I am bearish on Bed Bath & Beyond (Nasdaq: BBBY ) . There, I said it. I am not sure how many folks out there agree with me, but please give me a moment. I might at least make you wonder if paying $42 a share is really the best idea right now.
We'll start with my own shopping experiences. Living in a small town in New England, my family travels about thirty minutes to the nearest regional shopping center in Keene, N.H. Several years ago, Keene began developing a new shopping complex to house several national retail and restaurant chains. Among the first wave of retailers built was a Bed Bath & Beyond and a Pier 1 (NYSE: PIR ) .
While I found Pier 1 to be a pleasant enough place to shop, we found little there for our needs. On the other hand, we often frequented Bed Bath & Beyond for its wide selection of more traditional home goods. However, that all changed as the next wave of stores was built, including a Target (NYSE: TGT ) .
Once Target was built, we shopped less at Bed Bath & Beyond. First, it was always quite the challenge to navigate the store's cramped aisles, especially with a shopping cart. Secondly, we haven't needed anything that could only be bought at Bed Bath & Beyond. Third, Target's diversity of inventory -- from clothing to toys to entertainment products -- offered a compelling one-stop shopping experience that covered much of what we previously purchased at Bed Bath & Beyond.
Although this is only one shopper's experience, I believe it highlights the company's lack of real competitive advantages. While the focus of product mix helps ward off some competition, Bed Bath & Beyond's success has been achieved through superior operations. Its terrific operating model and ability to expand rapidly have made for many years of storied success, regardless of its lack of competitive advantages.
However, looking forward, the company's success looks more tenuous. First, the company's growth opportunities are slowing at its core Bed Bath & Beyond stores. At a 10% compounded growth rate, it will take the company roughly five years to reach 1,300 namesake stores from its current store base. Management, realizing that saturation is approaching, invested in two newer store chains, Christmas Tree Shops and Harmon Stores. But these alternative growth strategies have yet to prove themselves, and both remain small contributors to the company's gross revenues.
While most investors agree the top line is slowing, I believe that the comparable same-store sales growth might also slip. The strength in same store-sales has been generated by taking market share from its competitors like Linens 'n Things and Pier 1. However, to continue to take market share, it must increasingly compete with much stronger competitors like Target, Wal-Mart (NYSE: WMT ) , and even HomeGoods, a division of TJX Companies (NYSE: TJX ) . There is also the wild card potential that Pier 1 and Linens 'n Things might revive their businesses, which would only add to margin pressures at Bed Bath & Beyond.
However, even slowing top-line growth and margin pressures aren't enough to make me bearish on a company. But add a rich valuation, and the scale has been tipped. You have to be an optimist to value Bed Bath & Beyond over $45. At $42, the company is still priced for several years of optimistic growth, assuming that the retailer doesn't suffer margin compression because of competition or increased costs associated with expanding its store base.
I modeled Bed Bath & Beyond's invested capital (roughly $4.5 billion) to grow at 10% for 5 years, tapered down to 3% at 10 years, and maintaining a 6% spread over its cost of capital. What I got was a value around $39, using a 9.8% weighted average cost of capital. Using a slightly higher cost of equity of 12% versus 11% for a weighted average capital cost of 10.7%, I would be more interested at an even lower value, $34.
Fool's final word
Bed Bath & Beyond has a solid balance sheet and a proven track record. I would be tempted to purchase the company at the right price, like when it was trading in the low $30s last July. However, I think misplaced optimism is the vote for the day. So until we see those lows again, this Fool remains a bear.
For related Foolishness:
If you haven't seen the other pieces of the Duel, click here for the Bull case and the rebuttals. If you're ready to vote for a winner, click here.
Value investors know that price determines return. That's why they estimate the price of every business they research, just like lead analyst Philip Durell does at Inside Value. A free trial to the market-beating newsletter is but a click away.
Fool Contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the companies mentioned. Bed Bath & Beyond and Wal-Mart are Inside Value recommendations. Bed Bath & Beyond is also a Stock Advisor selection. The Motley Fool has a disclosure policy.