Tuesday, 11 April 2017

Why Bed Bath & Beyond (NASDAQ:BBBY) seems to offer a rare bit of US value

If you watch the work of a drug sniffing spaniel on TV you will note that occasionally they will have to plant some drugs in a car or container so the dog can find them otherwise it gets demotivated and gives up. Hunting for value at the end of a bull market is a bit like this for the humble analyst – one just wants to overturn a classic value opportunity occasionally to avoid becoming demoralized about the state of investment options. 

With US stocks trading at significant highs it is increasingly difficult to find any definitive value stocks. The so called ‘bricks and mortar’ retailers seem to be offering relatively low valuations with companies like Sears likely to go to the wall. This sector in the US is much like the one in the UK where the Next vs ASOS trade off with disruptive online retailers is driving down the margins and sales of established players – one stock in particular is often mentioned; Amazon.

Amazon is huge – the growth (especially top line) has been incredible. Amazon has managed to gain a wide moat from the application of network effects as consumers buy more and more from them utilizing their broad offering and impressive sales platform and distribution network. I will often see if an item is on Amazon first as the checkout is so straight forward as they already have my details. 

The success of Amazon is particularly pronounced in standardized items like electronics and books where price is the key determinant. I think retailers with things like clothes, home-wares, furniture etc have a greater chance of survival against total 'e-commercialization' due to the tactile nature of their products.

Where does that leave a stock like Bed Bath and Beyond? 

BBBY is a retail group principally composed of home-wares stores alongside a limited number of other concepts. Established in 1971 the company has grown to have a strong retail presence across the US with 1,530 stores across the US and Canada. BBBY like most traditional retailers is suffering a downturn which I think is in part structural and in part cyclical. Therefore my value thesis is that the cyclical element of the downturn is being underplayed and the structural disruption created by Amazon and other online retailers is being overplayed.

My view looking at retailers is that companies like Amazon and ASOS which grow top line, offer the lowest prices, and have therefore very low margins are successfully taking market share from traditional retailers. 

Amiable Minotaur Amazon Model: Revenues & Margins

However I think some of this is cyclical. I believe the wider economy is slowing and this is pushing consumers to be increasingly price conscious playing into the hands of the new web discounters. I think we are seeing a cyclical slowdown in consumer spending and we will see this before we see a real drop in GDP. 

I think therefore that the structural story which has been so prevalent in the media about Amazon and other disruptors is being slightly overplayed because it is a more exciting story about technological change. If this thesis is correct Amazon could suffer a sharp correction in due course as the tail end of the consumer slowdown starts to impact their top line growth and the trajectory of their world domination.

Now my thesis could well be wrong. But I take the view that there are two maxims to investing; the classic EM political argument ‘buy when there is blood in the streets’ and my own DM maxim ‘buy when the media can’t stop going on about a trend or crash.’

BBBY are adapting to the new environment and seem to have a decent website proposition. I think some good operators can take advantage of their physical retail operations in combination with E-commerce to give a broader offering. By which I mean sometimes the ability to order online and take back to a store and exchange can be highly convenient for consumers. There may also ultimately be a backlash against this move online if physical retailers can offer a different ‘experience’ and something more exclusive. 

Trends change. Right at their extreme the consensus becomes a foregone conclusion.

I think we have reached peak Amazon because of this;

The Economist
These things tend to hit the press right before a significant fall, remember this (before the worst recession in a generation):

The Economist

Now I don’t like to do too much macro prognostication and I don’t think I need to with BBBY because this stock is a rare combination of cheap and decent quality. Looking bottom up let us take a view of the numbers.

BBBY trades on 8x trailing P/E and 4x EV/EBITDA. That is cheap for a company which over the past 10 years has consistently created significant value for shareholders. The stock has 10 year CAGRs of 9.4% EPS growth (3.6% excluding buybacks) and 6.2% revenue growth. Decent numbers for a mature business. It has generated an average 14% ROA and no less than 20% ROCE every year for 10 years. This business has low capital intensity averaging 2-3% Capex/Sales ratio and around 20-30% Capex/Net income.

BBBY has not paid a dividend until recently having commenced a $0.125 quarterly dividend last year. The pay-out remains low with around a 1%-2% yield but could easily be increased depending on the scale of buybacks. BBBY has consistently been buying back stock for many years. 

The company has repurchased 42% of the shares in issue 10 years ago with 120m shares bought back. This has flattered the EPS but is a common if muddy method of capital returns often employed in the US due to high taxes on dividends. Better yet until recently all the buybacks were purchased with cash generated rather than debt. 

In 2014 the company issued a series of bonds totaling $1.5bn in three tranches with $300m due 2024 at 3.749%, $300m due 2034 at 4.915% and $900m due 2044 at 5.165%. Note these bonds are investment grade. Prior to this debt raising the company ran net cash:

Amiable Minotaur BBBY Model: Net debt & ROE

On the one hand the additional gearing should lower the cost of capital and enhance returns on equity – furthermore the attractive financing rates and long maturities give ample flexibility to BBBY in the future. They got the bonds away during a stronger period in their results which was smart.

The bad bit is any debt reduces financial flexibility. The present debt load is manageable being around 1 x operating profits so gearing is low. However, leverage works best with a growing business not a potentially declining one – still I think the modest gearing is a net positive for BBBY and it should enhance returns of cash to shareholders over the medium term.

The greater form of debt that BBBY has is the burden of a leased store base. The company has $3.2bn of future minimum lease commitments (undiscounted) with around $585m in annual costs at present. The good news is they appear to have a very flexible short term portfolio. Only 29% of that $3.2bn is due after 2020 suggesting the weighted average portfolio of commitments is short term ensuring greater flexibility to the company to change and close under performing stores if we have indeed reached ‘peak physical retail.’

Using my 8x lease multiple for $585m per year assumes a PV of leases at $4.68bn. This would give the company a total debt load of ~ $6bn if we treat those leases as debt. However as above we can see the actual undiscounted future minimum lease payments are substantially less than this. If we take a worst case $6bn of debt ‘like’ items on the balance sheet this still amount to ~4x operating profits (not adjusting for depreciation vs interest). So the operating leverage is clearly higher than the initial indebtedness would appear – but still the combination of the operating and financial leverage is manageable.

Fortunately defined benefit pension liabilities are only ~$20m and therefore negligible. 
Share based payments on the other hand are a little excessive. The company recorded $67m (2015; $66.5m) of share based payment expense in the last period. The post-tax values were $42.4m (2015; $42.4m) which represents 5% of profit after tax. Not a huge hit for shareholders. But I do question whether management really need this much of an ‘incentive’ to perform their jobs. I suspect this will be reduced in the current fiscal year due to the decline in the share price.

I do however like the feel I get from the governance report and the management. The CEO has worked his way up through the company over 25 years (CEO since 2003) and despite a mandate to hold a minimum of $6m in stock (~150,000 shares) he holds more like 2m shares. The co-chairmen are octogenarian founders. This is a family business with long serving directors. Now I think they are a little self-serving reading through the compensation disclosures. But I can live with that as they appear to be decent operators with the right level of investment and therefore incentives to grow value in the long term.

BBBY have no particular 'moat' or sustainable competitive advantage other than physical presence and scale. This is a big company with 1,500+ stores so some level of scale helps the business. The lack of any greater unique advantages makes this kind of retail subject to commodification and price wars that drive down margins.

What about the valuation?

I think BBBY shares are worth around $60 a share. 

I am baking in a relatively modest cyclical downturn and slow growth going forward. Forecasting 1% top line declines in 2017 and 2018 with 1-2% growth thereafter and operating margins dipping to 10% rising to 10.5% over 5 years (only in 2009 did the operating margin dip below 10%). I foresee capex at ~3% of sales over the medium term as the company invests more in its online offering. Using a 7.4% WACC I get a DCF value of $61.15. 

Amiable Minotaur BBBY Model: Revenue& Operating Margins

Unsurprisingly the stock screens less well on a DDM model due to the paltry pay-out at present. Given an assumed 2017 dividend of $1 a year and a 4% growth rate the DDM gives only an $18 a share value. But if we assumed they spend ~$1bn giving back cash rather than buybacks a dividend of $6 a share would be possible meaning a DDM of $107 per share (BBBY has spent > $1bn a year for the last 3 years on buybacks).

The 10 year average PE for this business is 11.3x – this seems low – paying 10x 2017E earnings suggests a value of $47 a share and there is a margin of safety here as these are likely to be cyclically depressed earnings. 

Amiable Minotaur BBBY Model: EPS

Therefore my floor value for BBBY would be $47 in the medium term and $60 in the longer term assuming a relatively modest downturn. I think the market is discounting the death of traditional retail at present many years before its time. Again I think from a value perspective much like Next vs ASOS paying <10 P/E for a decent quality and highly profitable retailer vs 185x P/E for Amazon - albeit an obviously brilliant and highly disruptive business looks a bit protracted.  

Things I like about BBBY:

  • The valuation is cheap (by my metrics)
  • Financial flexibility - Debt levels are modest and long duration / leases are short duration
  • Well established management team
  • It retails items that are tactile

Things I don't like about BBBY:
  • The business of BBBY has no particular sustainable competitive advantage
  • The company pays out some pretty generous share based comp
  • The retail industry is in a cyclical downturn and faces divisive secular trends and disruption
  • The dividend payout is a bit low 
Disclaimer: I have no interest in BBBY shares at present. I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

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