No-moat Bed Bath & Beyond announced its long-awaited successor CEO, retail veteran Mark Tritton, who is set to take the reins Nov. 4. Investors were clearly impressed by the choice, initially sending shares up around 20%, above our $11.40 fair value estimate. However, even a solid leader doesn’t offer an immediate panacea to Bed Bath’s long-standing problems, and we plan to maintain our Poor stewardship rating, a reflection of the weak return on invested capital profile we have projected over the next decade. For now, we plan to maintain our existing outlook which calls for same-store sales that decline 2%, total revenue that falls 3%, and earnings per share that tick down by 3% annually over the next five years.
However, we plan to assess the CEO’s rhetoric over the next few quarters, as he presses to transform the business via omnichannel amendments and other efforts already underway by his predecessors (assessing the cost and asset bases, for example). Tritton brings a robust legacy of successful execution from his time at no-moat Target (chief merchandising officer), narrow-moat Nordstrom (president, Nordstrom Product Group), as well as other high visibility brands (wide-moat Nike, Timberland). Tritton has familiarity with private label expansion, merchandising, manufacturing, marketing, and more, and as such we believe the strategic fit of this hire was fairly optimal. With strategic board efforts already in motion, and a wealth of outside experience, we have increasing confidence that Bed Bath’s new CEO may be able to utilize his knowledge to mitigate some of the massive market share erosion that has plagued Bed Bath in recent years. In order for us to have confidence that ROICs could be on an improving trajectory, however, we would like to see same store sales growth consistently over 2%, the gross margin stabilize, and omnichannel results resume a positive cadence.
Business Strategy and Outlook
Bed Bath & Beyond has struggled in recent years to capitalize on its historical strengths, including its merchandising strategy, the push to a wider omnichannel presence, untapped international growth opportunities, and widely recognized retail brands like the namesake Bed Bath & Beyond and Cost Plus concepts. No-moat Bed Bath has tried to stay abreast of evolving consumer demand in a retailing industry that has become increasingly price-competitive, which has led the firm to experience a higher number of coupon redemptions in 24 out of 30 quarters, with 25 of those periods also seeing rising coupon amounts. With ongoing pricing pressure and secularly slower footfall expected across the brick-and-mortar landscape, negative comp performance persists over our forecast, making cost leverage hard to capture.
Customer-led initiatives haven't taken hold at the pace we had hoped for, which has left the brand to languish and market share to recede from prior levels. Merchandise initiatives to increase brand loyalty, including offering exclusive product and private label and aid brand relevancy, and investments in point-of-sale and analytic programs could help improve product positioning but are unlikely to drive meaningful profit growth. Remaining successful will require investment that could be above historical levels to keep the firm relevant and to protect further market share degradation. This should pressure profits, leading to structurally lower results than in the past.
We have operating margins averaging around 3% (versus a 9% average over the past five years), and expect free cash flow generation to averaging 1% of sales over the next decade (from 7% over the past decade). However, faster cash generation could stem from the planned reduction of inventory by $1 million over the next 18 months, improving working capital and cash conversion. Further, the sale of any of the bigger banners (Cost Plus, Buybuy baby) could infuse cash to invest and elevate the Bed Bath brand, potentially driving higher profits. However, with the permanent CEO not yet announced, we are holding off incorporating a successful execution of these feats until we hear the new CEO's vision.
We do not believe Bed Bath & Beyond has established an economic moat, given the brand's limited pricing power, nonexistent consumer switching costs, and unsustainable cost advantages. As the company competes in largely commoditized retail categories with ample domestic brick-and-mortar and online rivals, we believe the lack of moat has become evident in the frequency and size of couponing, which underscores a consistently promotional environment and the price-sensitivity of the consumer base, which has easy access to pricing comparisons through use of smartphones and other handheld devices. We believe there are few indications of a near-term reversal or abatement in languishing profitability as the permanent CEO search continues, and a fresh board begins to implement changes required to keep Bed Bath relevant.
Despite the ability to substitute, the company still holds a decent position in the more than $121 billion domestic home furnishing retail category (using U.S. Census retail sales statistics), with approximately 10% share at the end of 2018. Our model currently forecasts average returns on invested capital of 4% over the next five years, lower than our 9% cost of capital assumption, and we remain concerned that this metric will stay constrained by a secular decline across much of the brick-and-mortar retail landscape due to increased price competition with online players like Amazon, warehouse clubs, mass merchants, and other specialty retailers.
We anticipate that consumers will continue to gravitate toward price leaders in the retail category, resulting in industry consolidation and share gains for players that can pass along cost advantages to consumers in the form of low prices. While we believe Bed Bath & Beyond generally compares well with online players and other mass merchants from a pricing perspective, we have concerns that weaker home furnishing, department-store, and specialty retail rivals could be forced into competitive pricing strategies to stimulate traffic, which changes the economics across the entire home furnishing retail category and dilutes company profitability. We believe Bed Bath & Beyond (and its secondary concepts) will remain a relevant shopping destinations for now, but a shakeout among traditional merchants could force suppliers to increasingly take their products directly to consumers or deflect some inventory to other online only players, like Wayfair. In our view, this could neutralize many of Bed Bath & Beyond's brand, merchandising, and supply-chain improvement efforts.
Fair Value and Profit Drivers
We are adjusting our fair value estimate to $11.40 from $10.80 per share after incorporating second-quarter results and to account for cash earned since the last update. Bed Bath & Beyond continues to feel competitive pressure, experiencing 24 out of 30 quarters of a higher number of coupon redemptions, with 25 of those also experiencing rising average coupon amounts. Our fair value estimate implies a 2019 price/earnings ratio of 6 times, an enterprise value/EBITDA multiple of 3 times, and a free cash flow yield of 19%.
We expect store closures every year in our forecast and don't think comp growth can turn consistently positive, leaving the company with the inability to leverage its cost structure at both the cost of goods sold and the selling, general, and administrative expense lines. We project that total sales decline at a low-single-digit pace over the medium term (falling 3% on average through 2023), hindered by declining foot traffic and store closures, offset by some unit location growth in Buybuy Baby and Cost Plus World Market stores, along with increased omnichannel offerings such as buy online/pick up in store. We forecast flat (around 34.1%) average gross margins over the next five years as the company remains unable to defend its gross margin, experiencing incremental pricing downside to remain relevant as Bed Bath chases incremental transactions. We forecast gross margins to fall around 40 basis points over our explicit forecast, despite the company's investments as couponing and incentives (free/fast shipping, discounts for college students, beyond-plus program) persist. We believe selling, general, and administrative expenses will deleverage modestly on negative same-store sales results, to our 2019 forecast of 31%, and will remain elevated over the next decade as supply-chain and distribution efficiencies for newer concepts are eventually offset by diminishing top-line growth projections. Ultimately, this generates operating margins that normalize below 3% in our base assumptions.
Bed Bath & Beyond has historically generated returns on invested capital above our weighted average cost of capital assumption (9%), but given poor capital allocation practices in recent years, ROICs are unlikely to surpass our WACC over the remainder of our forecast.
Risk and Uncertainty
In our view, the most significant risk facing the company is competition from online players like Amazon and other mass merchants, which have passed their scale and other cost advantages into lower prices for consumers, particularly in commoditized categories. While Bed Bath & Beyond's fundamentals are attached to the performance of the domestic home improvement market and other macroeconomic factors (which can influence life events like marriages and births), we think sales from other parts of the business (like Buybuy Baby and Harmon Face Values) and international expansion (which we don't expect imminently given the firm's ongoing redirection) could help stabilize the firm from material fluctuations in the revenue base, but should not be enough to stem top-line losses. Another risk, in our opinion, is a slowdown in the cadence of improvement in the real estate market, which could be indicated by increased home inventories for sale or slower growth in new- or used-home prices, influencing the wealth effect on consumers, and cause them to spend less on replacing goods in their homes.
Although new competitors could feasibly set up shop in Bed Bath & Beyond's territory, we think a new player in the industry would be hard-pressed to replicate the vast vendor relationships that the firm has built over more than 40 years, and would have a difficult time competing with the robust set of online-only incumbents (Wayfair, Amazon). While the biggest brands in home furnishings are likely to want to partner with big distributors like Bed Bath, we believe they are increasingly finding ways to integrate with Bed Bath's online- only peer counterparts, potentially repositioning key inventory away from Bed Bath. Internationally, the company risks marketing improperly to audiences in Mexico and Canada, which could have significantly different consumption preferences than Americans.
Our stewardship rating for Bed Bath & Beyond is Poor. With forecast adjusted returns on invested capital (4% on average over the next five years) that are set to remain below our weighted cost of capital estimate (at about 9%) over our entire outlook, implying that capital allocation is no longer generating excess economic rents. The board is has been overhauled in recent months. Prior CEO Steven Temares has been removed, and founders Warren Eisenberg and Leonard Feinstein have stepped down as co-chairmen and directors. Now, 12 of the 13 directors set for election are fresh to the firm, having been appointed within the last two years.
In the company's most recent proxy, the top five outside shareholders own around 51% of total shares outstanding, which could make change more difficult for outsiders. Historically, equity-based compensation had been a bit excessive compared with the peer group and considering the performance of shares in recent years. However, in June 2019, the compensation committee granted awards based on performance goals that included: a one-year EBIT goal, a three year cumulative company EBIT goal, and a three-year total shareholder return, metrics that we think should incentivize executives to make smarter capital allocation decisions. Furthermore, recent changes to CEO compensation seem prudent, with interim CEO Mary Winston set to receive an annual base salary of $1.1 million, versus the $3.6 million prior CEO Temares received in 2018 as performance faltered (total CEO pay in 2018 was $12.1 million). We expected scrutiny on compensation to ensue with activist investors calling for change.
In March, three shareholders of no-moat Bed Bath & Beyond--Legion Partners, Macellum Advisors, and Ancora Advisors--had nominated 16 candidates to take over Bed Bath & Beyond’s board of directors and called for the resignation of former CEO Steven Temares. We commend Bed Bath for taking the high road in response to pressures from the three-party investor group pushing the company to refresh its leadership team, as it has opted to cooperate as partners to improve the business.
Bed Bath & Beyond is a home furnishings retailer, operating around 1,534 stores in all 50 states, Puerto Rico, Canada, and Mexico. Stores carry an assortment of branded bed and bath accessories, kitchen textiles, and cooking supplies. In addition to 993 Bed Bath & Beyond stores, the firm operates 277 Cost Plus stores, 126 Buybuy Baby stores, 81 Christmas Tree Shops and And That Stores (gifts/housewares), 55 Harmon Face Values stores (health/beauty care), two One Kings Lane locations, linens/textile wholesaler Linen Holdings, and online retailers Personalizationmall and Ofakind.