balance Sheets below).  BBW's Q1 net cash position was $53m as compared to $34m for Q1 prior year.  We think BBW could end FY10 with a net cash position of $75m to $80m or $3.50 to $4 per share (FY09 ended with $60m of net cash or about $3 per share).

We believe BBW's strong balance sheet provides good downside protection and gives the company the flexibility to emerge from the current downturn as one of the survivors in a stronger competitive position.

Trades at A Large Discount to Replacement Cost

We believe the replacement cost of BBW's 345-store chain is at least $200m or 2x the current EV.  BBW has attractive positions in most major malls in North America.  From 2005 to 2009, BBW (which already had 170 stores) spent $155m in capital expenditures and an additional $39m for an acquisition of 40 stores located in the U.K. (about $1m per store).  Today BBW has an EV of about $100m or about $280k per store or roughly half this recent investment.   Some of these capital expenditures were ill-advised and do not earn their cost of capital but we think the large investment in its store network is a significant competitive advantage for BBW going forward.  And we are purchasing it at a very large discount to its replacement cost.

We believe it costs about $500k net of allowances to open a new store plus at least $100k in working capital for a total investment of about $600k per store.

Retailers are criticized as investments because they are easy to duplicate.  However, when you purchase a viable chain at more than a 50% discount to its replacement cost, you should have significant advantage.  BBW most certainly sells a discretionary product, but it has a limited amount of direct competitors and there are very few toy retailers residing in malls today.

Focused Strategic Plan in FY10

In recent years BBW has exited tangential activities (Ridemakerz LLC and Friends 2B Made LLC) and taken write-downs in order to focus more completely on its core retail operations.  The Company focused on reducing costs and capital expenditures in FY09.  In FY10 management is seeking to drive top line growth and profitability.  Management is focused on driving profitable growth at the current base of stores rather than expanding the store base and we think this makes a lot of sense.  Management is using five key strategies to do this.  These include:

• 1) Product innovation to improve the design and value of animals and increase size of product launches.
• a. strong results in Q1 with limited edition animals to drive urgency;
• b. well-coordinated with clothing & accessories to drive average transaction value;
• c. worked with vendors to reduce cost of animals;
• d. averaging about one new product launch per month and most of these are limited editions;
• e. Q1 themes included i-Carly Bear in January, Be Mine Dalmation in February, and Blossom Bunny and Easter Chick for Easter in March;
• 2) Fully integrate product, marketing, and store operations to create a strong sense of urgency for each launch
• a. one product statement supported by one focused message and one strong promotion to drive sales and traffic;
• b. own "must win" periods of holidays and times when kids are out of school and in malls;
• c. gifts with purchase - e.g., Easter basket and candy, crown, sound;
• d. strong visual impact of merchandise at lease line;
• 3) Selectively adding complementary interactive-type toys like Zhu-Zhu Pets to assortment
• a. lower gross margins but take advantage of extra store space, help drive traffic, and add to overall gross margin dollars;
• b. Zhu Zhu Pets was rolled out to all company stores in U.S. in late March
• 4) Growing engagement in virtual world (www.buildabearville.com)
• a. internet sales grew over 10% in FY10 Q1 and children are spending 30 minutes per visit online;
• b. one of three guests visit online before visiting a store; and
• 5) Creating new opportunities for products to be sold outside retail store base
• a. 65 international franchised stores; expect 3 new international franchised stores in FY10 and company thinks there is potential for up to 300;
• b. Agreements with franchisees in 16 countries currently;
• c. Signed licensing agreements in several product categories.

In particular, we think there is significant long-term growth potential, which is not capital-intensive, through franchising and licensing and thereby further leveraging the Build-A-Bear brand name throughout the world.

FY10 Q1 Results Were A Good Start

FY10 Q1 results showed some evidence of progress on these strategies.  North American comp store sales increased for the first time in 17 quarters to +1.9%.  Gross margin improved over 400 basis points compared to prior year.  SG&A expense increased modestly (we think there will need to be some add-back to the dramatic cuts of FY09).  The result was a small operating profit of $2.8m versus an operating loss of $1.5m prior year.  FY10 Q1 EBITDA was $10m compared to $6m prior year.  FY10 Q1 cash from operations also improved from -$11m in FY09 Q1 to -$1m in FY10 Q1 due to improved profits and better working capital management.

It is important to note the improved comp store sales numbers for FY10 Q1 were helped by the shift of Easter (a very big holiday for BBW) into Q1 from Q2 in FY09.  However, on the Q1 conference call management noted that comp store sales for FY10 March and April combined were slightly positive as compared to FY09.

Another fact to consider is that the upcoming Q2 (ending around 6/30) is BBW's seasonally weakest Q.  We expect BBW to reduce its operating loss in Q2 FY10 as compared to prior year.

FY10 EBITDA and FCF

Our estimate for FY10 assumes a 3% increase in comp store sales (versus -13.4% in FY09), improved gross margin to 41% (versus 37.6% in FY09) and slightly increased SG&A expense.  These assumptions would result in a small $2m operating profit for FY10.  We expect D&A expense for FY10 will be about $28m and capital expenditures to be $12m.  Our FY10 EBITDA estimate is $30m.

BBW is going to be rolling over some very weak comp stores sales numbers in North America in Q2 (- 17.5%), Q3 (-16.0%) and Q4 (-13.5%) of FY10 and we expect this factor plus the streamlined cost structure and strategic plan to help financial results in FY10.

Valuation and Target Price

BBW is trading at a $100m EV or 3.3x our FY10 EBITDA estimate of $30m and 5.5x our FCF estimate of $18m for FY10.

We think there could be upside to these numbers if the North American and European economies surprise to the upside (probably not going to happen).

Based on $18m of FCF in FY10 (close to $1 per share) and a net cash position of $70m to $80m ($3.50 to $4 per share) at FYE, we think BBW could trade at a share price of $13-$14 (80% above $7.50 current price).

We think downside is reasonably protected.  $6 per share implies market cap of $120m less $50m net cash equal $70m EV which would be pretty low for $350m to $400m revenue business that has positive cash flow and no leverage.

Furthermore, we think BBW could make an interesting strategic acquisition for an acquirer that seeks to connect with its substantial customer base.  When you consider the high name recognition of this brand and its position throughout the world through international franchise operations, we would not be surprised if someday BBW attracted a bid from a strategic investor.

Build-A-Bear Workshop

Catalysts

• 1. Improving profitability in Q2, Q3, and Q4 of FY10
• 2. Better comp store sales results.
• 3. Strong cash generation in FY10 (mostly in Q4) should increase net cash position on b/s.
• 4. Established global brand name and unique retail - entertainment niche.
• 5. Unleveraged FCF yield of 18% or more.
• 6. If North American or global economy is stronger than we expect, there could be upside to our estimates, especially into FY11.

Risks

• 1. Economic downturn worsens in H2 of FY10 and results suffer accordingly.
• 2. Q2 is weakest Q and will not have Easter in FY10. We expect a smaller loss in Q2 as compared to prior year.
• 3. People stop shopping at malls.

Disclaimer

Disclaimer:  We own shares of BBW.  We may buy or sell these shares at any time without notice.  The information in the write-up is believed to be correct as of the date written but VIC members should do their own verification of this information and analysis of this potential investment.  We undertake no obligation to update this write-up if new information arises at a future date.

Catalyst