Description

And now for my second negative comping retail idea of the night: Long BBW.

mCap: $135

EV: $103

Average Daily Trading Volume: $1.72mm

One can hardly open a financial website or newspaper or have a conversation on any given day without being reminded that for retailers (or any business) not named Amazon, things can only get worse, or much, much worse as Amazon will aggressively come after them with no regards for profits, no matter the industry. Have we reached peak hysteria surrounding Amazon? I can’t be sure as I thought we reached peak TSLA hysteria four years ago but it intensifies by the hour. We can, however, hopefully take advantage of the panic induced by Bezos within the specialty retail space by buying companies that are truly more insulated from Amazon (...I think...err..hope...). I believe Build-a-Bear is one such retailer. “Experiential” has become the buzzword du jour within retail, and yet despite BBW being a quintessential experiential retailer with an interactive process of stuffing your own teddy bear/animal, it’s stock is very out of favor. With 90%+ brand recognition across North America, and having been written up a few times on the VIC before, most likely everyone reading is at least familiar with what BBW is. Everdeen’s write-up of BBW (the last one on VIC ~5 years ago) stated: “The company has a franchise that would be difficult to replicate and offers an experience that is essentially Internet-proof.” The stock is up roughly 100% over that time (not a great IRR), however, it did rise to a high of $22+, so despite languishing for the first six months or so, it was a huge winner from there. At the risk of repeating the same theses posted to the VIC then, I’ll try to focus on what has changed and why now may be the time to take another look at BBW on the long side for small cap value investors.

Much has transpired since that last write-up, most of it unambiguously positive, at least up until December 2016, when traffic fell off a cliff and BBW posted a -8.3% Q4 same store sales comp print, despite positive comps through October and November.  Over the last several years BBW has closed many unprofitable stores, increased merchandise margins by a full 9%, and went from having ~22% of stores being unprofitable to 5% currently.

Here is a chart of quarterly SSS back to 2004:

I can’t sugarcoat it, it has not been a pretty picture.  The Q4 call is chock-full of excuses from management. Here are SSS comps on an annual basis:

Despite the long string of negative comps, BBW has remained EBITDA positive every single year. When no turnaround seemed in sight and there was little hope, the stock briefly went sub-1x EBITDA in February 2009 (oh, don’t you miss those days? Sort of…) and languished as low as 1.5x EBITDA even many years after the financial crisis even as a turnaround had then started to sink its teeth. The average and median EBITDA multiple over the last ten years is 4.8x:

Here is a summary of some key metrics:

Strategic Alternatives/Review Still underway

Along with their Q1 results, on May 3rd, 2016 the company announced they had hired Guggenheim to explore a sale (the enterprise value is down almost $90 million from the time of that announcement). Lo and behold, here we are 10 months later and no transaction has transpired and the Q4 print was abysmal. At this point pretty much no one is expecting anyone to buy them out. There were many “false positives” that had me believing BBW would attract a healthy bid prior to reporting Q4. The false positives were Canadian toy company Spin Master expanding their revolving credit line by $230 million (just the right amount to pay a nice premium on BBW, I thought), announced December 21st, 2016, with the explicit intention of using the credit line for M&A in the near term. Secondly, just two weeks later BBW cancelled their appearance to the ICR Retail Conference the second week of January, while this auction process was ongoing, despite attending the previous three years in a row.  Another thing was the company's amendments of the executive compensation plan shortly before announcing they were exploring a sale, including significantly increasing severance pay upon change in control. Additionally I had just bought my two nieces and nephew the Build-a-Bear at home kit and they went nuts over it and continued to play with the miniature stuffer for many days after initially making the bear (putting play-doh in it and cranking it out, like a pasta-maker). My limited sample size of channel checks showed this item was not merchandised well at Toys R Us (e.g. only in the back and available upon asking store employees), or repeatedly out of stock/unavailable.

It is difficult to pick the right transaction comps for a potential BBW valuation in a sale, but it is also difficult to find anything remotely related such as toy companies or specialty retailers getting bought out for less than 8x EBITDA (this would give 70%+ upside).

After two terrible Q4/Holiday selling periods in a row, does this signify the business is in structural and secular decline, or is the weakness temporary and can BBW stem the SSS declines and negative operating leverage that crushes declining retailers? There are a few silver linings that signal not all hope is yet lost, though many are hard to perfectly quantify.

• First, gift card sales were up double digit percentage in Q4, implying a slight backlog of sales demand as they are hopefully redeemed in Q1. If they are never redeemed, then that’s a nice cash flow boost for them.
• eCommerce sales did comp positively at +2% for Q4 (++3% for December, +7.4% for the full year), and management reports that web traffic was up double digits, though many top selling items were out of stock and there were generally other problems handling the throughput/demand of eCommerce. This bodes well for the brand overall, and is not indicative of a brand that is quickly collapsing into permanent obsolescence.
• Discovery Store format stores comp’d +4% in Q4, a full 14% better than overall North American store base. 80% of the store base has not been remodeled.
• Full year merchandise margins still expanded in 2016 by 30 bps over 2015 on a constant currency basis (weakening GBP hurt reported headline #s, but if GBP strengthens versus dollar this year it could flip and be a tailwind).
• Full year SG&A declined by $2.4 million, so management is keeping a tight lid on corporate costs. 
• They reduced media spend and moved away from traditional TV commercial spend and direct mail, trying to shift to digital advertising to reach Millenial moms that make up the core audience they are trying to reach.  They say they have immediately shifted marketing spend back to previous traditional/effective areas. From Q4 call: “media shift likely significantly affected our planned store visits, which is something that we can change and we're already in the process of changing.”
• Q1 SSS guide is weak in the -8% range, but there are two reasons that are explainable and at least partly to blame. One is that Valentine’s day was on a weekday and Easter has shifted into Q2. Comp guidance is positive Q2, Q3 and Q4. These will be easier y/y comparisons, but right now the market will likely not trust management guidance. 
• Proprietary brand/toy characters of Merry Mission remained #1 selling product and was up 20% y/y in Q4, boding well for BBW as brand and creative merchandiser.
• They remain debt-free with $32.5 million in cash.

Stock value is about the future…so what’s to like?

• First, I like that they have entered a new era to "monetize the brand." They are aiming to quickly diversify from traditional retail sales via outbound brand licensing and wholesale sales initiatives, like selling Build-A-Bear at home kits in Costco/Toys R US/Amazon. They’ve signed agreements with Spin Masters, the large Canadian toy company (just mentioned that I thought would want to buy them out), and Frankford for Build-a-Bear branded chocolate and novelty candies. The key to this licensing initiative is they've hired a third party licensing consulting firm and added a new key board member to grow this licensing business. Tim Kiplin. He was previously the Chief Commercial Officer at Mattel and head of new Intellectual Property development. He developed Monster High and took it to a billion dollar business for them very quickly. Before Mattel he was executive vice president at Disney in charge of franchising Mickey Mouse and Winnie the Pooh. He is a board member of the Toy Industry Association and Licensing Industry Merchandiser's Association.
• In my experience from checking their social media engagement and fan-uploaded YouTube videos (and insane number of views of each relevant Build a Bear video), they have one of the most rabid fan bases of any company in the world with many repeat customers/collectors (they have 4+ million loyalty members and frequently win social media engagement awards). This bodes well for continued outbound licensing opportunities and product demand, enough so that it can become a meaningful revenue/EBIT contributor and given its high margin it should skew the overall multiple upwards that BBW commands. For FY 2016 “Commercial” sales (wholesale + licensing) total $4.3 million or 1.2% of total sales, up from $2.7 million in FY 2015. International Franchising sales on a base of just 92 stores totaled $2.29 million or 0.6% of total sales. I believe both of these numbers could triple over time as the international store base goes from < 100 to 250+ and licensing initiatives continue to grow with no incremental cap-ex necessary. Australia is the largest franchised area (19 locations), followed by Germany (18) and Mexico (14). Just these three countries account for ~55% of franchised locations. They are underpenetrated and have room for growth in franchisees in Western Europe, Asia, and South America.

• Google searches are spiking for “Build a bear Beauty and the Beast” ahead of the movie premiere on March 17th in the US. BBW is often driven by theatrical releases, with a decent slate upcoming this year. This could be another “false positive” though and not something I put much weight in.

Store base overview

BBW has 438 stores total. They’ve hit a new peak in franchised locations at the end of 2016 of 92 stores. I believe they are significantly underpenetrated in terms of international locations. They are currently only in 11 different countries. The co-owned international stores are significantly more productive than domestic ones, with sales psf consistently 30-40% higher internationally, which bodes well for future international franchise growth.

BBW’s Average Unit Volume has dropped over time and unit economics have become worse. Sales per store is ~$1.03mm with ~19% 4-wall EBITDA margins. Each new store opening cost anywhere from $600,000 to $780,000. So pre-tax profit contribution is ~$196k on an investment of $780k, or ~25% ROI. Management cites a lower cost of new stores going forward as they’ve shifted sourcing of fixtures to China for some savings. An additional new initiative highlighted and discussed in the latest earnings conference call is a shift of new store openings to “Concourse Stores”—smaller store formats in non-traditional locations, such as out in the “concourse” of a mall, e.g. the large walkway spaces/common area of a mall where you sometimes see a Starbucks or QSR.

Management highlights these Concourse stores as being more flexible in lease terms, e.g. 3-year maximum lease terms with lower rents, and costing one-half or less than a traditional store opening, yet achieving >50% of the sales volume in pilot locations. The idea of all these smaller store formats doesn’t thrill me, but it is also not a bad option if they achieve management’s targets. Additionally, as they let leases of traditional stores with the mall lapse and convert some to the smaller Concourse format, this should free up significant working capital in inventory creating a one-time FCF windfall. Days of Inventory outstanding has been rising and has a lot of room to come down. 

Currently 2017 guidance is to open 20-25 new stores, with 15 in the new Concourse format, remodel 20-25 stores in the Discovery Store format, close 5-10, and extend 55-65 leases. All in they guide to end 2017 with 360 co-owned stores. I would push them to open fewer stores, especially any traditional format stores within enclosed malls, and let a lot more of the leases roll-off without extending.  The good news is that 50% of the North American stores have leases expiring within the next three years, leaving them a lot of optionality on continuing the turnaround with the ability to pruning the worst stores and have net store shrinkage. In my opinion they should aggressively be closing any marginal stores that are trending in the wrong direction.

Here is a table of annual capital expenditures:

They are in a period of heavy cap-ex. Some of it is admittedly defensive in nature (some Discovery store format remodeling to prevent further comp collapse), but the large majority is pure growth cap-ex from opening new stores and spending on IT to boost eCommerce capability, some of which is more one-time in nature. Capex guide for 2017 is $20-25 million (75% for new stores and store remodels, and 25% for IT infrastructure). I think they will eventually come out below the low end of this guidance due to shareholder pressure. Excluding 2015 and 2016 when they opened 35 and 32 stores, average cap-ex from 2010-2014 was just $14.7 million, despite still opening an average of 21 stores per year those five years. If they opened zero new stores I believe cap-ex could easily be less than $10 million on maintenance cap-ex (e.g. 2009, still opened 11 stores and spent just $8mm).  Operating cash flow average from 2010-2015 is $23.14 million. Again though to reiterate the gross margins are much higher now than in 2009/2010/2011, so the annually operating cash flow from the more recent years may be more representative of current steady-state.

But, gutting growth capex to a maintenance mode at $10mm and achieving the $23mm avg cash from ops, normalized FCF should exceed $13mm/year, putting them at under 8x EV/normalized FCF. Additionally, normalized inventory level could decline as leases roll off and the net number of stores declines, possibly providing a boost to this FCF estimate. While doing this (stopping store growth) BBW could simultaneously be growing the licensing/franchising revenues at nearly 100% gross margin.

The company achieved 9.58% EBITDA margins in 2015. Can they get back to that? Perhaps—and that would blow out expectations. At $370mm for 2017 sales (+2% in total sales over 2016 total, low end of guidance) and 7.6% EBITDA margins, they can do $28 million in EBITDA and would be trading at 3.5x forward EBITDA. Maybe this is the correct multiple for a low-growth brick & mortar retailer, but it seems too low to me given the unique nature of the brand, the growing franchising component, the potential/opportunity for quickly growing licensing revenue, etc.  A reversion to the 10-year median EBITDA multiple of 4.8x results in 25% upside from the $8.50 level.

Adjusted pre-tax income for 2016 was $11mm and they guide to surpass this in 2017 (of course, horribly missed pre-tax guidance for 2016) putting them at <9x EV/Pre-tax Income.  They are a full tax payer, so a lowering of the corporate rate would help, although a border adjustment tax would hurt as most merchandise is sourced from China.

There is a clear consensus among the large shareholders that I’ve spoken with that they are all pushing management that this the game plan to follow at this point…slow down or stop new store openings altogether, gut unnecessary growth cap-ex, and instead focus on stabilizing comps and returning cash to shareholders via buybacks and dividend initiation. If a few more months go by and there has been no acceptable bid for the entire company I anticipate the board will put out a press release stating something along the lines of the strategic review has concluded and they’re going to reduce the guidance on new store openings, cut cap-ex guidance, and get more aggressive on capital return while they continue to emphasize franchise growth and outbound licensing. I think the market would react favorably to this, as no one is still hanging around at this point in hopes of a quick sale.

Ownership dynamics:

Short interest is 9.8% of the float.

Carlo Cannel’s stake is swinging wildly, but he recently re-purchased shares and owns 5% of the company.

BML Capital is the activist fund that has been on the Board since April 2011. BBW remains >50% of BML’s portfolio.

Point72 recently established a very large stake (14.77%), which is unique for them as a firm. They have only ~10 positions in stocks with market caps below $250 million and BBW is by far the largest weighting and is the company with the largest ownership percentage they have by a margin of 5%.  The price action was wild (+/-10 to 20% a day) for a few days right before it was revealed that Point72 had acquired their stake, so they acquired pretty aggressively in a wide price range. FWIW, they are already about 15% underwater on the investment.

Dimensional is a passive firm and is the third largest holder at 8.4%. Nokomis Capital is somewhat of a retail specialist and owns 6.8% (have not yet filed a 13-D), a 2.3% portfolio weighting for them. All in all, the top ten holders have 60%+ of shares out, so the true float is pretty small.

Quick note on mall traffic trends: both Simon Property Group and General Growth Properties state that traffic was up at their malls (more A-class malls) during Q4. With ~90% of company owned stores in traditional enclosed malls, secular declines in mall traffic is a significant risk for BBW, and a major headwind to overcome at the very least.  SPG and GGP own more of the top-tier malls in the country and may be a better indicator of BBW’s real estate foot print as they claim to have culled most all of their C & B mall locations over the last few years.

I believe ~30% of their business is through private birthday parties (typically for girls ages 3-8). We looked up demographic data for 5-8 year olds and that population range has been declining, but should be roughly flat over the next few years and once again inflecting higher in 2019 and beyond:

FWIW, here is Sharon Price John on Undercover Boss, giving you some sense of Build a Bear stores:

https://www.youtube.com/watch?v=ODUP6GWLRHU

Catalyst

• Same store sale comp stabilization or return to positive comp growth
• Capital return: increase buybacks or initiation of a dividend
• LBO/company sale
• Cash generation