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Morningstar | Bed Bath’s Struggle To Stimulate Demand Continues to Weigh on Operating Margin; Shares Fairly Valued

Bed Bath has succumbed to further gross margin pressure in its second quarter, leading to another reduction in its full-year earnings per share outlook, to around $2.00, from the low to mid-$2 range (and down 6% at the initial midpoint of guidance, or $2.93). The firm’s consistent inability to manage margin has sent shares tumbling, as results indicate the turnaround remains stalled, and the promise to achieve EPS growth in 2020 offers nearly no insight to a near-term catalyst in shares (although gross margin stabilization would certainly help, in our opinion).

While Bed Bath attempts to pivot to better accommodate its customer base, adding options like Beyond-Plus ($29 for 20% off purchase plus free shipping, with around 1 million members expected by year end) and reinvigorating its website (with digital representing more than 10% of sales), we don’t think such efforts are enough to either differentiate the company’s business model or restore operating margin performance to historic double-digit levels, leading to mid-single-digit ROICs that are well below our 9% weighted average cost of capital estimate, which supports our no-moat rating. We don’t plan to make any material change to our $17.50 fair value and view shares as fairly valued, trading at 8 times the firm’s updated 2018 EPS estimate versus our average 4% EPS decline forecast over the next five years.

Bed Bath continued to lose share of the home furnishing market, growing at a flat pace in the first half of its fiscal year versus a market that increased 5%. Our long-term outlook forecasts the firm ceding share over the next decade with expected sales declines of 2% on average hindered by accelerating store closures as leases come due (the firm expects 40 closures this year, offset by 20 openings). A languishing top-line should precipitate difficulty in leveraging the cost structure and thus the operating margin, which we have reaching back to around 5% over our forecast from an estimated 4% in 2018.

Same-store sales were slightly worse than the 0.3% decline we anticipated, falling 0.6% and management’s updated outlook surrounding full-year comps, which are now anticipated to be relatively flat to last year, (versus low-single digit positive previously) remain largely in line with our full-year forecast which called for a 0.3% decline. The weak top line pressured expense lines, with the gross margin contracting 270 basis points to 33.7% (well below the 35% we modeled) as an increase in coupon expense and decrease in merchandise margin weighed primarily on the metric. SG&A was slightly better than the 31.5% we forecast at 31%, representing around 40 basis points of deleverage, as technology related, consulting and advertising costs remained inflated. All in, this led to an operating margin of 2.7%, a more than 300 basis point year-over-year decline and nearly 750 basis points below the second quarter of 2008, as consumers were embarking upon the previous recession (although we note this was during the same time Linens ‘n Things was entering bankruptcy).

Furthermore, the bright spot in the prior quarter was that the number of coupon redemptions declined for the first time in more than six fiscal years (when disclosure became regular), a pattern that the company was able to continue into the second quarter. However, the average coupon amount has rose again, following the pattern of the last four consecutive quarters. Without quantifying the magnitude, it can remain murky whether the number or redemptions or the average coupon amount had a more marked impact (negative or positive) on the margin performance at Bed Bath. Without further visibility into how some of these metrics might consistently trend ahead, and the company’s profit growth roadmap, we’d wait for a wider margin of safety before becoming constructive on Bed Bath shares.