Bed Bath & Beyond is up nearly 8.5% since the start of the year, but the company's long-term operating history and recent initiatives suggest that the stock has a lot more appreciation potential in the year ahead.
Bed Bath & Beyond sports the highest operating margin in its peer group despite selling its products at a similar price point.
The company is able to achieve this feat due to its superior sales productivity; it has more sales per square foot than Williams-Sonoma and Pier 1 Imports . The company's liberal return policy deserves a lot of the credit for high sales per square foot; customers who come in looking for just one item often leave with multiple items because returns are so generous. This also creates loyal customers.
In addition to high sales productivity, Bed Bath & Beyond has also shown a knack for efficient merchandising. The company's defensive products, such as linens, towels, and cookware, offer protection from downturns in cyclical products like those closely related to the housing market.
Bed Bath & Beyond is finally investing in its website to better compete with Williams-Sonoma's vast e-commerce presence. The company has additional growth opportunities in Canada and Mexico that will be aided by its e-commerce build-out.
Williams-Sonoma represents Bed Bath & Beyond's challenge to long-term prosperity. Williams-Sonoma has a large presence on the internet -- nearly 40% of its sales are made online. Its internet segment is the fastest-growing part of the business. It will be difficult for Bed Bath & Beyond to ever catch up with Williams-Sonoma's online presence.
Pier 1 poses a smaller niche threat to Bed Bath & Beyond. Pier 1 is pursuing a much narrower merchandising strategy that does not scale as well as Bed Bath & Beyond's. In addition, Pier 1 does not have the same product diversification that allowed Bed Bath & Beyond and, to some extent, Williams-Sonoma to weather the recession relatively unharmed. As a result, Pier 1 does not pose a serious existential threat to Bed Bath & Beyond in its current form.
Since 2002, Bed Bath & Beyond has averaged a 46% pre-tax return on tangible invested assets (defined as tangible assets minus cash). The company's return has nearly always been above 51% except during 2007-2009.
However, for purposes of valuation, I will assume a pre-tax return on tangible invested assets of 40% going forward. This is to account for hiccups in the e-commerce renovation as well as lower-than-expected returns on its recent acquisitions.
If you apply a 40% margin to the company's $5.6 billion in tangible invested assets, you get a normalized pre-tax earnings figure of $2.24 billion. Last year, the company earned $1.57 billion before tax -- so assuming $2.24 billion in normal pre-tax earnings assumes a reasonable amount of growth for the company.
The market currently values Bed Bath & Beyond at about $13.6 billion -- or 6x my estimate of normal pre-tax earnings. Using a 35% tax rate, this is a little over 9x normal earnings.
It seems incredible that a company with Bed Bath & Beyond's competitive superiority would sell at just 9x normal earnings, but remember that figure takes growth into account. However, the company trades at just 8.7x last year's pre-tax earnings, so shareholders will likely receive an adequate return even if the growth does not materialize.
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