Description

Build-a-Bear Workshop (BBW) is an experiential retailer whose stock price has been punished too severely for negative same store comps, despite a highly profitable store model, strong cash flow generation, solid balance sheet and significant growth prospects.

 

BBW is a mall-based retailer that offers 25-30 plush animal “skins” that can be stuffed, stitched, fluffed, dressed and named.  Sounds can be added, and animal hearts that children (or adults) make wishes upon are sewn in the skins.  Those of you without kids are probably yawning right now, but watch a child make their own stuffed animal and you’ll see their eyes light up.  On average, the process takes 45 minutes and the ticket price is $35 (animals can cost up to $25, and the accessories range from $5 - $15 but can be added at initial purchase or later).

 

Metrics:

Price:                           $17 per share

S/O:                             20.4 million

Market Cap:                $340 million

Net Debt:                     $(17) million

EV:                              $323 million

P/E Forward:               13.0x (2007), 10.9x (2008)

Historic Range:           13.7x – 33.1x

EV/EBITDA:                4.7x (2007), 4.0x (2008)

Historic Range:           5.2x – 12.5x

ROIC (3-year range): 62-126% (average capital)                            

 

 

INVESTMENT THESIS

 

Brand:

BBW is building a brand on par with Disney, Starbucks and Coca-Cola.  It may not be as well known yet, but spending time at the stores and with management it is clear that every decision, down to the smallest detail, is made based on reinforcing the brand.  BBW sends customers home with purchases, not in a generic plastic bag, but in a “cub condo” that furthers the child’s imagination and experience.  Making a wish and kissing the small heart that is sewn in the bear makes the animal come alive for a child. 

 

BBW has a wholesome image that parents trust.  It offers an escape from the ordinary with its interactive retail experience that captivates kids, making them want to return again and again (BBW has 60+% return customers).  The company believes that giving back to the community is not only the right thing to do, but also an act that returns full circle to you in positive ways.  As such, it partners with various charities such as the World Wildlife Fund, donating a certain amount of revenues on selected WWF bears.  This not only drives store traffic, but also teaches philanthropy to children and develops loyalty with parents.

 

Management:

Maxine Clark is a founder/CEO who launched the business in 1997.  She was President of Payless ShoeSource, and had 19 years experience with The May Department Stores focusing on merchandising, marketing, and product development prior to starting BBW.  She’s written a book called The Bear Necessities of Business: Building a Company with Heart.  The book gives you great insight into what motivates Ms. Clark and how she thinks of the business.  A few insights worth sharing: on “Being a Great Boss”, Ms. Clark talks about being willing to do any job, finding people who share your passion, respecting others, and creating a fun place to work; on “Connecting with Your Customers”, she comments on seeing yourself through the public’s eyes, making everyone feel special, learning from your customers, and making first impressions last; on “Growing Your Business” she speaks about creating buzz, embracing viral marketing, growing without compromise, being prepared for the unimaginable, innovating incessantly and, finally, giving back locally.

 

Ms. Clark owns 13.5% of the company.  All insiders combined own 26.3% of the company.  This is significant insider ownership that aligns management with shareholders.

 

Core Competency/Barriers to Entry:

BBW creates an emotional connection with customers, both parents and children alike.  Employees are energetic, fun-loving, and value creating a memorable experience for children.  We’ve experienced the palpable energy from employees first-hand with site visits on both coasts and in middle-America.  Customer satisfaction is taken very seriously.  Employees are empowered to handle any situation with a philosophy that there’s nothing an employee can give away to a customer that can hurt the company.  A free teddy bear utilized to turn a disgruntled customer into a satisfied customer before leaving the store, one who might otherwise generate negative sentiment within the community, is worth much more than the giveaway.  BBW expends a lot of effort tracking customer satisfaction and continually improving on it.  In fact, we understand that Nordstrom and Starbucks have contacted BBW to learn about its’ guest services and incorporate ideas into their own programs.

 

In addition, BBW has significant barriers to entry.  The company believes that other competitors can’t replicate its cost structure to build a 300+ store operation (new stores pay for themselves in 12-18 months).  BBW strategy is not so much geographic expansion, but instead to identify the best malls and the best locations within each mall, and being patient about waiting for these locations to become available.  Most of these leases lock up the mall, allowing no other competitor to open operations.  This would leave competitors with crumbs in the “B” or “C” level malls or strip malls with limited foot traffic.  BBW also has over 200 patents that protect such things as the process, names, equipment and POS systems.  BBW partners with other elite brands such as Disney, Nintendo, and Hanna Montana.  These relationships are used as brilliant marketing tools that reinforce brand loyalty, and can not be easily replicated.

 

Operations:

Specialty mall retailers averaged $403 in sales per square foot in 2006.  BBW averaged $573, beating out Abercrombie, Hot Topic, Claire’s, Pacific Sunware, Children’s Place and Toy’s R Us.  While Gymboree’s average per square foot was 3% higher, it was the only specialty mall retailer we are aware of that beat BBW, and it was the first year Gymboree inched above BBW.  Because the company is so customer focused, its’ store footprint has wide aisles so parents with strollers can maneuver effortlessly, and all merchandise is stocked lower so kids can reach it easily.  This makes its’ sales per square foot accomplishment that much more impressive.  We see further improvement in BBW sales per square foot numbers as the average store size moves from 2,800 to 2,500 square feet with no anticipated change in revenue levels.  Operational efficiencies have been identified, allowing the company to reduce the store footprint, such as one “stuffing” machine with two nozzles instead of two stuffing machines, and an inventory management system allowing the company to respond quickly to demand without holding as much inventory in the back room of each store.

 

Capital expenditures for a new store build out averages $500,000.  New stores pay for themselves within 12-18 months.

 

Store contribution for the last four years has ranged from 24-27%.  This is the equivalent of EBITDA per store after corporate, franchising and licensing sales and expenses are removed.  Note that many retailers omit marketing costs from store contribution calculations because the marketing budget is considered a corporate expense.  We understand BBW’s store contribution would have been 31%-34% if marketing costs had been omitted.

 

 

Growth: 

Like most retailers, growth will come in large part from adding new stores.  BBW has grown revenue at 21% CAGR the last five years.  BBW had 356 stores at the end of 3Q07.  There were 264 company-owned stores in North America (primarily U.S.) and 45 company-owned stores in the UK/Ireland and France.  There were 47 franchised stores internationally as well.  Management believes North America can support 350-400 stores, the UK/Ireland/France can support 70-75 and international franchising can support 300 stores.

 

In late-2003/early-2004 BBW rolled out a national TV advertising campaign for the first time.  Same store sales spiked 18% in 2004 in response.  In December 2007, BBW will roll out its new virtual social networking website which is a brilliant “new age” marketing tool.  BBW research has shown that children’s play patterns are changing, especially for girls who “age out” of BBW later, and are embracing the on-line world more.  Boys have been attracted to the on-line world because of the competitive nature of gaming.  But girls, who are getting into gaming more, also embrace the expressive and emotional aspects of virtual social networking.  In the store, the final step of the process is to “Name Me,” where the new furry friend is entered into a database with customer information and a birth certificate is produced.  As such, BBW has customer information on 33 million people.  These customers will be invited back to the store to get information and access to the new website.  When customers enter the website, their particular store-bought stuffed animal will be their virtual avatar.  Customers earn online “points” through in-store purchases and online game play, which are used to acquire clothing for the virtual animal.  There will be dozens of games to play, which will be changed regularly to keep the child coming back.  These changes will coincide with in-store promotions such as new animal introductions (20+ per year), thus driving traffic back to the store.  Points earned on-line can either be spent in the virtual store, donated to charities, allowing for an educational element that parents will embrace.  We believe the web-based sales & marketing channel could drive same store sales on par with the 2004 TV campaign.

 

Other store concepts are in the early stages, but could gain traction in 3-5 years when the BBW concept is reaching saturation.  These concepts include: a make-your-own-doll, make-your-own-toy-car and make-your-own-dinosaur associated with T-Rex Cafes.  Whereas the doll concept has cannibalization potential and the dinosaur concept is limited by the number of cafes, the RideMakerz concept has huge potential.  The first four stores are opening in 2007, so it is very early stage.  BBW has a minority interest in RideMakerz (growing, but expected to be a 34% stake in 2008).  This concept targets boys and therefore broadens BBW customer base (BBW is 70% girls, 30% boys).  The 20+ different cars will be customizable with decals, engines, spoilers, wheels and best of all, there is a remote control option so they can be raced.

 

Balance Sheet/Cash Flow: 

BBW has a clean balance sheet with no debt.  Operating cash flows have ranged from 10-15% of sales for the last few years and the company has been able to fund its capex for new store openings while staying free cash flow positive.

 

Catalysts:

• New virtual social networking site with a Dec 07 target release date will drive same store comps
• New BBW store openings will drive growth in the short-term; new store concepts will continue growth long-term
• Operational efficiencies will grow the bottom line even faster
• There’s also a wild card.  The Board undertook a strategic review in June and we believe a decision will be made by the end of the year.  If a strategic or financial buyer is announced, this undervalued stock will jump.  However, we view this as an unlikely outcome in today’s credit market and depressed valuation multiples.

 

 

RISKS

 

Same Store Comps:

Even though BBW has one of the highest sales per square foot ratios in the industry, the stock is under pressure because of negative same store comps.  BBW is dependent on mall traffic, which has been down mid-single digits the last few quarters.  BBW also had some merchandising missteps last year (betting too heavily on Shrek and not enough on Mumble) so its comps turned negative before the rest of the retail sector.

 

Part of the reason BBW comps are low is a factor of its strong growth, driven by new store openings.  BBW stores opened less than one year do very well because of the promotional activities surrounding a new store opening and the buzz that’s created.  As the buzz dies down, but the repeat customer base isn’t as established yet, store comps deteriorate.  Stores open five-plus years perform very well.  With stores open less than one year excluded from the same store comp calculation, but setting a high bar for the second year, and the significant store introductions the last few years, the majority of stores have been open less than five years, thus putting pressure on the comps.  We estimate this trend will gradually reverse itself by 2010 when there will be critical mass in the older, better performing store count.

 

We also believe that the virtual social networking website will drive traffic back to the stores, potentially masking the new versus old store issue mentioned above.  We believe that most, if not all, the negative sentiment surrounding this stock will dissipate with a turnaround in comps.

 

Strategic Alternatives:

We believe in this company’s performance and growth prospects, yet it’s trading at very cheap multiples.  This is a perfect scenario where you want to be long-term holders, so the last thing we want is a buyout where we make a quick profit but leave money on the table in the long-term.  As mentioned, we don’t think an outsider will buy BBW in today’s market.  BBW is Maxine’s passion and she’s not going to give away the company.  While it would be tight, she could buy it back herself by our calculations.  BBW can handle the debt load with its strong cash flow generation, so in theory it could take on the debt itself and take the company private without compromising growth.  Assuming an 8% interest rate, we estimate interest coverage would be 3.8x (2008 EBITDA/Interest Expense) and Debt/EBITDA at 3.3x.  Again, this is a stretch, but not impossible.  While Maxine commented that she doesn’t like debt, she feels like a recap could put more equity in employee’s hands, and avoid having to deal with continually telling the story to help outside investors understand the company and the same store comps issue.

 

 

Consumer:

Everybody is worried about the U.S. consumer; therefore retail stocks are not in vogue.  BBW has mentioned that when mall traffic is down, it expects to be down more (and vice versa).  BBW is less holiday-driven than most retailers because it focuses more on birthday parties and is as much an entertainment venue as a retail destination, but it is not immune to the holiday season.  We believe that the recent market turmoil is largely Wall Street driven versus Main Street driven.  While the subprime mess will leave its mark on Main Street, we believe that American’s put their kids first and BBW’s price point ($35 average ticket) is not a significant burden.  While housing can be a leading indicator into a recession, the job market has held up and wages continue a slow but steady climb.  Therefore, we believe the American pocketbook will not be hit as hard as the media portrays.  Even if you disagree with this opinion, recessions don’t last forever and BBW is a long-term investment trading at a deep discount.

 

Furthermore, a recent store visit on a Sunday afternoon lends credibility to our thesis.  We witnessed a line out the door with at least 40 people waiting to stuff bears.  There were another 30 people shopping for accessories and 10 in the checkout line.  Rudolph (with a lit nose) and mate Clarice are big hits this season, brought back after overwhelming demand a few years ago.  Accessories that sport Disney characters, Hanna Montana, High School Musical and Cheetah Girls are also driving traffic.

 

 

VALUATION

 

Selected Financials

 

(All Figures in $ millions, except per share and % data)
	2002A	2003A	2004A	2005A	2006A	2007E	2008E	2009E	2010E
Total Revenue	169.1	213.7	301.7	361.8	437.1	482.2	542.2	628.7	738.1
y/y growth		26%	41%	20%	21%	10%	12%	16%	17%
Gross Profit	78.5	97.4	150.8	181.4	209.6	225.0	254.8	301.8	354.3
Gross Margin	46%	46%	50%	50%	48%	47%	47%	48%	48%
Operating Profit	8.9	12.4	32.6	42.7	46.9	36.9	46.8	63.7	74.8
Operating Margin	5%	6%	11%	12%	11%	8%	9%	10%	10%
Net Income (Loss)	5.4	7.6	20.0	27.3	29.5	23.6	29.3	39.6	46.4
Profit Margin	3%	4%	7%	8%	7%	5%	5%	6%	6%
Diluted EPS	0.45	0.43	1.06	1.35	1.44	1.15	1.43	1.94	2.27
Capital Employed	34.2	37.1	28.2	39.4	111.2	113.4	112.5	106.7	97.1
EBIT	8.9	12.4	32.6	42.7	46.9	36.9	46.8	63.7	74.8
ROIC		35%	100%	126%	62%	33%	41%	58%	73%

 

 

Per Store Economics (2006A):

$1.8mm           Average Sales per Store

$1.0mm           COGS

$0.8mm           Gross Profit (45% Margin)

$0.3mm           SG&A

$0.5mm           Operating Profit (26% Margin)

 

A new store build out requires $500,000 in capex, which pays for itself in 12-18 months.  Store contribution (store EBITDA) has ranged from 24% - 27% the last four years (31-34% if you exclude marketing costs).

                       

Discounted Cash Flow:

Our DCF model yields an intrinsic value of $30 implying a 45% discount to the current price of $17.  We used VERY conservative assumptions: comps not improving until 2009, lower margins than historic performance, slowing owned new store growth (8% CAGR for the next 5 years versus 24% CAGR for the last 5 years) and a 12% discount rate.  We ignored growth potential from new store concepts and the virtual social networking site. 

 

As a market check, in August 2007 Disney announced it was buying Club Penguin for $700 million ($350 million cash plus a $350 million earnout by 2009).  Club Penguin is a social networking site, started in 2005, that took off largely because of the movie Happy Feet.  It has 700,000 paid subscribers ($5.95/month, $57.95/year) and 12 million activated users (there is limited gaming features for non-paying users).  Compare this to BBW’s market cap of less than $350 million and no debt; its customer database of 33 million potential users of its new virtual social networking site; not to mention it has a 350+ brick and mortar stores and counting.

 

Multiples:

BBW trades at 4.0x its 2008 estimated Consensus EBITDA of $81 million.  A more reasonable multiple of 8-10x for a small cap company with strong growth and store economics, yields a share price of $32 - $40.

 

BBW also trades at 10.8x its 2008 P/E (Consensus EPS of $1.52).  Applying a market multiple of 18-20x yields a share price of $27 - $30.

 

Like our DCF model, we believe the Consensus numbers used above place no value on the virtual social networking site or new store concepts.

 

BBW is not a stuffed bear company, but a brilliant customer-driven marketing company.  They understand their customer and know how to keep them loyal.  Management is experienced and focused on building the brand.  The balance sheet is clean.  Stores are highly profitable with one of the highest sales per square foot at $573 in the industry and a 24-27% store contribution margin the last four years.  There’s room to grow new BBW stores for the next few years and new concept stores over the longer term.  The new social network site has the potential to turn around the negative comps, we won’t venture on the number, but the 2004 TV campaign resulted in 18% positive comps.  Ignoring the growth potential from new concept stores and the social networking site, BBW is significantly undervalued, plus you have a free option on these catalysts that have huge potential for BBW long term.

 

Catalyst

(1) New virtual social networking site with a Dec 07 target release date will drive same store comps
(2) New BBW store openings will drive growth in the short-term; new store concepts will continue growth long-term
(3) Operational efficiencies will grow the bottom line even faster