Spending Shift Bites Bed Bath & Beyond

No-moat

Additionally, we see Bed Bath & Beyond as having a flexible financial position, with only $1.5 billion in debt on the balance sheet and more than $650 million in expected free cash flow annually over the next five years. With no part of its debt coming due until 2024 at the earliest and little chance of a dividend being initiated in the near term, we believe excess capital will be returned to shareholders in the form of share repurchases. The company said the $2.5 billion authorized in September 2015 would be used between 2016 and 2019.

Store Layout Sets This Retailer Apart Bed Bath & Beyond is one of the better-operated companies in the retail industry. It has a best-in-class decentralized merchandising strategy, an improving omnichannel presence, intriguing international growth opportunities, and widely recognized retail brands like the namesake Bed Bath & Beyond and buybuy Baby concepts. Management has constructed a unique store layout that groups related product lines into separate areas, creating the appearance and feel of a collection of individual specialty stores. This store layout, which also allows store managers to tailor the merchandise mix and respond to changing trends and conditions, has been successful historically; the firm has generated average sales per square foot of $270 the past three years.

Mobile and Web growth indicates to us that customer-led initiatives are taking hold and that such investments have a longer-term payoff for revenue and brand equity, likely positioning the business more strategically than in the past. Merchandise initiatives to increase brand loyalty, including offering exclusive product, private label, and quality for value, make the customer base stickier over time, and investments in point-of-sale and analytic programs will help deliver these products to the right place at the right time. The risk to success here seems to be that investment may need to be ongoing and inflated to historical levels if Bed Bath & Beyond wants to remain relevant and front of mind.

Additionally, trends that include a mix shift to lower-margin items, higher frequency and size of coupon redemptions, and costly free shipping signal a persistently promotional environment. Pairing this with rising competition from online retailers, mass merchants, and specialty chains, we think gross margin expansion opportunities in the near term will be difficult to find. While e-commerce enhancements along with increased use of data analytics to fine-tune marketing, and cross-merchandising efforts from the Cost Plus and Linen Holdings acquisitions could help increase sales, we believe price competition from Amazon AMZN and mass merchants is a trend that is unlikely to abate in the near future, limiting operating margin expansion.

Heavy Couponing Proves Lack of Moat We do not believe Bed Bath & Beyond has established an economic moat, given the brand's limited pricing power, nonexistent consumer switching costs, and unsustainable cost advantages. As the company competes in largely commodified retail categories with ample domestic brick-and-mortar and online rivals, we believe the lack of moat has become evident in the frequency and size of couponing, which underscores a consistently promotional environment (with few indications of an immediate reversal) and the price sensitivity of the consumer base, which has easy access to pricing comparisons through use of smartphones and other handheld devices. Despite the ability to substitute, the company still holds a decent position in the more than $100 billion domestic home furnishing retail category (using U.S. Census retail sales statistics), with approximately 11% share. While our model currently forecasts high teens returns on invested capital, ahead of our 8.5% cost of capital assumption, we remain concerned that this metric will be constrained by a secular decline across much of the brick-and-mortar retail landscape due to increased price competition with online players like Amazon, warehouse clubs, mass merchants, and other specialty retailers.

We anticipate that consumers will continue to gravitate toward price leaders in the retail category, resulting in industry consolidation and share gains for those players who can pass along cost advantages to consumers in the form of low prices. While we believe Bed Bath & Beyond generally compares well with online players and other mass merchants from a pricing perspective, we have concerns that weaker home furnishing, department store, and specialty retail rivals could be forced into competitive pricing strategies to survive, which may change the economics across the entire home furnishing retail category and dilute company profitability. We believe Bed Bath & Beyond (and its secondary concepts) will remain relevant online shopping destinations, but a shakeout among traditional merchants could force suppliers to increasingly take their products directly to consumers. In our view, this could neutralize many of Bed Bath & Beyond's brand, merchandising, and supply chain advantages.

Competition Is Biggest Risk In our view, the most significant risk facing the company is competition from online players like Amazon and other mass merchants, which have passed their scale and other cost advantages on as lower prices for consumers, particularly in commodified categories. While Bed Bath & Beyond's fundamentals are attached to the performance of the domestic home-improvement market and other macroeconomic factors (which can influence life events like marriages and births), we think sales from other parts of the business (like buybuy Baby and Harmon Face Values) and international expansion will help to insulate the company from fluctuations in the revenue base. Another risk, in our opinion, is a slowdown in the cadence of improvement in the real estate market, which could be indicated by increased home inventories for sale or slower growth in new- or used-home prices, influencing the wealth effect on consumers and causing them to spend less on replacing goods in their homes.

Although new competitors could feasibly set up shop in Bed Bath & Beyond's territory, we think a new player in the industry would be hard-pressed to replicate the vast vendor relationships that the firm has built over the past 40 years, particularly starting from a significantly smaller store base. Ultimately, the biggest brands in home furnishings will still want to partner with the biggest distributors, leaving a new competitor in a precarious position to acquire the appropriate inventory. Internationally, the company risks marketing improperly to audiences in Mexico and Canada, which could have significantly different consumption preferences than U.S. customers.