Signs of Weakness at Bed Bath & Beyond

The month of August was a good one for Bed Bath & Beyond (NASDAQ:BBBY). Its same-store sales increased 8%, several analysts upgraded its stock and the share price managed to lose less than 3% in a terrible month that saw the S&P 500 drop more than 5%. Everything seems to be going right for the home furnishings chain, and its stock price reflects this. While I can’t tell you how long this euphoria will last, I can tell you some of the reasons why it probably won’t.

Online Sales

This is my biggest argument against Bed Bath & Beyond. In 2010, its revenues were $8.8 billion, yet its online sales totaled just $88.7 million and grew by only 3%. Those transactions represent just 1% of revenues. Whoever’s in charge of their e-commerce either needs replacing or given a good pep talk. These numbers are truly embarrassing.

Restoration Hardware, which filed a registration statement with the SEC on Sept. 9 and is a direct competitor of Bed Bath & Beyond, did $161 million in online sales in 2010 on $773 million in revenue. That’s 21% of the total and double its much larger rival. For those who don’t remember, Restoration Hardware was taken private for $232 million in June 2008. At the time, it was struggling financially and only now is coming out of its tailspin. Yet it’s able to generate a greater return from its websites.

Bed Bath & Beyond is leaving significant profits on the table. Williams-Sonoma (NYSE:WSM) generates approximately 42% of its revenue online with operating margins three times those of its retail stores. Bed Bath & Beyond’s operating margins are the same as those of Williams-Sonoma, meaning it’s doing a good job delivering store-level profits. If its e-commerce revenues had grown to 25% of its overall total, in 2010 alone it would have generated an additional $100 million in operating profits. Unfortunately, it’s so far behind most other large retailers, it’s hard to imagine it seriously competing in e-commerce without a complete change in business strategy. And that’s not happening.

Share Repurchases

Bed Bath & Beyond loves buying back stock. In the past five years, it has used 75% of its $2.5 billion in free cash flow to repurchase 48.4 million of its shares at an average price of $51.65. Based on its Sept. 13 price of $59.21, its annualized return on investment is 2.5%. That’s not much for several billion dollars in shareholder funds. Perhaps the company could have taken $250 million of that sum and allocated it to the improvement of its e-commerce program. The company would be far better off.

In addition, because it has no debt and funds store openings through cash flow, it seems odd that it doesn’t pay a dividend. Evidence suggests that companies with higher dividend payout ratios experience faster earnings growth than those making lower payouts or, in the case of Bed Bath & Beyond, none at all. With annual free cash flow likely to hit $1 billion by 2013 and its stock riding high, regular or at least special dividends are a more suitable way to allocate capital while rewarding shareholders. Especially when all you can do is 2.5% a year.

Stock Price

This is where I’ll get the biggest rebuttal from existing shareholders. After all, Bed Bath & Beyond’s stock is less than 5% away from an all-time high of $60.55, which it hit at the beginning of July. It has returned 9.3% annually during the past decade compared to 2.7% for the S&P 500. There’s nothing wrong with this kind of performance.

However, we all know that what goes up must come down. Reverting to the mean is such a killjoy, but let’s face it, the company is in the third year of a very good run. With the stock up 20.5% year-to-date when the markets are taking a pummeling, it’s not a matter of if the stock will lose some of its value, but when. If you compare specialty retail’s performance the past few years with Bed Bath & Beyond, the conclusion you’ll come to is that with the exception of 2008’s recession year, when the industry as a whole fared much worse, specialty retail handily outperformed Bed Bath & Beyond.

Bottom Line

All good things must end. Bed Bath & Beyond might not drop like a stone, but I definitely see a slowdown in its appreciation.

As of this writing, Will Ashworth did not own a position in any of the stocks named here. 

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