Bed Bath & Beyond

(Nasdaq: BBBY)

An Analysis and Valuation of

Bed Bath & Beyond
By James Cullen, for Wall St. Newsletters
Originally Released January 3rd, 2008
Made Public January 23rd, 2008

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 Foreword
Numerous economists, market forecasters, politicians and others
have weighed in on the odds of a recession in the US - that is, a
decline in GDP for two or more consecutive quarters. Whether or
not a recession occurs, or is already underway, is a matter of pure
speculation. Attentions should be focused on prudent investments
and not on divining economic data.

There are two approaches frequently advocated in difficult eco-

nomic times. The first revolves around chasing growth stocks under
the thesis that, as fewer companies grow quickly, those that do will
be better rewarded by the market as a whole. The second favors
predictable, stable companies - conglomerates, consumer staples,
and general blue chip, mega-cap names.

Both methods have their place. Certain growth names will perform
well, with the obvious caveat that the growth must be for real. Too
often, however, I find the growth stories have a high degree of un-
predictability, and the stocks are not be cheap. Dogs may chase,
but prudent investors should not.
With the second strategy, it is difficult to argue against names like
Coca-Cola (KO) or Proctor & Gamble (PG) given their enormous
economic moats. The stocks, however, simply aren’t cheap at a
time like this - both trade around 20x EV/OCF. Still, the idea of
buying a consistently high-performing company at a reasonable
price should be particularly appealing at a time like this.

I will argue that the company in this report may be the most con-
sistent high-performer of the last decade, although it trades at less
than 60% of the valuation of more well-known firms that are
known as “recession stocks.”

The Stock Masters offer their Recession Resistance Newsletter free to all Full
Monte subscribers, or just $4 separately.

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 Consistency of Operations
The market as a whole tends to reward companies with highly pre-
dictable operating results. As I mentioned earlier, most mega-cap
staples companies (i.e. PG, CL, KO, PEP, MCD) tend to trade at
about 25x earnings and 20x operating cash flows. BBBY, on the
other hand, trades around 13x earnings and 11x operating cash
flows. On the surface, this comparison may seem fairly ridiculous:
yes, BBB does have a store base nearing 1,000, but it is still has
nowhere near the ubiquity of the aforementioned examples - some-
thing I’ll readily acknowledge. At the same time, consider the com-
parable performance data over the last decade:
Gross Margins over Time
80.00%

70.00%

60.00%
BBBY
KO
50.00% PEP
MCD
40.00% PG
CL
30.00%

20.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Bed Bath & Beyond has continually maintained gross margins in the
low 40% range; standard deviation is 0.70%, lowest of the group
above on both a gross and adjusted (coefficient of variation) basis.

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 Consistency of Operations
Operating Margins over Time
30.00%

25.00%

20.00% BBBY
KO
15.00% PEP
MCD
10.00% PG
CL
5.00%

0.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Bed Bath and Beyond has also steadily turned in operating margins
in the low double-digits. Again in this case, BBBY has the lowest
standard deviation of returns of the group.

The next two metrics to consider are about profitability: ROA and
ROE. On both fronts, Bed Bath & Beyond has historically done an
excellent job delivering results: ROA averages over 16% and ROE
averages over 24% in the last decade with little variation. This feat
has been accomplished because marginal return on invested capital
has held steady, meaning that the company can deploy additional
dollars of capital at little or no discount to its current rate of return.
See graph, page 9.

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 Consistency of Operations
Return on Assets over Time
25.00%

20.00%

BBBY
15.00%
KO
PEP
10.00% MCD
PG
CL
5.00%

0.00%
1 2 3 4 5 6 7 8 9

Using return on assets, Bed Bath & Beyond once again has the low-
est standard deviation of the group (absolute and adjusted) while
having the highest average ROA.
Similarly, BBBY has posted an excellent ROE over the past decade:

BBBY Return on Equity

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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 Consistency of Operations
Marginal Returns on Invested Capital
50.00%

40.00%

30.00%

20.00%
OCF
10.00% NI

0.00%
1999 2000 2001 2002 2003 2004 2005 2006 2007
-10.00%

-20.00%

2007 was the first year Bed Bath & Beyond did not post double-
digit returns on marginal invested capital. Previously, returns have
averaged 21.5% using operating cash flow (OCF) and 19.75% us-
ing net income. This datapoint is currently a minor concern, but
something worth monitoring going forward. More recent financial
data indicates that returns on marginal invested capital are re-
bounding somewhat, although they could remain depressed vs.
long-run mean over the next several quarters as a difficult spend-
ing environment is likely to be realized.

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 Bed Bath: Financials
Bed Bath & Beyond ended Q2 of FY2007 with $584 million in cash
and equivalents and no long-term debt. Because BBBY has a large
net cash position on its balance sheet, we will use an Enterprise
Value” (EV) approach to calculate many financial ratios. Using mar-
ket capitalization would not give an accurate assessment of any
relative valuation measures such as Price-to-Earnings (P/E) or
Price-to-Book (P/B). By using Enterprise Value, we can get a more
holistic picture of BBBY’s financial state. BBBY has an Enterprise
Value of $6.93 billion.

• BBBY’s last trade as of January 2nd was $28.36

• The 52 week trading range is $27.96 to $43.32
• Because BBBY is a retailer and finances many of its store loca-
tions through operating leases that do not create assets or li-
abilities listed on the balance sheet, price-to-book or other book
ratio metrics will not be used here
• BBBY trades for 6.65x EV/EBITDA
• Trailing twelve month (ttm) Operating Cash Flow was $657.8
million, for an EV/OCF of 10.5x
• Capital Expenditures (ttm) totaled $335 million, mainly attribut-
able to new store expansions. While this number may come
down slightly in the intermediate term (3-5 years), it looks ap-
propriate given the company’s current expansion strategy.
• Adjusted Free Cash Flow (ttm) was $322.8 million

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 Risks
Investing in equities involves risk. Certain risks are systematic and
cannot be diversified away; this “market risk” includes global mac-
roeconomic shocks including but not limited to economic slow-
downs, recessions and wars. Bed Bath & Beyond also carries spe-
cific risks. This includes but is not limited to:
• Consumer preference risk. BBBY must identify and react to
changing fashion trends in a timely manner or risk potential sig-
nificant adverse results including lower sales and profits as well
as losses due to higher markdowns.
• Other operations risk. This includes but is not limited to the cycli-
cal nature of retail and effects of that variable.
• Competition. BBBY competes against a number of companies in
a fragmented market, some of which may be more well-funded
or better positioned than BBBY, including in the ability to respond
to consumer fashion preferences. There is no guarantee BBBY
will be successful in its operations.
• Growth plans. BBBY relies on new store openings and increasing
same-store sales to drive profitability. Should the company be
unable to deliver on this strategy, their financial position could
suffer.

A complete list of risks can be found by accessing Bed Bath & Be-
yond’s latest SEC filings.

Additional Note: January 3rd will mark the release of quarterly

earnings for the stock, which may result in high levels of volatility
— including the chance that BBBY declines significantly on or
shortly after the earnings announcement.

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 Profitability Metrics
One key part of my assessment of a business is its ability to con-
vert capital invested into cash. The best businesses have a high Re-
turn on Invested Capital (ROIC). ROIC is measured against a com-
pany’s cost of capital. A ROIC in excess of cost of capital means
that management creates shareholder value for each dollar in-
vested in it; a ROIC below invested cost of capital means that man-
agement is destroying shareholder value. I believe that this meas-
urement of ROIC is superior to other measures of efficiency and
profitability such as Return on Assets (ROA) or Return on Equity
(ROE) because the ROIC approach equalizes differences in financ-
ing structures and focuses on the cash-on-cash yield from a com-
pany’s operations. While I prefer businesses with a high ROIC, good
businesses also will continue to increase ROIC in excess of the cost
of capital. Studies of past stock history also suggest that an in-
creasing spread between ROIC and cost of capital is an important
driver of a rising stock price.

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 Bed Bath: Profitability
There are several different measures that can be used to calculate
our formula for ROIC. Each specific measure allows us to isolate on
specific aspects of Bed Bath’s profitability.
• Earnings Before Interest and Taxes (EBIT) allows us to see how
effective at generating profits Bed Bath is before “non opera-
tional” costs related to financing structures and tax efficiency are
taken into consideration.
EBIT ROIC (ttm) was 33.1%, compared to FY2006 EBIT
ROIC of 32.8% and FY2005 at 37.3%
• “Owner Earnings” uses adjusted net income, but excludes depre-
ciation and amortization charges and takes into account capital
expenditures.
Owner Earnings ROIC (ttm) is 38.3%, compared to 36.9% in
FY2006 and 37.0% in FY2005.
• Structural Free Cash Flow (SFCF) adjusts net income for changes
in working capital, excludes non-cash charges, and subtracts
capital expenditures necessary for continuing operations.
SFCF ROIC (ttm) was 11.4%, compared to FY2006 at 10.4%
and FY2005 at 18%.
• Maintenance Free Cash Flow (MFCF) takes net income, adjusts
for changes in working capital, and separates expenditures used
to grow the company from expenditures required to continue op-
erations. We feel this is an appropriate metric because of the
current large capital expenditures needed by Bed Bath to open
new store locations.
MFCF ROIC (ttm) was 23.25%, compared to 21.6% for
FY2006 and 27.0% in FY2005.

ROIC has been relatively stable, as one might predict from much of
the earlier data. Overall, the company enjoys good returns and cre-
ates value with its investments.

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 Bed Bath: Valuation
We make only one main assumption for this fair value estimate:
1. Bed Bath’s performance will hold steady in future years

If we were to put a freeze on all of Bed Bath’s expansion plans and

only allow the company to operate from its present store base,
what would the company be worth? The valuation then becomes
MFCF (see page 13), plus a minor add-back to offset previous in-
ventory builds, with growth being something in the low to mid-
single digits to represent comps increases. The inventory correction
is worth about $30 million, and comps growth of 3% is conserva-
tive given that it roughly equals general US economic growth and
discounts Bed Bath’s own particular strengths.

Cost of capital as determined by the capital

asset pricing model (CAPM, diagram at right)
is 9.36% using 1–month Treasuries as risk-
free, BBBY’s beta of 1.55, and determining
the expected market return by taking the
S&P 500 earnings yield (from 20.7x earnings
and a 2.3% dividend yield).
Using those assumptions, I derive a value for the stock of $28.40,
or 3.5% below the most recent close. This means that the mar-
ket is pricing Bed Bath & Beyond as a company that will
never grow again. This market valuation also ignores the nearly
$2 billion in net tangible assets the company has excluding its cash
position.
Because we have established that Bed Bath creates value through
its store investments (page 13), a more realistic fair value is up-
wards of $41/share, or 40% above the most recent close - a value
that utilizes 8% intermediate annual growth and a 10.7x terminal
cash flow multiple, which itself looks to be close to trough and thus
on the conservative side.

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 Bed Bath: Final Word
I believe Bed Bath & Beyond shares are significantly undervalued
relative to projected future cash flows. Although no guarantee can
be made about the accuracy of such forecasts, using conservative
estimates leaves investors a margin of safety to cushion any disap-
pointments that may occur. BBBY shares have been taken down by
fears of the company’s potential association with the housing mar-
ket (see Appendix 1, page 14) and while this may present an op-
portunity it also requires a caveat: I have no knowledge of when
this seemingly nonsensical correlation will end. There is a very real
risk that the performance of the stock will not match the perform-
ance of the business (which I anticipate will be good) for an ex-
tended period of time.
Buying BBBY is a bet on a company with a proven history of perfor-
mace; very few companies can boast of the ability to generate a
25% ROE year after year, and those that do typically do not trade
at low double-digit earnings multiples. There are stock buybacks
authorizing the repurchase of more than $1 billion in shares, but
whether or not this will act as a floor on the stock price is currently
unknown. With a situation like this where the market looks to be
pricing in zero growth, patience will be required. At the same time,
the potential rewards for buying such a profitable company at a
very reasonable price should make your investment worthwhile.
Review the information again with an eye to the January 3rd earn-
ings release date.

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 Notes and Disclosures
• This report is by no means a recommendation to take action for
your personal portfolio. It is recommended that you consult your
own investment, legal, and/or tax advisor before acting on any
information contained within this report. Failure to seek profes-
sional, personally tailored advice before acting could lead you to
act in a manner contrary to your best interests; consequences
include but are not limited to loss of money.
• Equity valuation involves the use of theoretical pricing models
and estimates of factors such as future earnings growth and eco-
nomic trends, none of which are guaranteed to be accurate.
• At the time of this report, the author had no financial position in
BBBY, however, the author reserves the right to take a position
(long or short) at a later date.
• This report was prepared independently, and the author has no
relationship with BBBY. All opinions, estimates, and/or other sub-
jective statements are the author’s own.

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 Appendix 1
While it is difficult to prove (or disprove) spending correlations be-
tween BBBY and housing, consider the following period from early
1998 to early 2003, when housing starts saw no real growth, and
the economy saw a recession.

BBBY Income. Statement (Rev - Left, Inc - Right)

4,000.00 600

3,500.00
500
3,000.00
400
2,500.00 Revenues
2,000.00 300 Op. Inc.

1,500.00 Net Inc.

200
1,000.00
100
500.00

0.00 0
1999 2000 2001 2002 2003

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