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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Friday, July 27, 2007

Wall Street's Overlooking Bed Bath & Beyond's Long-Term Value

Bed, Bath, & Beyond Corporation (BBBY) has encountered a rough road recently. Currently trading at $35.46, BBBY shares are off nearly 18% from the high of $43.32 reached back in February.

I believe that three factors are responsible:

  1. The general weakness in the retail space from slowing consumer spending
  2. Housing market recession which affects demand for goods specific to BBBY
  3. Decelerating sales growth as new store openings are nearing saturation.
These are very significant concerns but I feel the first two are temporary and the last issue will be addressed with international expansion and new store additions outside BBBY's core concept.
In short, the market is discounting current weakness over a too long period of a time and underestimating long-term growth potential. For the a long-term hold strategy, BBBY shares are attractive at the current price level. BBBY is trading around 16x current year's estimated EPS and 14x next year's estimates. Analysts are forecasting 5yr annual growth of 14-15%, which translates into a PEG ratio close to one.

Remember these EPS estimates represent the depressed, current operating environment and not normal trend growth. From the long-term perspective, we don't select stocks based on this or next year's earnings, rather the long-term earning potential of the company. That being said, normalized near-term EPS would be much higher, thus the forward-looking multiples would be much lower making the stock even more attractive. Value presents itself under conditions of pessimism and near-term challenges, which should be taken advantage of because in the long run returns will be much greater when acquiring shares currently under pressure. Expectations have been lowered, weak hands have been forced out, and now the upside reward outweighs the downside risk.

Sales and EPS growth momentum is strong, averaging 18% and 24% annually the last five years, respectively; I believe 14-15% going forward is attainable. Same-store sales growth will probably average 3-4% and new stores will add 7-8% annual growth for the next five years. With a sizable cash position and weak stock price, I expect significant buy-backs that could provide an additional 4-5% boost to EPS growth. If growth ends up being more tepid that expected, shares will be subject to pressure, but also will provide share buy-back opportunities that could serve as a "hedge" by supporting EPS growth and share price.

The company has close to 900 stores and believes it can achieve more than 1,300 stores domestically. In addition, BBBY operates 30+ Christmas Tree Shops and about 40 Harmon Stores that also provide growth potential.

Bed, Bath, & Beyond has just begun to expand internationally by opening its first store in Canada. International growth could be very significant for BBBY. The firm demonstrated its power to expand rapidly into new markets with ease and should be able to duplicate that success in similar markets outside the U.S. A major advantage is BBBY’s management structure/policy. Store managers, only promoted from within, are responsible for 75% of product selection. This allows the firm to cater to local tastes and preferences as well as the ability to react quickly to any preference changes.

Most products are ordered directly from suppliers thus bypassing the need for company distribution centers. This results in a lower cost structure. By not forcing its concept when entering new markets, BBBY can attract customers by adapting to the local culture. This is a significant benefit when expanding abroad since cultural differences can be accommodated using this management structure.

Remember when the "No-Limit Texas Hold" poker fad erupted? BBBY shook me down when I visited a store to buy kitchen essentials and left with poker chip sets and a card shuffler. I had no intention or real need to buy such products but they got me because of management's ability to respond to consumer interest.

Seemingly, every time I make a trip to Bed, Bath, and Beyond for truly innocent purposes, I depart with those products found on center-aisle displays. If you have been to a BBBY, you know to what I am referring. Nifty products, often unrelated to BBBY's overall product concept, that are tough not to consider buying. It's that anecdotal evidence that illustrates the firm's prowess for making the shopping experience for mundane products exciting and unique. Most importantly, they offer sheik and appealing products at hard-to-beat prices. It's that type of consumer experience specific to Bed, Bath, & Beyond that will keep consumer interest and dissuade them from shopping elsewhere.

Aside from just prospective growth, BBBY deserves a higher multiple considering its high returns on equity and capital. ROE has averaged approx. 24% the past 5 years and profit margins are among the highest in its industry. The established position and consumer acceptance built over the years give BBBY a competitive advantage against existing and potential new competitors.

Bed, Bath, & Beyond’s high margins represent the massive potential cash flow that can be returned to shareholders. In the past five years, net margin has averaged 9.2% with a standard deviation of 0.7%, which is very impressive for a retailer. Over time, capital investment will decrease resulting in higher free cash flow available to owners. Economies of scale and operating efficiencies will continue to bolster return on invested capital and allow the firm to maximize free cash flow per $1 of invested assets.

On a comparative basis, consider the following illustration. For the last fiscal year reported, Bed, Bath, & Beyond's net income was 594 million, and if we did a rough discounted cash flow valuation, assuming zero real growth and zero net investment (capex-depreciation), we would get an intrinsic value around $46 when discounting at the long-term treasury rate (((Income/Treasury Rate)+(Cash-Debt))/Diluted Shares))). That value is about 30% higher than the current stock price. Applying the same calculation to similar firms such as Target (
TGT) and Macy's (M), yields intrinsic values 14% and 13% below current share prices, respectively.

Future growth is expected to make up the difference for those two firms, yet for BBBY growth is expected to destroy value? That's what the back of the envelope math implies, or that growth will be negative and cash flows will decline. Negative growth is highly unlikely just as it’s unlikely positive growth will destroy value when return on invested capital exceeds BBBY’s cost of capital. Relative to those similar firms along with dismissing alternative explanations, it appears that the stock is undervalued. Yet, that math is very crude and only somewhat meaningful in a relative context.

A more involved, 3-stage growth DCF valuation model suggests BBBY’s fair value is $50/share assuming: 9% sales growth and 13.5% EBIT margin for the next 5 years, for the subsequent 10 years assuming: sales growth gradually declines to 3%, EBIT margin falls to 11.3%, and capex & deprecation converge to equilibrium. For a reality check, applying the same valuation method to Target and Macy’s returns intrinsic values roughly inline with their current market prices. In sum, analysis suggests that the stock price is suffering from the recent, disappointing news surrounding Bed, Bath, & Beyond, and in addition, the market is overlooking the significant cash-flow generating potential of the firm over the long run.

Highly profitable, entrenched firms make great investments, but too often that’s no secret on Wall Street, thus the price tag accordingly accounts for such qualities. Yet, when the near-term future looks bleak and long-term picture is believed to be unaffected, an investment opportunity presents itself. Knowing that down the road a firm, such as BBBY, will still be an attractive business is a gift when the market is fixated on the immediate future and takes share prices down accordingly


pywong said...

Hi Turley,

Thank you for sharing. Just some comments on your format for better readability:
1. Provide a line break between paragraphs.
2. Each paragraph can be split into 3 paragraphs for ease of reading.



Turley M Muller said...

Thanks for your suggestion,I apologize for the poor readability. I made a couple improvements, but I will still work on trying to make it easy to follow. Haven't quite mastered the formatting through Blogger, it's not very functional. Thanks again, I appreciate your interest in my commentary.

Turley M.

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