Bed, Bath, & Beyond: Management Needs to Break Its Piggy Bank
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Now one could make the argument that if it weren't for the LBO premium that has been priced into the stock for months, BBBY would be trading @ a lower multiple. That stands to reason, given that the stock itself has been as exciting as watching paint dry: thus far in 2006, BBBY has returned about as much as a T-bill, whereas the S&P has returned a healthy 12%. A differential of 700 bps is troubling, we think, given BBBY's bulletproof balance sheet, brand recognition, and EBIT margins.


Besides its capital structure, the Stockmasters like BBBY's technicals: after the last EPS call, BBBY bounced off of its 200 moving day, a sign that longer term investors were willing to hold onto BBBY amid the quarterly disappointment. In addition, it would seem to us that BBBY is closing a 8-9 month cup and handle pattern (see diagram above), arguably the most bullish chart formation in our coverage universe. In other words, the 1st half of 07 could be a very interesting time for BBBY and its shareholders.

We believe BBBY could trade to the upside in 2007 if management takes it upon itself to unlock all the value hiding in plain sight on the balance sheet. Waning institutional sponsorship (fund managers have been skeptical about BBBY's growth opportunities), potential market saturation, and the recent options-related dark cloud have all contributed to the stock's downward price movement. Nevertheless, BBBY could reward patient investors who can stomach the blows that may manifest (higher interest rates in 07 could adversely impact sales next year if home-related spending contracts) before BBBY either sells itself or overcomes investor's growth-tilted expectations. Ultimately, the Masters thinks BBBY could become darling to investors with value appetites.

Bed, Bath, and Beyond is operationally sound, but in a world where management can only decide earnings (the Street assigns the multiple), this "best of breed" name in the home-furnishing space will have to shoot the lights out on an earnings front - or consider "strategic alternatives" - if it wants to truly stand out in an industry that has posted negative returns for the 6M, 1Y, and 3Y periods. We believe the latter scenario is more likely, given the fact that BBBY's high octane growth days are behind it. It is up to management, then, to generate value creation when the capital markets are not responding: "breaking the piggy bank," as we have been arguing, is the key to mending the wound BBBY has created between itself and Wall Street and returning value to shareholders that is commensurate with the amount of risk that they are taking as equity investors (we use an 11% WACC, or cost of equity, given BBBY's presence in retail and the housing space, which experiences high turnover).

On a relative valuation basis, assuming y/y comps grow ~450 bps, we see BBBY fairly valued in the $45-$47 price range, or 15% higher than where shares are
currently trading. Time will tell as to whether or not the marketplace agrees on a fair price for this domestics merchandise behemoth.

Article written by: Daniel A Jacome
Article posted on: December 27th, 2006

The author, Daniel A Jacome, is a MBA/CFA candidate at the Kelley School of Business at Indiana University, where he is a Finance major, Investment Management Academy (IMA) member, and Fellow Member of The Sterling Fund. At the time of publication, neither he nor his family owned shares in any of the stocks mentioned.