Bed Bath Beyond (BBBY) Stock Report

Bed Bath & Beyond (Nasdaq: BBBY) An Analysis and Valuation of Bed Bath & Beyond By James Cullen, for Wall St. Newsletters Originally Released January 3rd, 2008 Made Public January 23rd, 2008

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Foreword Numerous economists, market forecasters, politicians and others have weighed in on the odds of a recession in the US - that is, a decline in GDP for two or more consecutive quarters. Whether Whether or not a recession occurs, or is already underway, is a matter of pure speculation. Attentions should be focused on prudent investments investments and not on divining economic data. There are two approaches frequently frequently advocated in difficult economic times. The first revolves around chasing growth stocks under the thesis that, as fewer companies grow quickly, those that do will be better rewarded by the market as a whole. The second favors predictable, stable companies - conglomerates, conglomerates, consumer staples, and general blue chip, mega-cap names. Both methods have their place. Certain growth names will perform well, with the obvious caveat that the growth must be for real. Too often, however, I find the growth stories have a high degree of unpredictability, and the stocks are not be cheap. Dogs may chase, but prudent investors should not. With the second strategy, it is difficult to argue against names like Coca-Cola (KO) or Proctor & Gamble (PG) given their enormous economic moats. The stocks, however, simply aren’t cheap at a time like this - both trade around 20x EV/OCF. Still, the idea of buying a consistently high-performing high-performing company at a reasonable price should be particularly appealing at a time like this. I will argue that the company in this report may be the most consistent high-performer of the last decade, although it trades at less than 60% of the valuation of more well-known firms that are







Consistency of Operations The market as a whole tends to reward companies with highly predictable operating results. As I mentioned earlier, most mega-cap staples companies (i.e. PG, CL, KO, PEP, MCD) tend to trade at about 25x earnings and 20x operating cash flows. BBBY, on the other hand, trades around 13x earnings and 11x operating cash flows. On the surface, this comparison may seem fairly ridiculous: yes, BBB does have a store base nearing 1,000, but it is still has nowhere near the ubiquity of the aforementioned examples examples - something I’ll readily acknowledge. At the same time, consider the comparable performance data over the last decade: Gross Margins ove r Time Time 80.00% 70.00% 60.00%

BBBY KO

50.00%

PEP PEP MCD MCD

40.00%

PG CL

30.00% 20.00% 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Bed Bath & Beyond has continually maintained gross margins in the low 40% range; standard deviation is 0.70%, lowest l owest of the group







Consistency of Operations Operating Margins over Time 30.00% 25.00% 20.00%

BBBY KO

15.00%

PEP MCD

10.00%

PG CL

5.00% 0.00% 1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Bed Bath and Beyond has also steadily turned in operating margins in the low double-digits. Again in this case, BBBY has the lowest standard deviation of returns of the group. The next two metrics to consider are about profitability: ROA and ROE. On both fronts, Bed Bath & Beyond has historically done an excellent job delivering results: ROA averages over 16% and ROE averages over 24% in the last decade with little variation. This feat has been accomplished because marginal return on investe i nvested d capital has held steady, meaning that the company can deploy additional dollars of capital at little or no discount to its current rate of return. See graph, page 9.







Consistency of Operations Return on Assets over Time 25.00%

20.00%

BBBY

15.00%

KO PEP MCD

10.00%

PG CL

5.00%

0.00% 1

2

3

4

5

6

7

8

9

Using return on assets, Bed Bath & Beyond once again has the lowest standard deviation of the group (absolute and adjusted) while having the highest average ROA. Similarly, BBBY has posted an excellent ROE over the past decade: BBBY Return on Equity 35.00% 30.00% 25.00% 20.00% 15.00%







Consistency of Operations Marginal Marginal Returns on Invested Capital 50.00% 40.00% 30.00% 20.00% OCF

10.00%

NI

0.00% 1999

2000

2001

2002

2003

2004

2005

2006

2007

-10.00% -20.00%

2007 was the first year Bed Bath & Beyond did not post doubledigit returns on marginal invested capital. Previously, returns have averaged 21.5% using operating cash flow (OCF) and 19.75% using net income. This datapoint is currently a minor concern, but something worth monitoring going forward. More recent financial data indicates that returns on marginal invested capital are rebounding somewhat, although they could remain r emain depressed vs. long-run mean over the next several quarters as a difficult spending environment is likely to be realized.









Bed Bath: Financials Bed Bath & Beyond ended Q2 of FY2007 with $584 million in cash and equivalents and no long-term debt. Because BBBY has a large net cash position on its balance sheet, we will use an Enterprise Value” (EV) approach to calculate many financial ratios. Using market capitalization would not give an accurate assessment of any relative valuation measures such as Price-to-Earnings (P/E) or Price-to-Book (P/B). By using Enterprise Value, we can get a more holistic picture of BBBY’s financial state. BBBY has an Enterprise Value of $6.93 billion. • • •

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BBBY’s last trade as of January 2nd was $28.36 The 52 week trading range is $27.96 to $43.32 Because BBBY is a retailer and finances many of its store locations through operating leases that that do not create assets or lili abilities listed on the balance sheet, price-to-book or other book ratio metrics will not be used here BBBY trades for 6.65x EV/EBITDA Trailing twelve month (ttm) Operating Cash Flow was $657.8 million, for an EV/OCF of 10.5x Capital Expenditures (ttm) totaled $335 million, mainly attributable to new store expansions. While this number may come







Risks Investing in equities involves risk. Certain risks are systematic and cannot be diversified away; this “market risk” includes global macroeconomic shocks including but not limited to economic slowdowns, recessions and wars. Bed Bath & Beyond also carries specific risks. This includes but is not limited to: Consumer preference risk. BBBY must identify and react to changing fashion trends in a timely manner or risk potential significant adverse results including lower sales and profits as well as losses due to higher markdowns. Other operations risk. This includes but is not limited to the cyclical nature of retail and effects of that variable. Competition. BBBY competes against a number of companies in a fragmented market, some of which may be more well-funded or better positioned than BBBY, including in the ability to respond to consumer fashion preferences. There is no guarantee guarantee BBBY will be successful in its operations. operations. Growth plans. BBBY relies on new store openings and increasing same-store sales to drive profitability. Should the company be unable to deliver on this strategy, their financial position could suffer.

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Profitability Metrics One key part of my assessment of a business is its ability to convert capital invested into cash. The best businesses have a high Return on Invested Capital (ROIC). ROIC is measured against a company’s cost of capital. A ROIC in excess of cost of capital means that management creates shareholder value for each dollar invested in it; a ROIC below invested cost of capital means that management is destroying shareholder value. I believe that this measurement of ROIC is superior to other measures of efficiency and profitability such as Return on Assets (ROA) or Return on Equity (ROE) because the ROIC approach equalizes differences in financing structures and focuses on the cash-on-cash yield from a company’s pany’s operations. While I prefer businesses with a high ROIC, good businesses also will continue to increase ROIC in excess of the cost of capital. Studies of past stock history also suggest that an increasing spread between ROIC and cost of capital is an important driver of a rising stock price.







Bed Bath: Profitability There are several different measures that can be used to calculate our formula for ROIC. Each specific measure allows us to isolate on specific aspects of Bed Bath’s profitability. Earnings Before Interest and Taxes (EBIT) allows us to see how effective at generating profits Bed Bath is before “non operational” costs related to financing structures and tax efficiency are taken into consideration. consideration. EBIT ROIC (ttm) was 33.1%, compared to FY2006 EBIT ROIC of 32.8% and FY2005 at 37.3% “Owner Earnings” uses adjusted net income, but excludes depreciation and amortization charges and takes into account capital expenditures. Owner Earnings ROIC (ttm) is 38.3%, compared to 36.9% in FY2006 and 37.0% in FY2005. Structural Free Cash Flow (SFCF) adjusts net income for changes in working capital, excludes non-cash charges, and subtracts capital expenditures necessary for continuing operations. SFCF ROIC (ttm) was 11.4%, compared to FY2006 at 10.4% and FY2005 at 18%. Maintenance Free Cash Flow (MFCF) takes net income, adjusts for changes in working capital, and separates expenditures used

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Bed Bath: Valuation We make only one main assumption for this fair value estimate: 1. Bed Bath’s Bath’s performance will hold steady in future years If we were to put a freeze on all of Bed Bath’s expansion plans and only allow the company to operate from its present store base, what would the company be worth? The valuation then becomes MFCF (see page 13), plus a minor add-back to offset previous inventory builds, with growth being something in the low to midsingle digits to represent comps increases. The inventory correction is worth about $30 million, and comps growth of 3% is conservative given that it roughly equals general US economic growth and discounts Bed Bath’s own particular strengths. Cost of capital as determined by the capital asset pricing model (CAPM, diagram at right) is 9.36% using 1–month Treasuries as riskfree, BBBY’s beta of 1.55, and determining the expected market return by taking the S&P 500 earnings yield (from 20.7x earnings and a 2.3% dividend yield). Using those assumptions, I derive a value for the stock of $28.40,









Bed Bath: Final Word I believe Bed Bath & Beyond shares are significantly undervalued relative to projected future cash flows. Although no guarantee guarantee can be made about the accuracy of such forecasts, using conservative estimates leaves investors a margin of safety to cushion any disappointments that may occur. BBBY shares have been taken down by fears of the company’s company’s potential association with the housing market (see Appendix 1, page 14) and while this may present an opportunity it also requires a caveat: I have no knowledge of when this seemingly nonsensical correlation will end. There is a very real risk that the performance of the stock will not match the performance of the business (which I anticipate will be good) for an extended period of time. Buying BBBY is a bet on a company with a proven history of performace; very few companies can boast of the ability to generate a







Notes and Disclosures •

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This report is by no means a recommendation recommendation to take action for your personal portfolio. It is recommended that you consult your own investment, legal, and/or tax advisor before acting on any information contained within this report. Failure to seek professional, personally tailored advice before acting could lead you to act in a manner contrary to your best interests; consequences include but are not limited to loss of money. Equity valuation involves involves the use of theoretical pricing models and estimates of factors such as future earnings growth and economic trends, none of which are guaranteed to be accurate. At the time of this report, r eport, the author had no financial position in BBBY, however, the author reserves the right to take a position (long or short) at a later l ater date. This report was prepared independently, and the author has no







Appendix 1 While it is difficult to prove (or disprove) spending correlations correlations between BBBY and housing, consider the following period from early 1998 to early 2003, when housing starts saw no real growth, and the economy saw a recession. BBBY Income. Statement (Rev - Left, Inc - Right) 4,000.00 3,500.00

600 500

3,000.00 2,500.00 2,000.00 1,500.00 1,000.00

400 Revenues 300

Op. Inc. Net Inc.

200

Bed Bath Beyond (BBBY) Stock Report

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