Sale at Bed Bath & Beyond

Mobile and web growth indicates that customer-led initiatives are taking hold and such investments have a longer-term payoff for brand equity, likely positioning the business more strategically ahead. Merchandise initiatives to increase brand loyalty, including offering exclusive products, private labels, 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 visible, and the payoff in operating margin expansion may be stifled by pricing pressures.

The firm remains pressured by declining secular trends, including lower foot traffic as more sales move online and increased competition as pricing across players remains transparent; however, we still think the business model remains valid. While we have operating margins remaining depressed relative to historical levels (around 10%), we expect free cash flow to rise through 2020, providing some impetus for a higher dividend payout. We think Bed Bath & Beyond will be able to continue to return capital to shareholders despite capital expenditures that should remain around 3% of sales, as it attempts to keep up with evolving consumer demands (with higher IT spending offset by lower store growth costs).

Not Enough Pricing Power for 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 $104 billion-plus domestic home furnishing retail category (using U.S. Census retail sales statistics), with approximately 11% share. While our model currently forecasts low-double-digit returns on invested capital, ahead of our 8.3% 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 AMZN, 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 players that 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 stimulate traffic, 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 turned their scale and other cost advantages into 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 material 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 would be hard-pressed to replicate the vast vendor relationships that the firm has built over the past 40 years, particularly when 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 consumers in Mexico and Canada, who could have significantly different preferences than U.S. consumers.

Financial Health Is Solid Before its $1.5 billion debt raise in 2014, Bed Bath & Beyond had been debt-free since 1996 (excluding acquired debt), using cash generated from operations to fund new store openings and two acquisitions in mid-2012. The firm has access to liquidity through its $250 million revolving credit facility, which expires in 2019. There is ample cash on hand (roughly $473 million as of November) to cover expenses like operating lease obligations, which we estimate around $575 million in 2016.

Over the past five fiscal years, the firm has produced cumulative free cash flow of more than $4.5 billion, which helped support its all-cash acquisitions of Cost Plus and Linens Holdings in 2012. Bed Bath & Beyond's cash requirements are primarily for new stores, existing store improvements, and IT upgrades, among other projects, which we believe will mostly be funded by cash generated from operations with plans to invest in the business and buy back shares with excess capital. Free cash flow has averaged about 8% of revenue during the past five years, which we think is decent for a company that still has room to grow.

The board approved a new $2.5 billion authorization in September 2015, which it plans to use during 2016-20 to buy back shares with funds from operations. Bed Bath & Beyond is positioned to earn about $575 million or more in free cash flow every year for at least the next five years, and we believe these repurchases should help the firm toward its long-term target of double-digit earnings per share growth (we forecast a 10% average for 2017-25). The firm announced its inaugural dividend to distribute excess cash in 2016 at the rate of $0.125 per quarter.