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, 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 rising number of coupon redemptions and values over the majority of reporting periods across the last eight years. With ongoing pricing pressure and secularly slower footfall expected across the retail landscape (especially with the majority of stores shuttered as a result of COVID-19), negative comp performance persists over our forecast, making cost leverage elusive.
Past customer-led initiatives have failed, which has left the brand to languish and market share to recede. 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 relevant could require marketing and merchandising investments that are above past levels to keep the brand relevant and to protect market share degradation, however, we believe share will decline to 7% over the next five years from 10% in 2019 as efforts are unlikely to be fruitful. This should pressure profits, leading to structurally lower results than in the past.
We have operating margins averaging around 3% post COVID-19 (versus a 6% average over the past five years), and expect negative free cash flow to equity generation over the next decade (which could prompt the drawdown of incremental liquidity). Cash generation could stem from the reduction of inventory as well as further sale-leaseback transactions, improving working capital and cash conversion. Further, the sale of any of the smaller banners (like Christmas Tree Shops) could infuse cash to invest and help elevate the core Bed Bath brand, potentially driving higher profits post COVID-19.
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 remains 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. There are few indications of a near-term reversal or abatement in languishing profitability as CEO Tritton continues to assess ongoing concerns, but expect the plan for execution that was anticipated in spring of fiscal 2020 will now be delayed until at least 2021 as Bed Bath navigates the fallout from COVID-19.
From a market share perspective, the company still holds a decent position in the more than $117 billion domestic home furnishing retail category (using U.S. Census retail sales statistics), with a nearly 10% share at the end of fiscal 2019. Our model currently forecasts average returns on invested capital of 2% between 2020-24, 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 think Bed Bath & Beyond (and its secondary concepts) could remain an existing shopping destination post COVID-19, but depending on the depth and duration of the coronavirus outbreak, a permanent shift in consumer behavior could lead us to reassess our long-term prognosis for the business.
Fair Value and Profit Drivers
We are adjusting our fair value estimate to $11.80 from $11.30 per share after incorporating full-year 2019 results that included a sales decline of 7% and operating margin deleverage of 250 basis points (to 1.1%). Bed Bath & Beyond continues to feel competitive pressure, as noted through a persistently elevated number of coupon redemptions and rising average coupon amounts in recent years.
We already had forecast store closures every year in our forecast and failed to believe comp growth could 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 mid-single-digit pace over the medium term (falling 5% on average through 2024), 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 depressed (around 33%) average gross margins over the next five years as the company remains unable to defend its pricing, experiencing incremental downside to remain relevant as Bed Bath chases additional transactions. We forecast gross margins to rise around 40 basis points over our explicit forecast, as the company's investments generate a modest improvement, held back by incentives (free/fast shipping, discounts for college students, beyond-plus program) that persist. We believe selling, general, and administrative expenses will deleverage modestly on negative same-store sales results, to our 2020 forecast of 34%, and will remain elevated (around 31%) 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 many decades, 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 distributors that have a significant footprint, 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. Forecast adjusted returns on invested capital (1.5% on average over the next five years) 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 has been overhauled over the last year. Prior CEO Steven Temares has been removed (replaced by Mark Tritton in 2019, discussed further below), and founders Warren Eisenberg and Leonard Feinstein have stepped down as co-chairmen and directors. Now, 12 of the 13 directors are fresh to the firm, having been appointed within the last few years.
In assessing the firm'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, changes to CEO compensation appear prudent, with interim CEO Mary Winston contracted to receive an annual base salary of $1.1 million at the time of her employment, versus the $3.6 million prior CEO Temares received in 2018 as performance faltered (total CEO pay in 2018 was $12.1 million).
The company recently announced its long-awaited permanent successor CEO, retail veteran Mark Tritton, who took the reins Nov. 4, 2019. 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 will be able to use his knowledge to mitigate some of the massive market share erosion that has plagued Bed Bath in recent years (however, success of initial efforts could be delayed by COVID-19). 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. 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 (further assessing the cost and asset bases, for example).
Bed Bath & Beyond is a home furnishings retailer, operating around 1,500 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 976 Bed Bath & Beyond stores, the firm operates 261 Cost Plus stores, 126 Buybuy Baby stores, 81 Christmas Tree Shops and And That Stores (gifts/housewares), 53 Harmon Face Values stores (health/beauty care), and linens/textile wholesaler Linen Holdings. It is in the process of divesting online retailer Personalizationmall.com (which was supposed to be to be completed in March but has been postponed) and has recently sold the One Kings Lane business.