BBBY: Trying to Find a Coupon

Bed Bath and Beyond is expected to report results tomorrow after the close and we’re expecting another solid quarter.  Recall that this has been a name we’ve liked for some time now, mostly due to the company’s “mean reversion” opportunities.  An improving economic backdrop, the elimination of the company's most direct competitor, and the bottoming of the worst period in modern history for home furnishings consumption have all been key to the fundamental recovery in BBBY’s earnings and subsequent share performance.  Along the way, earnings have handily beat expectations for the past few quarters, even as expectations have gradually risen along the way.  This quarter is no exception, with the Street looking for $0.43 (up from $0.38 when the quarter began).  However, we still believe there is even further upside, with our model shaking out at $0.46. 

 

It is important to note that BBBY’s 3Q results are comparing against the single worst quarterly same store sales performance in the past 10 years!  As such, we are forecasting a 3% comp increase against the 5.6% decline last year (which may be conservative given this actually implies a deceleration on the two-year).  While any of us of can open a spreadsheet or review a transcript, the importance of fully understanding what exactly was taking place at the end of last year is key to near-term results.  The promotional environment over the 3Q/4Q period last year was especially aggressive, driven in part by overall economic uncertainty but more specifically by aggressive couponing brought on by the Linens ‘N Things demise.  As a result, BBBY’s gross margins were hit by 280 bps (largest drop in the entire housing bubble) as the company attempted to remain competitive and garner share in the midst of severe sales declines and the Linens’ liquidation.  Try finding a coupon now.  I actually did try and it’s not as easy as one would think, even with internet sites such as Couponcabin.com. 

 

Fast forward a year and we are now in a much more rational promotional environment.  BBBY’s couponing has subsided measurably, aiding gross margins and to a lesser extent SG&A (direct mail costs reside on this line).  Last quarter marked the company’s return to gross margin expansion after 10 consecutive quarters of declines.  We maintain that the single biggest factor that is misunderstood in the BBBY story is how long the gross margin recovery can last.  It is simply not a 1 or 2 quarter process in our view.  As such, gross margin expansion should continue for at least the next 12-18 months driven primarily by BBBY’s improved competitive position (it is now the only stand-alone game in town), substantial reduction in the use of irrational couponing, tight inventory control, and improving sales trends as pent-up demand in the home furnishings category fuels improving demand.

 

Adding a modest 5% square footage growth rate (yes, management is conservative but it serves well for the EBIT recovery story) and a growing cash balance expected to be near $1.5 billion (no debt), BBBY is a much more stable cash flow generator than the Street gives it credit for.  There are currently 9 buys, 15 holds, and 1 sell rating on the company.  Clearly this is still room for sentiment to improve here.  Tomorrow after the close solid results should further bolster our positive bias on the shares.   If there is one surprise to come, we still think it will be a firmer commitment to the buyback.  With $900 million remaining under authorization the company has barely bought a share back since the couponing began…

 

Eric Levine

Director


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