Thursday, January 23, 2020
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Don’t Sleep On Bed Bath & Beyond’s Dividend-paying stock

Investment thesis

As the year is coming to an end, one of the most substantially beaten-down stocks in 2018; Bed Bath & Beyond (BBBY), is set to close the year with a positive record. So far this year, the stock price has appreciated almost 30.5%. However, this ride has not been a smooth one for investors by any stretch of the imagination. There was significant volatility surrounding various internal and external developments.

The company is in recovery mode, but it would take a few more quarters to see the success of the initiatives implemented to tackle the disappointing financial performance. Shares are trading at a significant discount to my intrinsic value estimate. Dividend investors should bank in on the current yield.

Past performance and outlook

Revenue of Bed Bath & Beyond has stalled of late due to higher competition coming in from online retailers such as Amazon. The home improvement industry in the U.S. has expanded significantly in the last 3 years but Bed Bath & Beyond has not been able to participate in this growth due to its insignificant online presence.

Profit margins have also declined over the last couple of years as fierce competition from online retailers forced Bed Bath & Beyond to slash prices to stay afloat.

Source: Company filings
Source: YCharts

It’s interesting to note how the industry expanded while the company revenue failed to improve in line with the industry growth and margins contracted. An opportunity certainly exists for companies representing the home improvement industry in North America and it’s a matter of negating competition and growing the market share.

Total sales of home improvement retailers in the U.S. (2008–2021e)

Source: Statista

Industry outlook in the short to medium term looks promising as median household income in the U.S. is rising at a steady pace and the macro-economic indicators point to continued growth in disposable income for at least the next 5 years. The low-interest-rate environment is also supporting home furnishing activities, which is another factor driving the industry forward.

The home improvement industry as a whole will continue to grow as millennials and baby boomers are continuing to engage in home improvement activities.

Online retailers are driving the industry growth as they cater to this rise of millennials and baby boomers who are more inclined to shop online than to visit a brick and mortar store. Failure to adapt to the growing demands of the new breed can eventually threaten the existence of home improvement companies with a focus on physical stores.

Notably, Bed Bath & Beyond has been pumping investments to improve their online presence, which accounts for the bulk of capital investments the company has executed in the recent past. For instance, in the year-to-date(YTD) period, 70% of total capital expenditures were related to IT investments.

Although CAPEX has gone down in the last year or so as a strategic move to improve margins, the company is allocating sufficient capital now to establish a strong online presence in the United States.

Source: YCharts

Analysis of dividend safety

Bed Bath & Beyond implemented its dividend policy in 2016 and approved its first-ever dividend on April 6, 2016. The company is transparent about its dividend policy.

“Though subject to change, we currently expect to pay dividends on the third Tuesday of July, October, January, and April to shareholders of record on the third Friday of the preceding months.” — Company Website

Staying true to the dividend policy implemented in 2016, the company has paid a quarterly dividend ever since deploying the dividend policy.

Dividend history

Source: Seeking Alpha

A dividend history that is consistent is a plus point, which exhibits the capability and willingness of the management to distribute wealth to shareholders of the company.

Free Cash Flows (FCF)

Despite an increase in capital expenditures and margin compression, the company has been able to grow its free cash flow, which is a positive sign for income investors.

Source: GuruFocus

The ability to generate cash stands out as one of the most important metrics in deciding whether the future dividend stream is sound and safe. Rather than the FCF growth rate, what’s more, important is to analyze whether dividends have been covered by FCF in the past.

Dividends were easily covered by FCF and not to forget, capital expenditures were on the rise during the same period. This establishes the company’s ability to generate sufficient cash to cover dividends, which provides a margin of safety to income investors.

Balance sheet strength

Balance sheet indicators provide insights into the sustainability of dividends. A healthy cash balance that can cover dividend payments and a low level of debt are both indicators of a company’s ability to distribute wealth to its shareholders.

Source: Company filings

Bed Bath & Beyond has an acceptable level of debt in its capital structure and the company is in a position to service its debt comfortably, even if revenue decline in the short term and online expansion projects fail to deliver desired results for some time to come.

The debt-to-equity ratio has improved in the last few years, despite a disappointing financial performance.

Bed Bath & Beyond has the option of injecting more debt to its capital structure to boost company performance and facilitate expansion projects, once current expansion projects start yielding results. At the moment, the company is better off using its free cash to support growth operations.

The total cash balance has grown over the years as well and the company can maintain its current dividend for years to come. If considered on a stand-alone basis, this is not a reliable indicator of a company’s ability to maintain its dividend payout but when combined with other measures such as FCF growth, debt/equity level, and the dividend payout ratio, total cash balance vs dividends declared provides a meaningful insight into a company’s ability of maintaining the same level of dividend in turbulent times.

Source: Company filings

Overall, despite the not-so-promising financial performance in the last 3 years, the company pays out a safe dividend, which should attract income investors. The company has implemented several initiatives to drive the earnings higher in the future as well, which supports this thesis.

Investment case

Bed Bath & Beyond Incorporation is trading at a significant discount to its historical levels, which is fair and acceptable given the industry-lagging performance in the last 5 years.

However, this undervalued status provides an additional layer of safety to dividend seeking investors.

Source: YCharts

While investors would be able to enjoy a healthy rate of return via dividends, they would be exposed to a reduced risk as the price has already adjusted to reflect the fundamental outlook of the company.

Moving forward, company revenue should stabilize and gain traction as technology-related investments will help generate a new stream of income to the company through online sales and Beyond+ program will help build customer loyalty around the brand name.

In addition to these initiatives, the company is revamping its store outlook to cater to the growing needs of the younger generation. The company has emphasized the importance of marketing decorative furnishings as a means of attracting a young crowd to its stores and the result so far has been commendable.

The stock price might decline further before we see positive results from all these initiatives but a dividend yield of above 4% should suffice to compensate long-term oriented investors. More importantly, the safety of dividends is high and this should encourage investors to consider investing in Bed Bath & Beyond. The appointment of the new CEO, on the other hand, has boosted investor confidence in the last couple of months as well.

Risks and challenges

Bed Bath & Beyond’s major challenge is the threat posed by online retail giants such as Amazon. Amazon’s wide reach, brand value, and access to disruptive technologies place the company in an advantageous position to compete in the home improvement industry. Retailers with a primary focus on physical stores, including Bed Bath & Beyond, will have a difficult time competing with the likes of Amazon, especially since the company does not have a wide economic moat. Capital investments in IT-related developments will be key to mitigate the risks posed by online retailers as this will bring in a fresh stream of revenue through online sales.

However, the company needs to be wary of its capital allocation procedures since the company stands a better chance of succeeding in the physical store sales segment as the likes of Amazon are difficult to beat in their own backyard. Revenue generated via online sales must be considered complimentary.

Conclusion

Bed Bath & Beyond is facing headwinds and investors are by large bearish on the outlook of the company. The strong competition in the industry has eroded the profit margins of the company while revenue has lagged behind industry growth rates. These negativities have taken the center stage but investors should pay close attention to the more than 4% dividend yield. Income investors can take a stake in Bed Bath & Beyond to capture this high dividend yield with the assurance of a safe dividend, as analyzed using various metrics. Investors with a long-term perspective are encouraged to consider this opportunity as there’s every chance of a further decline in share price in the short term, fueled by fears of increased competition in the industry. I rate Bed Bath & Beyond a buy at the current market price for income-seeking investors and I do not see a dividend cut on the horizon.


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Disclaimer:
This information is not considered as investment advice or investment recommendation but instead a marketing communication. This material has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead of the dissemination of investment research.

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