Saturday, January 12, 2013

Bed, Bath and Beyond Continues to Underperform

In theory, Bed, Bath and Beyond (NASDAQ: BBBY) should be firing on all cylinders. The whole sector is enjoying what seems to be the beginning of a housing recovery. It’s almost like spring is in the air; companies are reporting accelerating same store sales growth, input costs are moderating and restructuring plans seem to be a lot easier to implement. Everyone is happy. Everyone, that is, except for Bed, Bath and Beyond stock holders.

What Is Going Wrong?

Superficially the numbers look good. Earnings are predicted to rise in the double digits this year and the next, while the company has been doing the right things and making acquisitions when borrowing is cheap and the home goods market looks set to turn up. Well, if this is all good news then why is the market busy punishing the stock?

The issue with BBBY is that comparable same store sales are not doing well while margins are increasing, thanks to a combination of factors. Sandy affected same store sales to the tune of 90 basis points, and they came in at a paltry 1.7%. This is significantly below what other housing related companies are reporting. It gets worse. BBBY is forecasting only 2-4% growth for Q4 and the full year, and this is nowhere near its peer group.

For example Williams-Sonoma (NYSE: WSM) came in with ‘comparable brand revenue’ growth accelerating from 7.4% to 8.5% in the quarter. Pier 1 Imports (NYSE: PIR) reported comparable same store sales growth at 7.9% with particular strength cited in its furniture range. In addition, the major home improvement stores like Home Depot (NYSE: HD) and Lowe’s Companies (NYSE: LOW) have both been reporting an increased willingness among their customer bases to buy into the more discretionary items in their product lines.  Indeed, Lowe’s is undergoing a program of restructuring how it sells its products, and it is achieving considerable success in doing so.

There is little doubt that the sector is doing well, yet BBBY’s comparable numbers are disappointing. The second major issue is the margin compression this year.

Bed, Bath and Beyond’s Margin Problem

I’m going to graphically represent what has been going on with margins this year.

Gross margins declined with rising costs from an increase in coupons as well as a mix shift towards lower margin products. This is rather odd given the overall environment where other companies are reporting an increase in customers’ willingness to spend.

On the other hand, the increase in SG&A costs was partly due to the inclusion of the acquired World Market and Linen holdings businesses. In addition BBBY ramped up expenses on enhancing its e-commerce capabilities as well as some relocation expenses. Nevertheless, the hike in SG&A expenses to 26.4% from 25.7% last year is not welcome.

Furthermore, free cash flow conversion is declining as capital expenditures are rising. Indeed, in the nine months of 2012 they are already at $238 million whereas last year they totaled $243 million, although much of it is for new stores and IT improvements. Capital expenditures are forecast to total $325-350 million in 2012 with a mix of new stores, relocations and refurbishments planned for Q4. Additionally, more restructuring is planned for 2013.

Where Next for Bed, Bath and Beyond?

Unfortunately the company doesn’t appear to be executing as well as it could be right now, and investors will be watching to see if it can turn around the declining same store sales trends. The environment is favorable and this is what makes BBBY attractive. In a sense it is the ‘special situations value play’ in the housing recovery sector. Whichever metrics are used to monitor when a company is back on track are really up to the conscience of the individual stock picker. However, in my view it really is gross and operating margins. Both are going in the wrong direction for BBBY, and the increases in couponing and lower margin sales don’t suggest BBBY has its merchandising right.

Restructuring and integrating new businesses takes time and management effort, and I think it is better to wait and see for some more positive news flow from BBBY before getting too interested in the stock. Nevertheless, this is a stock worth monitoring.

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