Contrarian: Bed Bath & Beyond Is Nothing Like Best Buy

By: SumZero Staff | Published: March 21, 2013 | Be the First to Comment

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Bed Bath and Beyond (BBBY) is an exemplary free cash flow story which many market participants don't seem to buy at this moment. One of the market's concerns is that the current misfortunes of declining sales and a subsequent drop in multiple at Best Buy or Staples may repeat at Bed Bath and Beyond. While BBBY and BBY have similar tickers, common sense would help anyone understand that the story of BBBY is a fundamentally different one.

BBBY is still growing, albeit at lower rates, maintaining superb margins to other retail competitors with seasoned management developed in-house and most importantly, generating a massive amount of free cash flow. It also boasts a remarkable track record of sound capital deployment with high returns on invested capital at over 20%.

The Company has been crystal clear with investors on where to spend its cash - share repurchase. At the current pace of $1bn a year in share buyback, the Company can remove all outstanding BBBY shares within 13 years or so provided that long-term bears keep the BBBY share at the current price of ~ $60.00 or lower. Yes I admit that it is dumb to assume a static share price for the next 13 years but it's just one way to demonstrate BBBY's ability to generate immense free cash flow over its undervalued equity. I thank Mr. James Grant for an inspiration for this BBBY idea.

Grant's Interest Rate Observer article on Wal-Mart dated on July 1, 2011 recommend buying the shares of WMT for a huge potential upside on the back of WalMart's use of its cash flow (not even fully free cash flow as WMT was aggressively adding debt) for massive share buybacks, which significantly grew EPS despite its flat to negative US SSS y/y growth. WMT performed quite well, up 36.4% before dividends of 2.6% annum since July 1, 2011. This is an amazing performance for a $200+ bn market cap name when S&P 500 returned about 15% before dividends during the same period.

Now looking at BBBY, I think the current situation is even more interesting than that of WMT in July 2011 as BBBY is quite cheap at 11.75x forward P/E (FYE Feb 25, 2014) , 7.8x EV/LTM EBIT and 13x in EV/LTM FCF. With shares outstanding likely declining 7-8% a year at the current rate, significant equity returns are expected for shareholders with patience as long as the intrinsic value grows modestly.

So is BBBY a value stock or a value trap? Since everyone can agree that BBBY's capital deployment policy is very shareholder friendly, I want to focus on [1] stability in BBBY's free cash flow and [2] longevity of its business model, which would allow me to come up a proper multiple for that FCF. Based on publically available information and some anecdotal analysis with common sense, I am comfortable with stability and longevity of its cash flow. There might be a significant re-pricing opportunity in BBBY equity once the Company clarifies a low but sustainable growth trajectory and speeds up its newly launched $2.5bn buyback program.

Is BBBY going to be the next BBY?
Let's get real on Bed, Bath and Beyond. I don't want to buy bed sheets and pillows online because I really want to touch those before I buy them. I go to Bed Bath and Beyond because there is very little individual brand recognition in that segment unlike clothing brands. Those are commodities but very standardized to the levels of consumer electronics.

A reasonably tech-savvy shopper like me cannot check out the product and buy it online elsewhere because the very product I test at a BBBY store may not be available anywhere else but bedbathbeyond.com. I also noticed that BBBY offers the most competitive pricing on some brand name bedding products. I want to point out longevity of some popular products in a typical BBBY store. J.A. Henckels has continuously been in business selling knives since 1731, Pfaltzgraff ceramics since 1811), Riedel glasses since 1756, and Le Creuset pots since 1925.

In-store purchase patterns of bed linens and bath towels probably won't change for a long time just as I still go to a local grocery for fruits and vegetables because I must inspect those in person before purchases. The product categories at BBBY are too costly to ship due to heavy weight or low-ticket prices, which makes the distribution of household goods fundamentally different from that of books, cameras, computers or even clothes. That is why I think even in the bear case BBBY may experience a very slow and gradual decline but not an unexpected sudden failure.

Conclusion
In the 2011 letters to Berkshire Hathaway shareholders, Warren Buffett explained why he would definitely prefer IBM's share price to stay depressed than move up. He is in IBM almost indefinitely and can most effectively increase the percentage of his ownership if IBM buys back shares at the lowest possible prices. That is why is he wish for IBM's stock price to languish for a while. I think the same logic applies to the behaviors of the Walton family and the co-chairmen, Mr. Eisenberg and Mr. Feinstein.

Obviously, the Walton Family strongly believes in stability and longevity of their retail empire. Buffett almost always chooses stocks with no intension to sell while carefully selecting great companies of excellent economics. Bed Bath and Beyond's two co-Chairmen would have reasonable faith in the Company's stability and longevity; and I do as well. During the transitioning period that growth-oriented investors move out and that gap is not readily filled in by other willing buyers, the Company can use this buy-back magic most effectively to enhance per-share value.

In the case of BBBY, patience can greatly pay off as the current valuation is already very reasonable to its own historical trend or the current levels at other comp retail names. The target price of $80 is reached in consideration of the following: [1] a 13.1% decrease in outstanding shares via $2.0bn (2 yrs of $1bn run-rate in the last two years. $191mm from the old program + $1.8bn from the $2.5bn new program) in share repurchase for an average price of $67 per share (10% above the current price), [2] 8.0x EV/EBIT multiple on consensus EBIT of $1,842mm for the fiscal year 2014 ending Feb 2015 and [3] no increase/decrease of cash or debt.

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