EUR 850.00 For Business Accounts Only

Morningstar | BBBY Updated Star Rating from 26 Mar 2019

Three shareholders of no-moat Bed Bath & Beyond--Legion Partners, Macellum Advisors, and Ancora Advisors--have formally nominated 16 candidates to take over Bed Bath & Beyond’s board of directors. Nominees that have been posted include topnotch business leaders with vast retail experience (many who have experienced retail struggles), including the former CEOs of Guess and Pier 1, as well as executives from Coach, Macy’s, Gap, and others. The three shareholders together hold a 5% stake, not enough to guarantee a change facilitated solely by the next proxy vote. However, we think a repeat of ISS' 2018 proxy recommendations is likely to occur this year, supporting a change and calling for further votes against at least some board members, given the firm’s continued failure to stall market share losses or generate excess economic rents.

We agree with the activists' contention that leadership is in dire need of an overhaul, which underlies our Poor stewardship rating. With forecast adjusted returns on invested capital (5% on average over the next five years) that are set to fall below our weighted cost of capital estimate in 2018 (8%), capital-allocation efforts have failed to benefit the firm. For now, we are making no change to our outlook, which includes a five-year average sales decline of 2.5% and further operating margin declines (contracting to around 3% in 2022), given the uncertainty around whether such changes will occur. Our $9.40 fair value estimate is intact, rendering the shares overvalued. However, the investor group plans to unveil a strategy in the coming weeks to extract $5 in earnings per share (versus our current-year $1.98 estimate) by "stabilizing top-line sales and expanding margins by 300-400 basis points over the next few years," and once we perceive that change is possible, we could improve our outlook. Given the time it would take to implement change, we wouldn’t expect Bed Bath to gain traction in profitability until 2020.

We highlighted our concern about the composition of the board in our November 2018 report, "Profits at Bed Bath Hampered as Customer Traffic Moves Beyond." Last year, Institutional Shareholder Services suggested that investors withhold their vote on three members of the compensation committee, but the company’s board had gone largely unchanged post the proxy vote. Even with more than 60 million votes against, compared with 50 million votes for, along with a resignation letter from Victoria Morrison (a board member since 2001 who had historically been on the compensation committee), the board decided to keep her on staff. The board noted Morrison's strength in strategic planning and real estate, something we think other members (including Dean Adler, a 17-year Bed Bath board member who is CEO of a private real estate investment firm) could easily have filled the gap in for the team.

Furthermore, excluding the three newly elected members in 2017-18, we argued that the tenure of the board, which averaged 22 years, could limit the independence of strategic decisions, given the long-term loyalty to the existing management team. At the time, the board had nine of 12 directors who were independent, but here we suggested a larger board size could provide broader retail turnaround expertise as well as limit the influence of founders Warren Eisenberg and Leonard Feinstein as well as current CEO Steven Temares. For reference, when assessing the home improvement/furnishing companies on our coverage list, both Home Depot and Lowe's have a larger board size, and when including Williams-Sonoma, all three companies only had one insider (CEO) sitting on the board. The other companies in the industry that we cover that have multiple insiders on the board, RH and Wayfair, have failed to generate consistent returns on invested capital that surpass our weighted average cost of capital estimate, and we believe the lack of independence in decision making on the board is a factor.

Additionally, when we assessed the last proxy vote, more than 85 million shareholders voted against, versus 23 million for, the company’s compensation plan. Given the nonbinding nature of the vote, the company or board has still not undertaken any announced initiatives to alter the compensation plan since the vote, although we’d hope to hear some update on this factor in the company’s upcoming fourth-quarter report. While the company’s issued response to ISS noted, "Our board of directors, through its compensation committee and nominating and corporate governance committee, has engaged extensively with shareholders and been responsive to the major issues raised over the last several years," we disagreed for a few reasons.

First, while the company reduced the CEO pay, we contended that versus the peer group in the company’s proxy, total pay remained high. Reducing the CEO's target pay by 40% is commendable and realizing an aggregate pay over the last three years that is 49% lower than the target is a step in the right direction, but we note shareholders also lost around 70% of stock value from the beginning of 2015 through the end of 2017 while this reduction occurred. Furthermore, Temares gets paid more than nearly the entire peer set outlined in the company’s proxy based on total compensation and the peer group's most recently published proxy numbers. In fact, only two of the CEOs in the peer group were paid more in total than Bed Bath’s CEO, according to recent proxy filings.

Additionally, neither the CFO nor the COO took any haircut to their compensation packages as profitability and performance fell at Bed Bath. Rather, both executives took pay increases at both their salary and award levels, increasing their total compensation significantly. Over the last five years, prior CFO Sue Lattmann increased her total pay package more than threefold while COO Eugene Castagna had a total pay hike of more than 30%.

We view today’s shareholder effort as an echo of the sentiment we suggested in late 2018. Perhaps with enough support from those pushing for change along with shareholder advisory firms like ISS and Glass Lewis potentially supporting rational changes being pursued, such an overhaul could save Bed Bath from an unsavory long-term contraction in earnings power.