Is Bed Bath & Beyond an Undervalued Turnaround Play?

Bed Bath & Beyond (BBBY) lost nearly half its market value last year amid concerns about its negative comps growth, contracting margins, and competition from Amazon, Walmart, IKEA, and other big competitors.

However, its stock rebounded nearly 60% this year as the company reaffirmed its plans to generate positive earnings growth again by 2020. Activist pressure from three major investors -- Legion Partners Asset Management, Macellum Advisors, and Ancora Advisors -- also brought back some bulls.

At roughly $18 a share, Bed Bath & Beyond's stock looks cheap at nine times its earnings estimate this year, and it pays a forward dividend yield of 3.8%. Do those numbers indicate that it's an undervalued turnaround play?

Image source: Getty Images.

What happened to Bed Bath & Beyond?

In its latest earnings report (out this week), Bed Bath & Beyond said revenue fell 2.6% to $12 billion in fiscal 2018, which ended on March 3. It mainly attributed that decline to the lack of an extra week in 2018. However, its comparable store sales, which align the calendar years, still dipped 1.1%. Here's how Bed Bath & Beyond's comps growth and gross margins looked over the past year:

Source: Bed Bath & Beyond quarterly reports.

Bed Bath & Beyond's 1.4% comps decline in the fourth quarter marked a slight improvement from the third quarter's 1.8% drop, thanks to "strong sales growth" in its digital channels, which partly offset declining sales at its brick-and-mortar stores. However, analysts were still expecting a milder 1.3% decline.

Its gross margin improved sequentially, but declined significantly from a year earlier. During the conference call, CFO Robyn D'Elia blamed the contraction on "a decrease in merchandise margin and an increase in coupon expense." In other words, it tried to boost its sales growth with big markdowns.

D'Elia also noted that its Beyond+ membership program would "continue to unfavorably impact our gross margin as the rate of member enrollment increases." This means that it's running Beyond+ -- which offers customers free shipping (with no minimum purchase) and 20% discounts on their entire orders for $29 per year -- as a loss leader to widen its moat against Amazon Prime.

However, Beyond+ hasn't meaningfully boosted the company's comps growth since its launch last summer. Beyond+ reached 1.1 million subscribers at the end of 2018, but Amazon's number of Prime members hit 101 million in the U.S. at the end of the year, according to CIRP. This indicates that Bed Bath & Beyond is aggressively sacrificing its gross margins for very little comps growth.

Furthermore, the company's increased dependence on digital sales will weigh down its operating margins with higher fulfillment expenses. It could also cannibalize sales of its brick-and-mortar stores, which are already struggling against Walmart and IKEA.

Image source: Getty Images.

What's Bed Bath & Beyond's turnaround plan?

In its earnings report, Bed Bath & Beyond outlined its ongoing efforts to boost its sales and margins with four main strategies.

First, it's working to optimize its product portfolio by focusing more on room- or area-specific categories (like the bedroom, bathroom, and kitchen), selling more private label brands, and improving the customer experience with improvements to its stores and e-commerce platform. It believes these moves with lift its "mid- to long-term revenue growth" after its projected sales decline of 3%-5% this year.

Second, it believes that it can boost its gross margins by pivoting its product mix toward higher-margin products, optimizing its coupon strategies, and making improvements to its supply chain.

Third, it's making efforts to cut operating costs by negotiating better leases, streamlining its marketing efforts, and, potentially, reducing its workforce.

Lastly, it's trying to improve its business by tracking shopping trends with analytics, and enhance its "global sourcing capabilities" -- which could help it sidestep the trade drama with China and purchase products from countries with cheaper labor costs.

This stock is still cheap for a reason

Bed Bath & Beyond's adjusted earnings (which exclude a big impairment charge in 2018 and tax-related charges in 2017) fell 34% to $2.05 per share in 2018. However, it expects its earnings to improve 3%-7% in 2019, followed by "double-digit growth" in 2020 as its turnaround plans kick in.

Bed Bath & Beyond's stock would be cheap if the company hits those targets. However, I think it set those rosy targets to placate the activists who want to replace its entire board, and that it could be incredibly hard to fulfill those promises amid escalating competition from Amazon, Walmart, and other rivals. This stock is cheap for a reason, and shouldn't be considered an turnaround play just yet.