EUR 850.00 For Business Accounts Only

Morningstar | Bed Bath’s Competitive Position Unchanged Despite Efforts to Stall Share Losses; Shares Overvalued

No-moat Bed Bath continues to cede share in the furniture and home furnishing market (which averaged 2.3% monthly increases over the firm’s fiscal year) posting a 3% sales decline in fiscal 2018 on a 1% same-store sales contraction. However, the firm anticipates earnings stabilization in 2019, improving its prior outlook from around $2 in EPS to $2.11-$2.20, excluding charges. This includes gross margin that is better than we had forecast (33.8%) by 60 basis points, but SG&A expenses that were worse by 30 basis points (30.4%) at the midpoint. We expect to lift our $1.85 EPS estimate modestly but think full earnings potential could be constrained by pricing competition in the category the firm operates within. In response, we expect to raise our $9.40 fair value by $1-$2 but still view shares as overvalued, trading around 8 times 2019 guidance, and reiterate our forecast for EPS declines over the next five years.

The activist investor group pushing for change at the C-suite level issued 10 questions on April 9 that it wanted the firm to answer to assess the success of previous efforts, with a significant portion of these questions going unanswered. Most important, the investors suggested management outline specific performance that placed management ahead of its plan, which remains vague. With only modest results achieved in slowing the cadence of operating profit losses in 2018, we don’t plan any material change to our outlook for the business, which includes sales that contract almost 3%, comps that fall 2%, and operating margin performance of 3% on average over the next five years. We do believe operating margin could expand with the rapid closure of boxes, if the firm shuttered around a third of the namesake locations; however, we do not plan to restore double-digit EPS growth in our model including such closures. This is a long-term goal the firm has articulated which could be difficult to achieve, particularly with flat sales growth still expected in 2020.

Overall, fourth-quarter results weren’t materially different than we had expected with sales of $3.3 billion and EPS of $1.20 tracking not far from our $3.3 billion and $1.14 sales and EPS estimates, respectively. The gross margin was 20 basis points ahead of our model, at 34.7% but down 120 basis points from the prior year, hindered by lower merchandise margin and higher coupon expense, as the average coupon amount continued to rise. Additionally, the SG&A ratio was about 20 basis points higher than our estimate and 140 basis points higher than last year, at 28.2% as technology related expenses and associated depreciation rose while occupancy and litigation costs weighed on the metric.

The 6.4% operating margin marks a 270-basis point deceleration from the fourth quarter of 2017, although we note the cadence of operating margin declines has improved over the last two quarters, from a 370 basis point downtick in the second quarter of fiscal 2018. In our initial take on fiscal 2019, full year non-GAAP operating margin guidance of 3.5%-3.9% doesn’t appear meaningfully different that the 3.4% we had previously forecast for 2019, conveying the headwinds the company continues to face. However, given the weakness set to surface in the first quarter (with adjusted operating margin guidance of 1.6%-1.9%), the remainder of the year must generate modestly improved year over year operating margin performance in order to reach 3.5% operating margin for 2019, within the initial guided range.

As a reminder, in March, three shareholders of no-moat Bed Bath & Beyond--Legion Partners, Macellum Advisors, and Ancora Advisors--had formally nominated 16 candidates to take over Bed Bath & Beyond’s board of directors. The three shareholders together hold a 5% stake, not enough to guarantee a change facilitated solely by the next proxy vote. However, we continue to believe a repeat of ISS' 2018 proxy recommendations are likely to occur this year, supporting such 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.

We highlighted our concern about the composition of the board and lack of competitive stance in our November 2018 report, "Profits at Bed Bath Hampered as Customer Traffic Moves Beyond." We view ongoing efforts by outside shareholders 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 changes, such an overhaul could save Bed Bath from an unsavory long-term contraction in earnings power.