Let’s face it: Bed Bath & Beyond delivered a real stinker of a quarter last week. To add insult to injury, the company lowered its earnings guidance by about 5% for the rest of year. A laundry list of items is to blame, including online competition, heavy discounting, bad weather and a tired consumer. As a result, Bed Bath’s stock price has fallen a dramatic 16% from its pre-earnings price. An over-reaction to say the least and we think that the drop represents an excellent opportunity for investors.
Bed Bath operates close to 1,500 stores in North America, under a number of different banners. New store openings have slowed over the past couple of years and it’s clear that there is limited growth for the current store concepts in North America. Opportunities exist internationally and that may be an avenue the company takes in the future. In the meantime, Bed Bath has a nice problem. It has over $700M in cash on its balance sheet and it generates close to $1B a year in excess free cash flow. Bed Bath doesn’t pay a dividend; instead it has preferred to buy back stock hand over fist. Charlie Munger calls these stocks cannibals— businesses that consistently buy back their own shares. A company that aggressively buys back its own shares is essentially doing the heavy lifting for existing shareholders. By shrinking its share count, a company makes its profits more valuable to current shareholders because the profit is allocated to fewer shares. Ultimately, rising earnings per share will lead to a higher share price. Since 2003, the company has reduced its shares outstanding by 30%. Over the same period, its stock price has doubled and its earnings per share has grown by close to 400% The high flying days of trading at 30 times earnings (Lululemon and Dollarama fans take note) have come to an end and now the stock is trading at a very reasonable 14 times this year’s earnings before taking account its $3 a share net in cash.
We believe that the company is on a path to doubling its share price over the next five years and here’s how.
First, we assume that Bed Bath’s earnings grow at a modest pace of 3% a year going forward. While that doesn’t get you out of bed in the morning, here’s the fun part. Bed Bath’s free cash should continue at $1B a year. Next, using that free cash flow to buy back stock and adding leverage, you can see from the following three scenarios that significant value could be created.
Share buybacks are the best use of free cash when a company is trading at a reasonable valuation and produces a high return of equity. Yes, a 3% dividend yield would be attractive, but that won’t double the stock price for shareholders.
Disclosure: Clients of Baskin Financial own shares in Bed Bath & Beyond.