Description

Build-a-Bear Workshop (the “company”) is the leading international “make your own stuffed animal” interactive retail store, operating 288 stores in the United States and Canada and 58 stores in the UK and Ireland, with an additional 79 international franchised locations, with franchisees in continental Europe, South America, Asia, and the Middle East.

After disappointing Q4 earnings, the stock is languishing near three-year lows and is down nearly 50% year-to-date, but has a healthy balance sheet with net cash equal to two-thirds market cap and no debt, heavily-invested top management (Chief Executive Bear Maxine Clark – note that all employees are referred to in ursine terms – owns 11.6%) that has engaged in significant repurchases, and a value-focused manager (a 13.3% owner) on the board. I believe the company is significantly undervalued and that the market’s overreaction to recent bad news presents a compelling entry point. The company announces Q1 Thursday morning, and so I am posting this thesis now to prevent the possibility of it becoming stale.

My thesis proceeds on four basic ideas:

1. The company is historically cheap by numerous metrics, even when compared to distressed comparables in the retail space. While these numbers do not themselves prove an attractive situation, they indicate a potential misvaluation.

2. The company is taking constructive steps to improve its main problems (stagnant revenue and too many nearby locations).

3. The company has a franchise that would be difficult to replicate and offers an experience that is essentially Internet-proof.

4. Management is efficiently deploying capital through repurchases and the presence of a value investor and major shareholder on the board increases the chance that this will continue.

Readers should be somewhat incredulous at this point, since the company has been written up twice on VIC before (June ’10 and November ’07), and the both writeups focused on #2 and #3. The stock is down 39% and 73%, respectively, from those write-ups.  However, we have reached a point where the valuation is simply too compelling not to justify another look.  This is no longer a story of a great business at a good price, but instead a decent business at a bargain-basement price with, excuse the cliché, a meaningful margin of safety. 

The Numbers

The company is trading at a market cap of $77m, approx. 3.5x trailing EBITDA of ~$22m and 1.4x EV/EBITDA (enterprise value of ~$30m). Price/Book is .54 and Price/Sales is .18, both seven-year lows.

A sampling of some other common mall retailers specializing in (i) children’s products or (ii) discretionary items in the $50-100 range include Steve Madden (11.2x EBITDA and 10.6x EV/EBITDA, Wet Seal (6.7x EBITDA and 3.2x EV/EBITDA), Children’s Place (6.3x EBITDA and 5.4x EV/EBITDA), Carter’s (14.1x EBITDA and EV/EBITDA), and Hot Topic (12.8x EBITDA and 11.2x EV/EBITDA).

While the numbers themselves are superficially attractive, they are only a snapshot in time, and can change quickly if this is business in secular decline.  Even distressed retailers, however, are trading at richer valuations. A few examples include Radio Shack (3.3x EBITDA, 3.7x EV/EBITDA), Best Buy (4.3x EBITDA, 4.9x EV/EBITDA) and cash-rich GameStop (4.1x EBITDA, 3.2x EV/EBITDA). Unlike RSH, BBY, and GME, each of which is being buffeted by market factors and heavy competition through retail and online channels, there is no clear logic as to why the stuffed animal industry is in a death spiral, or why the Internet can seriously compete with the hands-on experience of designing and stuffing a personal teddy bear.

For a bit of a reality check from an entirely different sector, even Research in Motion is trading at 2.3x EBITDA and 1.8x EV/EBITDA.

The company is also sitting on a significant cash pile of over $46m, representing two-thirds its market cap and leaving a miniscule EV, and has no debt and an existing $40m credit line that is fully available. While about half of the cash is retained abroad, existing tax assets and accompanying foreign tax credits would likely absorb most/all income from repatriations.

But numbers this attractive usually suggest fundamental problems, and there are certainly some here.

The Problems

The company has been stuck in a long spiral of declining same-store sales and overbuilding. Same-store sales were down 2.1% in FY2011, 2% in FY2010, 13.4% in FY2009, 14% in FY2008, and 9.9% in FY2007. Revenue has been stagnant since 2009 while number of stores has remained constant at approximately 345 locations worldwide despite the subpar performance.

In February, the company announced a disastrous Q4 – 34c earnings vs. estimates of 51c, 117m revs vs. 128m estimated and, critically, same-store declines of 4.9% for Q4. This is of course critical because Q4 is essentially the only time each year BBW is profitable. Management blamed poor movie tie-ins (Alvin & the Chipmunks 3: Chipwrecked and Happy Feet 2). It is difficult to assess how large an impact the film underperformance had on the bottom line, but movie tie-in stuffed animals are prominently featured at the company and both Chipwrecked and Happy Feet 2 significantly underperformed prior films in each series (drop-offs of approximately 40% for the former and over 60% for the latter in North America). Management also said on the most recent call that consolidated sales would have been up if not for this underperformance, though it is not clear how confident this prediction could be. But it is indicative of the importance of movie tie-ins during the Christmas season.

An additional large one-time charge in establishing a valuation allowance for the tax assets (required under GAAP) introduced some further noise. The stock reacted in kind, and is down approximately 48% YTD.

Constructively, however, the company has finally acknowledged that some closings are necessary, and has announced it plans to close 15-20 stores in North America (approximately 6-8% of all locations), while only opening 4-6 new stores and moving and remodeling several others in a new store design. It seems management realizes, for instance, that it may not make sense to have two stores in Paramus, NJ that are three miles from each other, two in Portland within 10 miles, or two in the near vicinity of Pittsburgh (not implying that any of these are on the list).

This would reflect the first meaningful decline in store locations on record and is cause for significant optimism, though the moves and remodels are expected to result in a one-year capex increase to $20-25m, reflecting increased store activity.

While the company does have significant lease obligations – approximately $170m through 2016 and $36m beyond 2016 – many of the leases have termination rights or escape clauses if minimum sales levels are not reached. While these are significant figures, they do not appear to present a significant liquidity risk given the potential termination rights, cash balance and credit line availability.

In addition, the company expects to add 10-12 international franchises in 2012, which are essentially pure profit compared to the company-owned retail business (though they are an extremely small portion of the business at the moment - $3.4m in fees for 2011).

While it is impossible to assess the results of these changes until the Q1 announcement, management commented on the Q4 call that through Valentine’s Day, same-store sales are flat in North America, with significant increases in the UK and online (both significant improvements).

The Franchise

Build-a-Bear has a significant moat in their exceedingly small sector and their sector (narrow as it is) would be highly difficult to penetrate, given their name recognition and locations in flagship malls. They provide a highly-interactive experience that makes children feel special – it’s illustrative to read some Yelp reviews of various locations (for example, http://www.yelp.com/biz/build-a-bear-workshop-glendale-2 or http://www.yelp.com/biz/build-a-bear-workshop-miami), and you can see that nearly every location has average ratings of between 3.5 and 4.5 stars. A read of the reviews shows a strong loyalty to the brand and high appreciation for the customer experience, with words like “fun”, “cute”, and “unique” commonly being used to describe the stores.

The company also benefits from significant licensed merchandise, offering movie tie-in animals, sports team “make your own mascot” products, and even branded “Angry Birds” merchandise (see http://www.buildabear.com/shopping/contents/content.jsp?id=2900006). Unlike some of the apparel retail comps mentioned above, the company is able to take advantage of popular movie franchises (though, as in Q4, sometimes big-budget films disappoint) and other products, while teen apparel companies need to build their own trends to capitalize on the fickle tastes of teen consumers.

The company is also widely regarded as a top employer, was ranked #48 on Forbes 2011 Best Companies to Work For, and had an average 3.7/5 rating on Glassdoor (for context, only 9 companies scored a 4 or above last year), with Clark receiving an 88% approval rating.

The Management

Chief Executive Bear Clark has been with the company since their founding in 1997, and currently holds over 10% of outstanding stock. Remaining management holds approximately 5%, named management are required to maintain holdings at least equal to their base salary, and are well-incentivized to improve profitability through the company performance bonus plan, which weights revenue at 25% and EBITDA at 75% of the bonus calculation.  Management did not receive bonuses under this plan for 2011. Remaining incentive compensation is in equity.

In addition, management has shown a strong willingness to buyback stock and has repurchased $41.3m worth of stock since 2007, with $8.7 million of authorization remaining, with almost $5m purchased in Q4 alone, the majority near quarter lows. 

Finally, BML Investment Partners, a value fund, owns 13.3% of the company, and its principal, Braden Leonard, was elected to the board in April 2011. While there is minimal public information available with respect to his election, issuer repurchases increased significantly in the months following his election, and he has continued to increase his position, acquiring approximately 100,000 shares in Q1. Similarly, whether it is because of poor Q4 performance or other influences, 2012 is the first year in the history of the company’s public history in which it expects to actually net close locations. These are highly positive signs that make the company’s historic lows an opportunity well worth further consideration.

Catalysts

1. Stabilization of same-store figures via closing of underperforming and redundant locations.

2. Productive use of cash for repurchases.

3. Reversion to a reasonable EBITDA multiple.

4. Improved performance through better product tie-ins and performance of film-related limited editions.

Risks

1. The company resumes its historical expansionist plans.

2. Same-store sales continue to stagnate despite downsizing and remodeling.

3. Significant economic downturn and decline in discretionary spending.

4. Poor movie tie-in decisions cutting into holiday sales.

Disclosure: I am currently long BBW and may buy or sell it in the future. This posting is solely for the evaluation of fellow VIC members, is not intended as investment, legal, or tax advice and is not a recommendation to buy or sell this stock.

Catalyst