Sunday, July 14, 2013

Bed, Bath & Beyond and Beyond

With the housing market seemingly at the start of a multi-year recovery, the market has been keen to bid up any stock related to the sector. Usually this is for good reason, because the earnings outlook is improving for these companies. However, in the case of homeware retailer Bed Bath & Beyond (NASDAQ: BBBY), I think the market is giving it the benefit of the doubt over the prospects for its restructuring, acquisition and expansion strategy. The stock is already up 26% this year. How much further can it run without definitive evidence of success?

A special situations play

Going into this year, BB&B was challenged to adequately integrate its World Markets and Linen Holdings acquisitions, restore same-store sales growth and margins, and successfully continue is store expansion plans.

It needs to do these things because It has been suffering from margin contraction as its sales mix has been shifting towards lower margin item sales. Meanwhile, its acquisitions have increased selling, general, and administration (SG&A) costs.

Here's a graphical representation of how its margins have moved in the last few years:

Source: Company financial statements.

Readers will note that there wasn’t much improvement in the recent quarter.

Latest scorecard from the Q1 results

The bad news in the quarter was that the acquisitions continued to increase SG&A costs by 100 basis points, while gross margins declined thanks to increases in couponing and redemptions. Meanwhile, sales have continued to drift toward lower-margin categories.

The good news was that same-store sales increased by a healthier 3.4%. This was put down to an increase in transactions and transaction amounts. While this is a good sign – and Q1 was a difficult retail environment -- I can’t help but remark that it should be able to sell more items if it is offering more coupons. Unfortunately, the drive to increase sales is coming at the expense of margins. Furthermore, its guidance of 2%-4% same-store-sales growth for Q2 and the full year was nothing to write home about.

So the acquisition integration appears to be holding back margins, but the company hasn't slowed down its expansion plans. In fact, store space (including acquisitions) increased by 16% for the year, and capital expenditures for 2013 are forecast to increase to $350 million in 2013 from $315 million last year.

The company plans the number of new stores opened in 2013 to be in the "mid thirties," although the management gave notice that it would update investors in the final figure as the year progresses.  And finally, a significant amount of investment is being made to upgrade Bed Bath & Beyond's websites and e-commerce facilities in order to drive multichannel sales. Will it all work?

The benefit of the doubt?

Are investors being too keen to cut the company slack over its performance and prospects?  It’s not hard to see why they would, because so much has being going right for this subsector of retail in 2013.

On the other hand, each company must be judged on its own merits. For example companies like Williams-Sonoma (NYSE: WSM) and Pier 1 Imports (NYSE: PIR) have done very well by increasing their multichannel sales efforts. But they are way ahead of where Bed Bath & Beyond is right now.

Williams-Sonoma is trying to increase its Direct to Consumer (Dtc) revenues (things like catalogue and online sales) because they tend to fetch higher margins than selling through retail and wholesale channels. Indeed, its DtC-based revenues rose to 22.9% of total revenues from 20.8% last year. This helped its operating margins rise by 60 basis points in the last quarter. Similarly, Williams-Sonoma is engaging in a program of opening new stores and expanding existing ones -- albeit mostly abroad. It's also increasing capital expenditure plans this year to $200 million-$220 million, this year, compared to $205 million last year.

The difference is that Williams-Sonoma is firing on all cylinders. It is expanding margins and demonstrating success with its expansion plans, and it generated 7.2% overall growth in its comparable brand revenue.  This is a far cry from Bed Bath & Beyond’s 3.4% same-store sales growth.

As for Pier 1 Imports, it recently reported comparable store sales growth of 5.9% and has just reached the anniversary of its e-commerce enabled site. It has seen its e-commerce contributions to total revenue make ‘progressive increases’ since their launch (even though investors will have to wait until Q1 2015 for a breakout of its comparable-sales calculation for DtC sales), and it is investing heavily in that effort as an integral part of its plans.

Pier 1’s strategy is to arrange for in-store pick up capability (customers seem to use this extensively), and it's rolling out an in store point of sales system (90% of its stores are already operating it). Pier 1 grew its overall sales by 9.3% in the quarter. Again, this company is executing very well within a favorable end market. Furthermore, note that Pier 1 is well ahead of Bed, Bath & Beyond with its online plans.

Where next for Bed Bath & Beyond?

Of course, what BB&B does have going for it is its valuation. On these grounds it compares quite favorably with the two other companies mentioned in this article.

BBBY PE Ratio TTM data by YCharts

Moreover, if it hits analyst estimates for $5.02 in EPS it will trade on a forward PE ratio of around 14.4 as I write.

Ultimately, an investment decision here is going to depend on your level of belief in the successful execution of the plans outlined above and an ongoing belief in the housing market recovery. The company will see better end market conditions thanks to an improving market, but I don't think that is enough of a reason to buy the stock.

Moreover, If the the housing market stalls, then this stock’s prospects will be called into question. There are always risks with expansion plans, not least from a company that has been seeing margins falling and lackluster same-store sales growth. Sentiment will likely take the stock higher, but I think the company needs to demonstrate better underlying performance before justifying buying in at this level.