the price action of Bed Bath & Beyond (NASDAQ:BBBY) has been quite volatile in the past few days and weeks. In fact, from August 17 onwards the price is down by more than 60%. Typically, Mr. Market’s “analysis” seems to follow the price action. Since the price is down, it is inferred that fundamentals must be bad. In fact, fundamentals are being termed so bad that most “news” flows, articles and “buzz” is that Bed Bath & Beyond is going into bankruptcy.
The Scientific Investor, on the other hand, first goes into the fundamentals and then makes judgments about whether the company is a going concern, has persistent competitive advantages, can be valued or not, and if so, what is the range of intrinsic values.
BBBY is part of a diversified portfolio for us and our clients. This analysis is being done with the stock being part of a diversified portfolio and not being held directly as a sole stock holding.
Is BBBY a going concern? Will it be able to manage liquidity and survive?
As per the FY2021 (fiscal year ending in February 2022) 10-K, BBBY is a company with 32000 employees, 28000 square feet store space spread across 953 stores and with revenues of nearly $8 billion. It is also a Fortune 500 company.
Facts as per the Q1 2022 balance sheet
- Cash on the Books = $108MM
- Inventory = $1760MM
- Long-term debt = $1380 MM
- Total Assets = $4949MM
- Quarterly Sales = $1463 MM (Prev. Year same quarter $1954; 25% decline)
- Interest Cost = $16.4MM
- Cash flow from operations = -$384 MM
- Capex = $105MM
The Company disclosed in the Q1’22 10-Q that it has borrowed an additional $200 MM during Q2 via its Asset Based Lending (ABL) facility.
During Q1 the company sales declined by 25% due to reduced demand and, probably, wrong assortment. Receipt of delayed supply of inventory resulted in excess inventory of more than 15% above the originally targeted sales. With 25% lower sales the proportion of excess inventory is much higher. The CFO estimates that it is nearly worth $0.5 billion.
According to the management, Q2 continues to be challenging with sales down in the 20% range.
Simulation and Stress Test of Company Operations & Key Financials
Based on information shared by the management, we simulated the potential Q2 financial situation. Most important is to estimate the cash outflow towards the following uses, viz., vendor payments for merchandise ordered in the previous quarter, SG&A (selling, general, and administrative), and interest payments.
The previous year Q2 had sales of nearly $2 billion and the inventory would have been ordered accordingly in the first couple of months of Q1. Only by the end of Q1 would the later orders have been reduced seeing the declining sales.
For a $2 billion targeted sale, the COGS would be $1350 MM. With a declining trend the inventory ordered is estimated at nearly $1240 MM.
We assume a 25% drop in sales from the previous year, resulting in sales of nearly $1.49 billion. Even though the management has indicated “aggressive actions to align cost structure to sales”, we assume a 10% reduction in cash SG&A compared to Q1, which is $480 MM. Interest costs are assumed at $20 MM. This is a total cash outflow of $1740 MM. This results in a net cash outflow of nearly $250 MM as per our simulation.
In reality, as stated in the Q1, 10-Q, the company has borrowed an additional $200 MM via its ABL facility during Q2.
The above borrowings by the company broadly verify and validate our simulation. It turns out that we are simulating a slightly more stressed situation than reality resulting in $50 MM higher borrowing requirements.
Availability of $875 MM of further liquidity
The company still has access to $500 MM remaining under its ABL facility. Also, the fact that the company was able to access $200 MM under the facility during the quarter indicates that the lenders are comfortable lending them more money despite the bad performance in Q1 and continuing bad performance in Q2.
There is another $375 MM available linked to the ABL facility on a First-In-Last-Out (FILO) basis.
We simulate a 20% lower sales for Q3, $1.5 billion and related inventory ordered in Q2, to be paid for in Q3 of $943 MM with around $78 MM of inventory reduction from the excess inventory. We assume that cash SG&A is reduced by 15% from the Q1 levels, resulting in $453 MM and interest costs of $23 MM. This results in a positive cash inflow of $82 MM.
Management has indicated that H2 2022 should get better. We simulate a 15% decline in sales for Q4 with a 20% reduction in cash SG&A from the Q1 levels. We estimate the company ends FY22 with total sales of $6.2 billion, positive operating cash flows and slightly negative to zero free cash flows.
While the current management, including the interim CEO, are quite capable and experienced in managing retail operations, they have also engaged the Berkeley Research Group for assistance. This makes it even more likely that they are able to stabilize operations with a positive cash flow, albeit with much lower revenues than earlier years.
In short, we conclude:
The company is a going concern and likely to survive despite the negative sentiment and news flows around it.
Normalized Operations and Potential Business Valuation
It is likely that BBBY is likely to survive FY2022, ending with stabilized operations. A new CEO is likely to join during the year. The new CEO is likely to unveil a plan which, in the first phase, will aim to bring the revenues to earlier levels while maintaining strong cash flows and a strong balance sheet.
We estimate that a normal year would generate revenues of $8-$9 billion with operating cash flows to the firm (ie, interest payments being cash flows to the debt holders and the remaining cash flows to the equity holders) in the range of $675 to $800 MM and free cash flow to the firm in the range of $280-$365 MM.
With this, the valuation of the firm should be in the range of $4 billion to $7+ billion. This is the enterprise value of the firm. With nearly $2 billion of debt paid-off or repurchased, the equity value could go to $6 billion to $9+ billion.
Current market value of equity is approximately $800 MM and the market value of outstanding debt is around $1100 MM (with face value of $2 billion). This is a current enterprise value based on market prices of $2 billion.
One can see the deep discount to intrinsic value at which BBBY is currently available. Of course, there are risks, some of which we discuss below.
Risks to the above thesis
Some potential scenarios which could pose risks to the above thesis:
- Supply chain disruption other inventory/merchandise/brand mistakes leading to lower sales due to wrong assortment or non-availability of desired products.
- Significant demand declines resulting in much lower sales than the 15%-25% modeled.
- Inability to align costs to the lower sales assumed.
- Inability to manage liquidity.
Prey becomes the predator: A twist in the tale
The company filed the following 8-K on August 17, 2022:
We were pleased to have reached a constructive agreement with RC Ventures in March and are committed to maximizing value for all shareholders. We are continuing to execute on our priorities to enhance liquidity, make strategic changes and improve operations to win back customers, and drive cost efficiencies; all to restore our company to its heritage as the best destination for the home, for all stakeholders. Specifically, we have been working expeditiously over the past several weeks with external financial advisors and lenders on strengthening our balance sheet, and the Company will provide more information in an update at the end of this month.
Most of the statement reiterates the management’s commitments during the Q1 earnings call and also qualitatively validates the assumptions in our simulation. But, the key phrase to focus on in the above statement is the phrase “strengthening our balance sheet”.
This could mean a fresh infusion of equity, probably accompanied by more debt, as many are claiming, thus diluting existing shareholders. Or, existing debt is refinanced with debt of lower costs and longer maturity.
Most prominent are rumors that they are working with Kirkland and Ellis, so-called bankruptcy experts, to file for chapter 11. Of course, that doesn’t exactly tally with the phrase “strengthening our balance sheet”. Also, Kirkland and Ellis offer 40-50 other services, including Asset Finance and Securitization and Capital Markets.
Since our simulations and analysis above show that the company can stabilize its operations without needing too much further borrowings, we think that the company means debt reduction when it says “strengthening our balance sheet”.
The outstanding debt of $1.2 billion (2024 ($300MM), 2034 ($225MM), 2024 ($675MM)) is selling in the market significantly below face value.
We think that the company plans to raise the $375 MM available on a FILO basis to bring in added liquidity. Probably $200 MM could be kept as cash on the books for operational liquidity and flexibility and the remaining could be used to repurchase the outstanding listed debt at a discount. Alternatively, all of the cash could be kept on the books for operational flexibility until the operations are fully stabilized and then the debt repurchase could be done.
Fully utilizing the $375 MM for repurchasing as much of the discounted distressed debt as possible is probably the best course of action. This could immediately result in significantly reduced debt and the gain on the transaction would accrue to equity holders thus giving a significant boost to equity given the current distressed market cap of equity.
The remaining unutilized ABL facility of $500 MM is sufficient to provide operational liquidity and flexibility.
Thus, in our opinion, far from the company planning to file for bankruptcy, as the current narrative holds, it is likely that the prey becomes the predator and the company likely repurchases significant amounts of 2034 and 2044 debt.
This transaction strengthens the balance sheet, reduces the interest outflow, and boosts shareholder’s equity.
Not that this is a new playbook for the company board and management. The company retired $300 MM of debt at a 25% discount, resulting in a nearly $75 MM gain, in August 2020.
Yes, this section is speculative. But as Sherlock Holmes, says:
When you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.
We cannot eliminate alternative future scenarios, but those are much less likely, in our opinion. But, there is small, non-negligible probability that the company doesn’t survive despite the best intentions and efforts of the management.
Risk management through portfolio diversification
In principle, the share price of any specific company can go to zero. With the use of our Scientific Investing Framework, we try to reduce this possibility significantly but can never eliminate it. This is where the portfolio design comes to the rescue. With allocation for any company restricted to 5% at the time of portfolio construction the maximum loss due to one company in the portfolio going to zero is capped at 5%.
It should be clear that a deep value investment like BBBY should only be carried out as part of a portfolio operation and not as an individual, solo stock play. The risk levels are enormously different in both cases. Also, a portfolio operation allows the law of large numbers to work in favor of the investor.
Nothing in this article should be construed as a recommendation to buy, sell or hold BBBY. Please read the disclaimers thoroughly.
Catalysts to monitor
- Announcement about the $375 MM FILO debt raise or any other debt raise
- Achievement of revenue and cash flows at better-than-expected numbers
- Announcement of new CEO
- Announcement of a debt repurchase plan
All of these could unlock significant value.