Hesitant About Stepping Into Bed Bath

 | Dec 07, 2012 | 10:30 AM EST
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We have been combing the market for companies and stocks that will benefit from the coming housing recovery and which have not yet had strong rallies in the past year. In that time, most of the major homebuilders, such as DR Horton (DHI) and KB Home (KBH), have seen share-price recoveries of 50% to 100% on a rebounding housing market. Home Depot (HD) and Lowe's (LOW) have also seen large upward movements over the past year. 

After running our sector and statistical screening processes, we tried to focus on shareholder-oriented companies that have strong management teams. The one housing-related name that potentially looked most interesting was Bed Bath & Beyond (BBBY). The stock sells at a modest 11.1x 2013's expected earnings of $5.23. The shares are flat for the year, compared with a red-hot housing-related group.

There is a lot to like about Bed Bath, such as its strong business franchise, enviable long-term double-digit earnings growth track record, strong management and merchandising teams, robust margin structure with 40% gross margins, 14% net margins, 20%-plus return on equity and no debt. The company has also been shareholder oriented and has accelerated its earnings growth over the years through a share-buyback program. Furthermore, it seems like the company should be a big beneficiary of an improving housing market. It will likely have a strong economic tailwind.

These significant positives are largely offset by our nagging concerns that the company will face a number of competitive threats and troublesome issues in the upcoming years. In the past year, the stock has not recovered on the better housing-related news. Home Depot and Lowe's now trade at 17x to 19x earnings. Why shouldn't Bed Bath trade at a comparable multiple? While Bed Bath has always outperformed the housing-related industries and traded at a premium multiple to the group, it is now trading at a significant discount to the sector and to the overall market at 11.1x 2013's earnings.

Upon deeper analysis, we are beginning to see that the franchise may be undergoing significant secular changes. For one, overall organic growth is slowing to 2% to 3%, compared with its historical 10%-plus levels. In addition, margins are beginning to contract because of increased price and promotional competition. Over the past four quarters, gross margins contracted 200 basis points because of increased competition from Amazon (AMZN), Macy's (M), Target (TGT) and Kohl's (KSS).

One particular area of worry is that the growing Amazon product line overlaps with Bed Bath's. Most calculations show the product overlaps at greater than 30% and growing. Amazon is winning these customers with lower price points. Single-serve coffee cups have been the biggest disappointment to Bed Bath over the past year as customers buy coffee much cheaper online.

Management is taking this increased threat very seriously and aggressively investing in new store concepts such as World Markets and Cost Plus, expanding its Internet presence and returning money to shareholders via buybacks to re-accelerate growth.

While we expect these actions to add to shareholder value over time, we remain uncomfortable with these emerging trends. Once a retailer is outflanked, its margins begin to contract, and in many cases this results in a P/E multiple contraction, slower earnings growth, a reformulation of its store growth strategy and an underperforming stock price. Many of these negatives often feed upon themselves.

There is actually a reasonable likelihood that the company could be entering a whole new era in which more and more of Bed Bath's customers will prefer to buy their merchandise online. As a brick-and-mortar-focused organization, Bed Bath might not be able to adjust quickly enough to the new realities. Over time, we have seen many retailers falter as they have tried to transition from pure brick-and-mortar organizations to a bricks-and-clicks business model.

The company might end up going down a similar path that resulted in major declines in such well-regarded retailers as Best Buy (BBY) in electronics, and Staples (SPLS) in office products. Because of these shifting tides, we do not yet have the conviction to invest in BBBY shares, even as the housing market recovery begins to pick up steam.  

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volatility is quite low here, and we could see some downsides here in the short term. ...



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