Description

Bombay Company is a specialty retailer of classic furniture, wall décor and accessories with 500 stores across the United States. Bombay’s primary competitors are Pier 1 Imports, Kirklands and Cost Plus.

Investment Thesis
Bombay is an attractive buy at $4.18 because it has a very healthy balance sheet, yet its earnings are temporarily depressed due to the execution of a strategy to take costs out of the business. The stock is trading at a 15% discount to tangible book value, about 4 times normalized EBITDA, and has no debt. Bombay is moving out of the malls and into better locations, while cutting occupancy costs by 20%. The company’s chief executive has substantial experience in both real estate and retail and has personally been buying a substantial amount of stock.

2004 was the first year in at least 15 years (as far back as I looked) that Bombay generated negative EBITDA. There are several reasons why this occurred.
• In the last two years the company closed 70 mature stores, or 15% of its store base, and opened 168 new stores which have yet to mature. Typically, it takes about three years for a Bombay store to reach maturity. In some cases where the new store is very close to the closed store, this ramp time will be shorter.
• The head of merchandising, Steve Woodward, left Bombay in July 2002 and returned in August 2004. Bombay lost its focus on merchandising during Woodward’s absence, when the head of marketing doubled as merchandiser.
• During 2004 the company faced extremely tough sales comparisons from 2003, when comp sales increased 13% for the year.
Looking out to the remainder of 2005 and into 2006 there are positive catalysts ahead.
• Bombay has two and a half years of its store repositioning effort behind it, with more and more off-mall stores entering the comp report.
• Steve Woodward’s first assortment since returning to the company will hit stores this spring.
• The company now faces a same store sales comparison of negative 12% from its disastrous 2004 results.

Real Estate Strategy
In 2002 Bombay’s board of directors recognized the cost savings that could be achieved by moving stores from mall to off-mall locations. At that time, the large majority of Bombay stores were located in malls. In December 2002 the board hired Jim Carreker as Chairman of the Board, and six months later, Carreker was named Chief Executive Officer. Carreker gained an extensive background in both real estate, as president and CEO of both Trammell Crow and Wyndham Hotel Corp., and retail, as president of a division of Federated Stores and as a former board member of one of Bombay’s primary competitors, Pier 1 Imports (PIR).

With 180 mall store leases having expired in 2003 and 2004, Carreker has aggressively been moving stores to off-mall locations. As a result of these store moves and the growth of Bombay KIDS stores, approximately 40% of total stores were off-mall at the end of fiscal 2004 (January 2005) compared to just 12% of stores two years ago. Bombay’s per square foot lease expense averages about $44 for these new off-mall stores, compared to $55 for existing mall locations. The off-mall stores will be 20% larger than the mall stores, so the company in essence gets the additional floor space for free. Provided Bombay can match the per square foot sales performance in its new off-mall stores that it achieved in its mall stores that are being replaced, the off-mall stores will realize a 20% cost savings.

Of the 168 stores the company has moved off-mall in the last two years, 90 have been open 12 months or longer and are thus in the comp results. As compared to the 262 remaining mall stores, these 90 off-mall stores on average are comping 1-2% better, and more importantly, are averaging a 400 basis point improvement in four-wall profit margin.

Capital Spending
As of the end of fiscal 2004, Bombay had cash and equivalents of $9 million and no long-term debt. The company uses a credit facility to fund seasonal working capital needs. The $125 million facility is in place for five years. Bombay has averaged annual capex of between $10 million and $20 million for the past few years. Incremental spending to carry out the company’s real estate strategy was approximately $15 million in 2003 (total capex of $29 million), and $22 million in 2004 (total capex of $37 million). With 168 new stores opened in the past two years, Bombay will slow square footage growth in ’05, but continue to focus on the real estate strategy. The company plans to close 42 mall stores and open between 45 and 48 new off-mall stores. Total capex is estimated to be approximately $20 million, roughly equal to cash flow from operations at breakeven.

Assumptions
In order for Bombay to realize any occupancy cost savings from its real estate strategy, the company must generate higher per store sales in its new off-mall stores than was generated in the smaller mall-stores they replace. What this means on a per square foot basis is that the new stores have to generate better than 80% of the old sales per square foot to start realizing savings. As indicated above, the off-mall stores are outperforming the mall stores in terms of comp sales and margin. Given the performance of these newly relocated stores thus far, as they mature they should significantly outperform the stores they replace. A reasonable assumption, therefore, is that relocated stores can at least maintain 95% of the sales productivity as the stores they replace, and so generate a 15% savings on occupancy costs. This is logical given that newer retail centers often outperform older ones as a result of the advantage of current traffic flow and newer facilities.

Detail of Cost Savings
Occupancy costs are about 19% of total COGS. Therefore, a 15% cost savings on a 19% cost line for 41% of square feet (and growing) will generate improvement of 1.2% on the operating margin line. Again, this assumes the new off-mall stores will be less productive than mall stores, a conservative assumption given that after just the first year the average off-mall store is more profitable than the average mall store. Prior to 2004, the five year company average operating margin was 2.7%. The impact of a minimal 1.2% margin improvement on earnings will be substantial. Keep in mind that the off-mall square footage will continue to grow every year towards 100%. So the estimated 1.2% margin improvement will increase over time.

In addition to relocating stores, management is undertaking other initiatives to improve efficiencies. For example, the company spent $4-5 million to build a new east coast distribution center, almost twice the size of the old facility, which eliminates the need for third party storage in its eastern markets. This distribution center opened in the third quarter of 2004. The company also invested in a new planning and allocation system, which reduces inventory levels and remote storage costs, and allocates SKUs according to where each item sells best. This system was also implemented in the third quarter of 2004.

Valuation
Given all the transitional noise related to its store repositioning, the lack of a merchandising manager, and extremely tough sales comparisons from 2003, it is no surprise that 2004 was a very tough year for Bombay. However, management has a sensible plan to improve the profitability of its store base, and they have meaningful evidence that the plan is working. For the five years prior to 2004, a more normal environment given that the company did not undertake any substantial structural changes, the company averaged comp sales growth of 5%. Over the same period Bombay averaged a 2.7% operating margin. Using that as a base and applying the minimum impact from the occupancy cost savings of 1.2% margin as described above, Bombay has earnings power of at least $0.75 (5.5 times earnings at the current price). Using the typical peak multiple in the home furnishings space of 11, Bombay is worth $8.25 on its earnings power. Even if I am wrong about its true earnings power, earnings will still improve going forward as the more profitable off-mall stores ramp to maturity and as the company laps miserable sales from last year. With the stock trading at a discount to tangible book, the market is providing a wonderful entry point for this investment.

Insider Ownership
CEO Jim Carreker’s opinion of the value of Bombay’s stock reads loud and clear through his actions. Carreker holds 400,000 shares directly. In addition he has 750,000 shares of restricted stock, which vest at the end of three years, and 400,000 options, which vest over three years with a strike price of $9.23. He took his 2003 salary in stock, which worked out to about 80,000 shares. He bought the remaining 320,000 shares in the open market at prices ranging from $5.60 to $9.98 over the last two years.

Catalyst

Catalysts
• Sales improvement: For the next six months Bombay will lap average sales comparisons of negative 18%. With returning merchandising manager Steve Woodward’s first assortment hitting stores and the catalog now, sales should improve.
• Margin improvement: Decreased occupancy costs will lead to improved margins, especially with leverage from improving same store sales off easy comparisons. The combination will lead to substantial earnings growth in 2005 and 2006.

Risks
• Consumer spending could slow. Investors can hedge out this exposure by shorting one of Bombay’s peers, such as PIR or WSM.
• Very competitive market: Bombay faces substantial competition in the home décor and home furnishings market. However, Bombay does not appear to be losing market share from its closest competitor, Pier 1, as Bombay has grown sales at an average rate of 12% over the past 11 years, versus Pier 1’s rate of 10.5%.