Bed,Bath and Beyond Competition Coming?

With the housing sector perking up Bed, Bath and Beyond (NASDAQ: BBBY) is the sort of stock that investors should be looking at. It is supposed to be a simple play on an improving housing maket. Unfortunately investing is rarely that simple and the company delivered a set of results that sent the stock down nearly 10%. Moreover it created more questions than answers. So I thought I would try and make sense of it all and suggest some other ways to play the housing theme.

With the housing sector perking up Bed, Bath and Beyond (NASDAQ: BBBY) is the sort of stock that investors should be looking at. It is supposed to be a simple play on an improving housing market. Unfortunately, investing is rarely that simple and the company delivered a set of results that sent the stock down nearly 10%. Moreover, it created more questions than answers. So I thought I would try and make sense of it all and suggest some other ways to play the housing theme.

Bed, Bath and Beyond’s Results

Net sales increased 12.1% but same store sales growth declined to a 3.5% increase from 5.6% last year. However, the real story here was about margins. The company was hit with a double whammy of increased cost of sales margins and higher selling, general and administrative (SG&A) costs. The result was a 200bp reduction in operating income margins which actually took operating profit down 1.7%. Not good.

A quick look at how these margins have been moving.

Costs have been going up this year while same store sales growth has been slowing. Furthermore, acquisitions have been made in 2012 which suggest that it is trying to buy growth to compensate for slowing organic growth.

Turning to the specifics with cost of sales, the increase was attributed to three factors. First, an increase in coupons coming from redemptions going up and average coupon amount increasing. Second, the mix of product sales resulted in an increase in lower margin sales. And third, the inclusion of costs from the acquired (World Markets) business.

With regards SG&A the management put it down to higher payroll, occupancy, and advertising costs. In addition all of these costs included contributions from the acquired business which has higher costs ordinarily.

In a nutshell, BBBY is paying for top line growth at the expense of margins and earnings. This is fine if it is just a transitional issue before the revenue contributions from the acquired businesses start to anniversary but the slowing same store sales growth is a concern.

A look at how the acquired businesses contributed to sales growth.

To be fair BBBY is in process of rolling out new stores so we can expect new stores contributions to increase in future. Nevertheless, slowing same store sales growth is an issue particularly when considering how well competitor Pier 1 Imports (NYSE: PIR) is doing right now.

What the Industry is Saying?

Pier 1 recently reported in line results but raised full year guidance and forecast same store sales growth in mid-single digits. Interestingly, it is accelerating its e-commerce activities and I take this as a sure sign that online competition is coming to the industry. I have concerns about Pier 1’s online activities affecting its margins but then again businesses are obliged to respond to competitive threats.

BBBY would be advanced to take note because companies like Amazon are expanding their product offerings.  Amazon’s subsidiary Quidsi launched casa.com this year. A website whose rasion d’etre is arguably to grab market share from BBBY and Williams-Sonoma (NYSE: WSM). While Quidsi seems to operate with relative autonomy from Amazon it is hard to imagine that Amazon couldn’t drive significant traffic flows to its websites if it wanted too.

As for Williams-Sonoma, it recently reported revenue growth of 7% with comparable brand revenue growth improving to 7.4%. In a sign that e-commerce support is now essential in the industry it saw online revenues go up 14%. Williams Sonoma has driven top line growth through a mixture of innovation in its core brands, new brand launches and international expansion. All of which requires a lot of management focus and execution.  So far, so good for Williams-Sonoma.

The home goods space is becoming crowded and when you consider that off-price retailers like Ross Stores (NASDAQ: ROST) are aggressively expanding their store roll outs and home goods are a big part of the expansion. Ross describes its traffic as being more robust than it has been in a long while. And footfall is the holy metric of retail. It’s hard not to imagine that the off-price retailers are grabbing market share although that sectors operational performance is not as closely tied to housing and consumer spending.

In summary, the industry is becoming more competitive and BBBY is underperforming.

Where Next For Bed, Bath and Beyond?

The company needs to do a few things going forward to make it a more attractive investment proposition. First, it needs to get same store sales growth back in line with its peers. I would guess around mid-single digits would do. Second, it needs to successfully integrate the acquisitions and demonstrate it can reduce SG&A costs accordingly. Third, it needs to make hard decisions over whether it wants to chase/protect top line growth or expand margins.

I expect a lot more competition in the sector going forward and its combatants need to prepare for an online onslaught. I prefer companies that are in shape to deal with challenges rather than struggling to keep up with its peers. BBBY can turn this around because end demand is looking good for the sector but cautious investors will wait to see some evidence first.