Bed Bath & Beyond (BBBY) just announced that it has received a default notice from a key lender. Management has stated that bankruptcy risk is very high over the coming year. But bankruptcy is normally a slow-moving process that drags on and on -- only at the very end will it speed up dramatically.
There were signs of Bed Bath & Beyond's increasing bankruptcy risk well before the most recent announcement. Here are three red flags investors should track for any company in distress.
1. A going concern notice
The most glaring warning that a company is headed toward bankruptcy can often be found within the company's own Securities & Exchange (SEC) filings. The most recent 10-Q filing from Bed Bath & Beyond states specifically:
Based on recurring losses from operations and negative cash flows from operations for the nine months ended November 26, 2022 as well as current cash and liquidity projections, the Company has concluded that there is substantial doubt about the Company's ability to continue as a going concern for the next 12 months.
The filing explains the current situation with regard to its debts, but it's important to understand that this wasn't the first warning.
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In Sept. 2022, when the retailer filed its previous 10-Q, management said:
The Company is required to perform a two-step analysis of its ability to continue as a going concern. It must first evaluate whether there are conditions and events that raise substantial doubt about the Company's ability to continue as a going concern (Step 1). If the Company concludes that substantial doubt is raised, it is also required to consider whether the Company's plans alleviate that doubt (Step 2).
This process only gets highlighted if there is a very real problem.
Management said at the time it was taking actions that it believed would allow it to remain a going concern (Step 2) unless the company "encounters unforeseen circumstances that place further constraints on its capital resources." And it also noted that, "Management cannot provide any assurance that the Company's efforts will be successful."
This wasn't nearly as dire a warning as what investors found in the most recent 10-Q filing, but the takeaway here is that investors should listen when a company starts to talk about its ability to remain a going concern. Basically, management is saying that bankruptcy risk is worryingly high. Note that the September warning was provided nearly four months ago with the current 10-Q simply representing an escalation of the risk.
Put simply: If management is telling you to worry about its ability to function as a business going forward, then you should worry about bankruptcy.
2. Financial statements
The September quarterly update was the point at which the company felt it had to announce the risk to investors (which is a legal requirement), but it was not the first sign of trouble for Bed Bath & Beyond. Astute investors have been watching the problems unfold in the company's financial statements, specifically through key debt-related financial metrics.
Two important items that are most easily observed are leverage and the ability to pay interest expenses. In the case of Bed Bath & Beyond, its debt-to-equity ratio rocketed higher in 2022, rising from below 1 to more than 4.5. It was accompanied by ongoing weakness in the company's earnings (or in this case losses). The red ink has led to the company being unable to cover its interest expenses, as measured by the times-interest-earned ratio, for most of the last four years.
Data by YCharts.
A lot of leverage and an inability to cover interest costs are signs of trouble that often arise well before a bankruptcy filing, or even a going concern notice. While not every company that exhibits these traits goes bankrupt, most companies that go bankrupt usually display them. It is worth paying very close attention to these metrics when examining a highly-leveraged company that's losing money.
3. Leaders leaving and hiring advisors
Very few management teams are blind to the financial risks they face. Boards of directors are similarly aware of the problems that arise at the companies they oversee. That's why top-level management changes often take shape at financially troubled companies. CEOs and CFOs are frequently replaced or step aside on their own, which happened at Bed Bath & Beyond in 2022, notably before the September SEC filing that contained the going concern note. And there have been other high-profile management changes as well, though lower down in the executive ranks.
There are different ways to look at such changes. For example, key leaders might be trying to exit a sinking ship, or a board aware of the problems might believe that a new leadership direction is needed. Regardless of how you spin such changes, however, when you combine big leadership moves with a company that is clearly struggling financially, it suggests that risks to the company are rising.
That becomes even more apparent when a company brings in "advisors" that have bankruptcy experience. Often, however, a company uses other terms to describe what's going on. Notably, Bed Bath & Beyond added two new board members in March 2022, one with "expertise in capital allocation and structure strategies, corporate governance and strategic reviews," and the other with "expertise in capital allocation, corporate governance and mergers and acquisitions." These board members appear to have been added, because they know how to deal with companies facing material change.
Just recently, the company took the additional step of hiring outside advisors with direct bankruptcy experience. That, however, was simply another confirmation of the increasing bankruptcy risk -- ongoing financial troubles and management changes had already been sounding the alarm for some time.
The signs were there
There is no single path that every company takes as it slides toward bankruptcy. And until Bed Bath & Beyond actually files, there is always a chance it manages to avoid this fate. However, history often rhymes, and the common red flags allow astute investors to get ahead of rising bankruptcy risk well before a company actually seeks out court protections.
Those key warning signs include a "going concern" statement, high leverage and weak profits, an inability to cover interest costs, major management turnover, and the hiring of advisors with bankruptcy (or related) experience. All of these elements are in play at Bed Bath & Beyond, and investors should avoid this highly speculative stock.
