A Financial Analysis and Valuation of Bed Bath & Beyond 1 Harvard College Analyst Report | Bed Bath & Beyond EXECUTIVE SUMMARY Historical Performance Our analysis of Bed Bath & Beyond (“BBBY”) revealed strong profitability for the firm and its investors as well as consistent growth over our time period of study spanning FY 2000-10. As a company focused on selling consumer durables, BBBY was inevitably affected by the decline in consumer spending during the recession, but managed to weather the difficult conditions affecting the overall macroeconomic environment relatively well compared to other retailers. Overall, BBBY’s stable cash flows, lack of debt and other strong technical fundamentals made BBBY a very attractive company over the past decade, as validated by the rapid growth in its stock price during this time. Key Observations The recession was the primary reason why BBBY’s profitability ratios such as ROA and ROE decreased by 6% and 10%, respectively, in 2007 and 2008. Further decomposition of these two ratios, however, provided insight that these decreases were not a result of volatile changes in cost structure or turnover, but rather strategic manipulation by management to lower profit margins and increase coupon redemption to boost sales. Since 2008, the company’s profitability ratios have returned to pre-recession levels, and we expect the company to post steady positive gains in the coming years. BBBY’s capital structure is unusual in the sense that the company holds relatively little debt, reflecting a business model that is financed nearly entirely by equity. Since 2008, the company’s current ratio has steadily increased as a result of increases in cash, and though nearly half of its current assets lie in inventory, BBBY’s deepened cash reserves mitigate any possibility of short-term liquidity issues. Our financial statement and valuation analysis also led us to look at BBBY’s cash management. Using the residual income valuation method, we observed that without any current changes to how management uses the company’s cash, BBBY’s cash reserves would exceed $8bn by 2020, representing 68% of total assets. Therefore, BBBY can either use cash to take on cheap debt (especially in the short term) or return cash to investors in the form of a dividend or stock repurchase. Findings and Conclusions Our discounted cash flow model and relative valuation analysis value BBBY at $69.92 with benchmarks in-line with peer group industry averages. Our residual income valuation model values the company at $55.88, suggesting that BBBY is overvalued today at a share price of $69.41. Hence, we are likely to put a “Sell” rating on the stock, though a “Hold” rating is also a viable option for the risk-averse investor.
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A Financial Analysis and Valuation of Bed Bath & Beyond · BBBY has marginal negotiating power with its suppliers. Although BBBY has developed strong relationships with select suppliers,
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A Financial Analysis and Valuation of Bed Bath & Beyond
1 Harvard College Analyst Report | Bed Bath & Beyond
EXECUTIVE SUMMARY
Historical Performance
Our analysis of Bed Bath & Beyond (“BBBY”) revealed strong profitability for the firm
and its investors as well as consistent growth over our time period of study spanning FY
2000-10. As a company focused on selling consumer durables, BBBY was inevitably
affected by the decline in consumer spending during the recession, but managed to
weather the difficult conditions affecting the overall macroeconomic environment
relatively well compared to other retailers. Overall, BBBY’s stable cash flows, lack of
debt and other strong technical fundamentals made BBBY a very attractive company over
the past decade, as validated by the rapid growth in its stock price during this time.
Key Observations
The recession was the primary reason why BBBY’s profitability ratios such as ROA and
ROE decreased by 6% and 10%, respectively, in 2007 and 2008. Further decomposition
of these two ratios, however, provided insight that these decreases were not a result of
volatile changes in cost structure or turnover, but rather strategic manipulation by
management to lower profit margins and increase coupon redemption to boost sales.
Since 2008, the company’s profitability ratios have returned to pre-recession levels, and
we expect the company to post steady positive gains in the coming years.
BBBY’s capital structure is unusual in the sense that the company holds relatively little
debt, reflecting a business model that is financed nearly entirely by equity. Since 2008,
the company’s current ratio has steadily increased as a result of increases in cash, and
though nearly half of its current assets lie in inventory, BBBY’s deepened cash reserves
mitigate any possibility of short-term liquidity issues.
Our financial statement and valuation analysis also led us to look at BBBY’s cash
management. Using the residual income valuation method, we observed that without any
current changes to how management uses the company’s cash, BBBY’s cash reserves
would exceed $8bn by 2020, representing 68% of total assets. Therefore, BBBY can
either use cash to take on cheap debt (especially in the short term) or return cash to
investors in the form of a dividend or stock repurchase.
Findings and Conclusions
Our discounted cash flow model and relative valuation analysis value BBBY at $69.92
with benchmarks in-line with peer group industry averages. Our residual income
valuation model values the company at $55.88, suggesting that BBBY is overvalued
today at a share price of $69.41. Hence, we are likely to put a “Sell” rating on the stock,
though a “Hold” rating is also a viable option for the risk-averse investor.
A Financial Analysis and Valuation of Bed Bath & Beyond
2 Harvard College Analyst Report | Bed Bath & Beyond
COMPETITIVE AND ECONOMIC ENVIRONMENT
Description
Bed Bath & Beyond (BBBY) is a chain of retail stores located primarily in the United
States and Canada. The chain’s brands include Bed Bath & Beyond, Christmas Tree
Shops, Harmon and Harmon Face Values, and buybuy BABY. BBBY primarily sells
mid-ranged domestic merchandise and home furnishings. The Company currently has
1,139 stores in the United States, Puerto Rico, and Canada and has a current market
capitalization of $16.4bn.
Market Fundamentals
Source: U.S. Bureau of Economic Analysis
Source: The Federal Reserve Economic Database
The US furnishing and household
equipment market is very fragmented and
competitive. Indeed, there are many
different types of household goods that
can fall into this category, and many
retail stores address the various sub-
categories of this market. BBBY
competes with local, regional, and
national retailers that include specialty
retailers, department stores, discounters,
and online retailers. From Figure 1, the
market peaked at $271bn in 2007 but has
since contracted to $235bn in 2009. In
2010, consumer spending went up to
$244bn.
Despite this muted increase, consumer
sentiment remains relatively depressed,
as seen in Figure 2. With consumer
confidence remaining low in the wake of
the recent recession, it is difficult to
imagine a large upswing in consumer
spending occurring in the near future.
Since BBBY specializes in selling home
furnishings and domestic merchandise
it’s financial success is very closely
related to the housing market. The Wells
Fargo National House Market Index is a
measure of the number of sales sold each
month (seasonally adjusted).
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llars
Sp
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Fiscal Year
Figure 1: Home Furnishings Consumer Spending
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Figure 2: Consumer Sentiment
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Figure 2 – Standard and Poor’s.
The Case-Shiller Home Price Index is a measure of the price of homes sold each month
(also seasonally adjusted). From Figure 3, the prices for homes appear to have retraced
greatly over the past five years, dropping more than 25% as measured by the Case-Shiller
index. Similarly, Figure 4 shows that home sales remain well below pre-recession values.
Yet, despite the depressed state of the U.S. housing market, BBBY has seen a continual
and strong increase in net sales. BBBY appears to remain on an upward trend even in the
wake of the recent recession. Despite this continued increase in net sales, however, the
potential for further decline or continued stagnation in the housing market remains a
nontrivial concern for BBBY.
Source: Wells Fargo
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Ind
ex
Figure 4: Case-Shiller Home Price Index
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ex
Figure 3: Wells Fargo National HMI
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Short-term Challenges
The past few years have clearly presented an unfavorable economic climate for the home
furnishing retail industry. The collapse of the housing market and subsequent recession
has precipitated a decline in consumer spending, especially discretionary spending.
Nevertheless, BBBY has averaged a 5% increase in same store sales and increased its
number of stores fivefold over the past ten years. Moreover, in 2008, BBBY’s main
competitor, Linens ‘n Things, went bankrupt and was liquidated. This collapse of its
closest competitor has buoyed BBBY’s sales and performance at a time when the home
furnishing market has shrunken markedly. We are therefore unable to disentangle
BBBY’s strong performance during the recession from the concurrent collapse of its
nearest competitor, naturally begging the question of whether BBBY will be able to
maintain its recent growth.
Bed Bath & Beyond must
focus on increasing same store
sales. Much of the percent
increase in store sales has
come from the first few years
of a store’s opening while
older stores have reached a
plateau in sales. BBBY must
therefore reassess and retool its
growth strategy as market
penetration increases and new
store openings become less
likely. The focus should
instead be on improving same
store sales.
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Figure 5: End of Year Store Count
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Figure 6: Percent Change in Same Store Sales
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Long-term Challenges
In the long-term, BBBY must focus on its market share and actively work to maintain its
positioning in the face of increasing Internet sales. In fact, for the past five years, there
has been double-digit growth in online retain sales, a trend which eMarketer expects to
continue in the near term. For instance, in the home furnishing online market, eMarketer
expects sales to have double-digit growth through 2016; in 2010, home furnishing online
sales were at $11.9bn and is expected to grow to $18.8bn by 2013 and $26.6bn by 2016.
To combat this new competition, BBBY will have to either bolster its online presence or
break into the international market. BBBY currently does not have the infrastructure to
handle a large increase in online sales.
Figure: 7: U.S. Online Retail Sales
Source: eMarketer
BBBY will have to reconsider its current operating model as its stores mature in their
local markets. As of FY2011, BBBY only operated three central distribution centers.
Most of its merchandise is on display at the sales floor at all times; the remaining stock is
stored in the back of the stores. Third-party vendors ship the vast majority of supplies to
the local stores because BBBY does not have the capacity to service itself. As an
expanding company, this strategy has allowed BBBY to strategically place stores in areas
without warehouses relatively quickly and to remain lean and flexible. However, as
BBBY grows larger, it must consider revamping this system in order to gain greater
bargaining power with its suppliers, provide consistent brands across stores, and maintain
more control over its distribution chain. Bed Bath & Beyond currently fails to take
advantage of the economies of scale that can come with the operations of a large retailer.
Furthermore, this current decentralized model prevents BBBY from being an effective
player in the online retail market.
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COMPETITIVE FACTORS
Buyer Power
In today’s market, retail stores have increasingly less power relative to the consumer.
Consumers have local mom-and-pop shops, regional shops, and national shops from
which to purchase their furnishings. Even within the national shops, there are many
retailers who specialize in other wares, but inevitably sell similar goods. Finally,
consumers have with increasing frequency gone to the Internet to purchase their goods.
Many of today’s consumers do not care about the brand of the stores, but rather the
brands of the goods. Furthermore, eMarketer claims that 45.9% of shoppers have
researched a product in a store before purchasing it online. Thus, the buyer has gained a
significant advantage over the brick-and-mortar retailers.
Supplier Power
BBBY has marginal negotiating power with its suppliers. Although BBBY has developed
strong relationships with select suppliers, some of its suppliers are only regional. In
FY2010, BBBY had roughly 5500 suppliers, with the largest supplier accounting for less
than 5% of merchandise purchases. Each BBBY store (or group of BBBY stores)
purchases its own supplies and warehouses them individually. Despite its size, BBBY is
not one of the largest customers for many of its suppliers. It instead believes that this
method allows it to quickly switch from one supplier to another, as it does not highly
value brand. If BBBY becomes more centralized, it will have more bargaining power
with its suppliers becoming a more significant customer to many of its suppliers.
Threat of New Entrants
Retail shops are relatively easy to open; new entrants do not need much capital or
expertise. However, many local mom-and-pop shops do not survive in this saturated
environment because consumers prefer shopping at chain stores, where the quality of
service, expertise, and supply of goods is known. Because BBBY often deals with
suppliers on a regional basis, BBBY does not have a highly sophisticated and established
distribution chain that would give it a significant advantage over new entrants. Therefore,
BBBY only has its brand as a barrier to entry for new competitors. In the domestic
merchandise market, many national and regional retailers, who specialize in other
domestic goods, are encroaching on the BBBY’s established market. For big players with
established supply chains and the shelf space, selling home furnishings or domestic
merchandise is the next logical and easy step.
Threat of Substitutes
There is very little threat of substitute for the goods that BBBY sells; people will always
need their domestic merchandise. However, as mentioned in the “Buyer Power” section,
customers have many options for where they can shop. As a whole, brick-and-mortar
retailers are negatively impacted by the rise of the Internet and thus retailers will become
increasingly threatened, as online purchases become viable substitutes for actual store
visits.
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Rivalry Among Existing Firms
Since the bankruptcy of Linens ‘n Things, Bed Bath & Beyond has had one big rival:
Williams-Sonoma. However, Kohl’s and Pier 1 Imports also compete in the same market.
Many of these companies are chasing stagnant or falling consumer dollars. In addition to
these close rivals, BBBY does face competition from retailers in adjacent markets such as
IKEA or Wal-Mart. Even though the retail market is highly competitive, BBBY has an
established brand that is well known for high quality customer service. As a national
brand, BBBY performs strongly in its saturated market. BBBY has gained market share
in the most recent years because of its customer service and diverse product offerings.
Strategy
BBBY has always had great customer service and therefore often outperforms other
brick-and-mortar retailers. The high quality of service allows it to differentiate itself from
its closest competitors. It advertises itself as a one-stop shop for all possible home needs.
A core strategy for the firm has been to offer more low margin items to increase customer
choice and sale value. In fact, BBBY reported lower gross margins but higher gross profit
growth these past few quarters because BBBY has recently begun pushing the
introduction of more coupons in order to attract customers. The increased merchandise
offering has driven sales productivity. 80-90% of BBBY’s inventory is out on the floor
for customers to view. The idea is that with “everyday low prices,” customers may find
goods that they “need” as they walk through the stores. In addition, BBBY wants to
present itself as a collection of specialty stores with related product lines grouped
together. This method allows a customer to focus his search for specific needs, yet
increases the chance that a customer finds related items to purchase.
In FY2010, BBBY opened many stores with its nimble distribution operations. The
depressed real estate prices allowed BBBY to open stores in previously expensive
locations. This strategy should continue through 2012. BBBY lists its expansion program
as one of its greatest successes; from FY1992 to FY2010, the company grew from 34 to
1139 stores. This expansion program includes a management structure that allows BBBY
to immediately place high quality managers in new locations. As the more obvious store
locations disappear, BBBY should begin to consider how to retool its strategy for future
growth in a method less dependent upon the opening of new stores to drive growth.
Return on Assets
We begin our analysis of Bed Bath and Beyond by assessing the profitability of the firm.
To do this, we consider the evaluation of several key ratios beginning with BBBY’s
Return on Assets (ROA) ratio. ROA measures the profitability of all capital invested in
the firm regardless of capital structure.
A Financial Analysis and Valuation of Bed Bath & Beyond
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Source: Financial Reports
Figure 8 shows that BBBY’s ROA held relatively stable at the beginning of the decade
with an ROA of over 16%. Beginning in 2006, however, we notice a significant decline
in BBBY’s profitability. Because this is a company that specializes in affordable
domestic merchandise relative to higher-end competitors such as Crate and Barrel and
Williams Sonoma, we were not surprised that BBBY’s performance was greatly affected
by macroeconomic trends. Concurrent with the recent financial recession and collapse of
the housing market was a precipitous decline in BBBY’s ROA, dipping as low as ~11.0%
in 2008 before recovering after the recession to pre-FY 06 levels.
In the MD&A section of the company’s FY 2008 10-K, they note that: “The Company
believes factors such as the increase in the unemployment rate and issues specific to the
housing industry, including a decline in home values in conjunction with a downward
trend in home sales, have negatively impacted consumer confidence and the level of
discretionary spending by consumers, resulting in an adverse impact on the Company’s
net sales, net earnings and operating cash flows.” Though BBBY is a retail company that
relies on operating leases for its stores, operating leases accounted for just 7.8% of total
assets in FY 2010. For this reason, we have decided not to exclude operating leases in the
firm’s total asset calculation, as the effect of excluding operating leases would have had
little effect on BBBY’s profitability.
ROA Decomposition
We have broken down Return on Assets into two ratio components: Asset Turnover and
Profit Margin. Asset turnover measures the efficiency with which BBBY is using its
assets to generate sales, while the profit margin measures how much of every dollar in
sales BBBY actually keeps in earnings. As we have learned, the two ratios generally
move in opposite directions: companies with lower profit margins tend to have higher
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12.0%
16.0%
20.0% R
OA
Figure 8: BBBY's Return on Assets
A Financial Analysis and Valuation of Bed Bath & Beyond
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asset turnover, while companies with higher profit margins tend to have lower asset
turnover.
Source: Financial Reports
Figure 9 shows some volatility in BBBY’s profit margins over the past ten years. Profit
margin trends follow ROA trends closely, suggesting that the decline in ROA during the
recession was due mainly to lowered profit margins rather than asset turnover. Even with
the volatility, BBBY’s profit margins hover around the high single-digits – a comfortable
position for a company with mid-price range market positioning in the industry. (For
comparison, higher-end competitors like Cost Plus and Pier 1 Imports post lower double-
digit profit margins.)
Profit Margin for ROA Analysis
From our decomposition, we observe that the profit margin rose steadily from 2000 to
2005, declined during the recession and then began rebounding in 2008. Figure 10,
however, shows us that the cost structure of the company in the last ten years has stayed
relatively constant despite changing business environments: COS, which includes Cost of
Goods Sold (COGS) and distribution costs, remained roughly constant as a percentage of
sales at 60%, whereas SG&A as a percentage of sales rested at approximately 30%.
Therefore, if COS and SG&A expenses are not accounting for the decrease in profit
margins from 2006 to 2008, we arrive at the conclusion that BBBY’s strategy was to
intentionally discount the price of its products – thereby lowering profit margins – to
keep sales afloat in the wake of tough macroeconomic conditions. This has been
accomplished through an increase in coupon redemptions and the shift in the mix of
merchandise sold to lower margin categories. As a result, though BBBY consistently
experienced double-digit growth in previous years, BBBY was able to capture year-over-
year sales growth of 6.5% and 2.2% in 2007 and 2008, respectively. We see then that our
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Figure 9: BBBY's ROA Decomposition
Profit Margin Asset Turnover
A Financial Analysis and Valuation of Bed Bath & Beyond
10 Harvard College Analyst Report | Bed Bath & Beyond
fundamental ratio analysis validates the trends observed in the Competitive and
Economic Environment section of the report.
Source: Financial Reports
Asset Turnover Analysis
We observe from Figure 11 that inventory turnover stayed fairly constant from 2000 to
2010 but that PP&E turnover – also known as Fixed Asset turnover – decreased starting
from 2006 before returning to pre-recession levels after 2008. The fixed asset turnover
ratio measures a company’s ability to generate sales from PP&E investments. Thus, the
decline in PP&E turnover makes sense; as BBBY continued to make property and
equipment investments in 2006 and 2007 (25.8% and 20.7% growth, respectively), sales
slowed down considerably, thereby lowering asset turnover. However, PP&E consists of
just 20% of total assets, so the fluctuation in PP&E turnover did little to drastically affect