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This Retailer's Stock Is About to Pop

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There are really only two business strategies that lead to long-term success: (1) exploit a competitive advantage and (2) be the low-cost producer. If a business cannot do #1, it must do #2. As an investor I do not spend time looking at companies that are not following either strategy; their future is almost always too murky to even guess at.

If you have to choose between the two, you should always choose the competitive advantage. However, not all companies operate in industries that lend themselves to competitive advantages. Such is the case with Bed Bath & Beyond (NASDAQ: BBBY). The company is the most efficient in its industry, which is why it is so much more profitable than its competitors.

Low-Cost Producer

Even for investors looking at the company for the first time, it does not take long to learn that Bed Bath & Beyond does something better than its peers. The company posts gross margins similar to that of Williams-Sonoma (NYSE: WMS) and Pier 1 Imports (NYSE: PIR), yet earns a much higher operating margin.

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Bed Bath & Beyond is a more efficient operator than Williams-Sonoma and Pier 1. It has more sales per square foot than the two and is widely considered to have better merchandising and inventory management. This is essentially Bed Bath & Beyond's secret to outperformance.

In addition, Williams-Sonoma has a strong e-commerce presence and markets a lot of its products through catalogs. It Pottery Barn catalog is issued monthly and mailed to customers who sign up for distribution. However, with $9.5 billion in revenues, Bed Bath and Beyond has a far greater share of the market than Williams-Sonoma.

Bed Bath & Beyond's only other major competitor is Pier 1, which had only $1.5 billion in sales last year. Pier 1 has a narrower merchandising strategy that does not overlap as much with Bed Bath & Beyond as Williams-Sonoma does.

Business Will Improve

Although margins have already bounced back from the Great Recession, store traffic continues to suffer from the overhang in the housing market. As new housing starts rebound, more customers will be flooding the stores to buy linens and appliances for their new homes. A rebound in the general economy may also lead to the return of cost-conscious consumers who were willing to buy discount merchandise in the poor economy.

In addition, Bed Bath & Beyond has enormous growth opportunities on both borders; it is in the early stages of expanding into Canada and Mexico. It has yet to establish the same dominance in either of those countries that it has in the U.S., but success abroad would provide an additional boost to shareholders' wealth.

Buy BBBY, Get Acquisitions for Free

Bed Bath & Beyond trades at 11.6x last year's free cash flow and 14.4x last year's earnings. However, last year's numbers do not reflect the company's recent acquisitions of Cost Plus and Linen Holdings.

A pre-acquisition valuation reveals that the company is valued as though the two acquisitions will provide no value to the company. The company has historically earned (pre-tax) 31.13% on tangible invested assets; it has done much better than that in recent years. If you apply the 31.13% margin to its recent tangible invested assets of $5.2 billion, you get a pre-tax earnings figure of $1.62 billion. At an 8x multiple, the company is worth $57.21 per share.

Since the stock trades near $55, it appears as though investors have a free call option on Cost Plus and Linen Holdings. If the two acquisitions turn out well, this stock could pop.

Bottom Line

It is not inconceivable that one day Williams-Sonoma or Pier 1 could match Bed Bath & Beyond in efficiency; that is why a durable competitive advantage is always better than cost efficiencies. However, is seems unlikely that BBBY's margins will plummet any time soon. As a result, the stock looks cheap when you consider the future impact of its recent acquisitions as well as continued progress in its international stores. But, as always, it’s up for you to decide if it makes sense for your own portfolio.

titans8904 has no position in any stocks mentioned. The Motley Fool recommends Bed Bath & Beyond. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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