Saturday, 3 September 2016

Bed Bath and Beyond, Serious Underperformance, Why? Part 2

In my previous post, I drew attention to relative under-performance in Bed Bath and Beyond (BBBY) vs. basically everything (this year), and wondered what the market might be inferring.

I'm going to attempt to answer this question with reference to John Huber's series of articles on ROIC over at Base Hit Investing.  If you haven't read these articles, I highly suggest you do.

There are two particularly powerful articles which I've read, and re-read, and re-read again which provide an amazing conceptual framework for understanding ROIC and identifying companies with moats.

The first article, entitled "Importance of ROIC: "Reinvestment" vs "Legacy" Moats, link here, articulates an approach to distinguishing between both types of moats, and the role ROIC plays in compounding returns over time. I've never really thought along these lines until recently, but I'd hazard a guess that any serious investor has likely has thought along these lines without knowing it.

The second article, entitled "Calculating the Return on Incremental Capital Investments, link here, articulates the math behind evaluating ROIC. Like any other point in time return parameter, ROIC cannot be evaluated just at a point. I believe it is most useful when evaluating returns over time.

The key takeaway from the first article is that a serious investor looking to compound returns abnormally needs to spend his/her time identifying companies with reinvestment moats. Simply put, a reinvestment moat allows a company to reinvest earnings at exceptionally high rates of return over time. This type of company likely has a durable competitive advantage combined with a long runway of growth.  One of my favourite observations from this article is as follows:

On the subject of "Judging the "Runway" to Reinvest:

"Many investors focus purely on growth rates driving up the valuation of a company growing at high rates even if the growth does not carry positive economics. The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time. Instead of focusing on next quarter or next year, the key is to step back and envision if this company can be 5x or 10x today's size in a decade or two? My guess is for 99% of businesses you will find that it is almost impossible to have that kind of conviction. That's fine, be patient and focus your energy on identifying the 1%."

Absolutely brilliant comment and a clue. My interpretation as applicable to me? Don't try to force ideas. Every single day there's a flurry of opinion surrounding everything ticking red/green by the mili-second. Most companies out there likely don't have reinvestment moats. And the ones that do? Well, the market has most likely priced the reinvestment moat in (think Amazon, Facebook, Google, etc.) Focus instead on a) identifying companies with possible moats, and b) distinguishing between legacy vs. reinvestment moats. Once a reinvestment moat is identified, conservatively envision how a company might be able to grow to 5x - 10x today's size in a decade.

The key takeaway from the second article is thinking forward. The act of calculating ROIC over time forces you to evaluate where a company is at in terms of likely future runway to reinvest. The author gives two examples, comparing Walmart (Legacy Moat) to Chipotle (Reinvestment Moat, well up until recently anyway).

I'm going to demonstrate my findings using Bed Bath and Beyond, and doing so, I hope to evaluate whether BBBY has any type of moat, and/or future runway to reinvest (source = company 10k's)

Some overall observations:

I have split the periods evaluated into three distinct phases, as follows
  1. Hypergrowth: Growth from 34 stores to 396 stores between 92 and 2002. Hypergrowth was accompanied by > 100% reinvestment rates (as an aside, reinvestment rate = incremental capital invested / cumulative earnings over period). This was a function of expansion, as the company took on off balance sheet commitments (new store leases). Capitalizing the future commitments, you get a sense of the extent of growth. BBBY needed to commit to new leases as they expanded aggressively, and reinvested more than their cumulative net earnings in terms of future lease commitments. ROIC is around 9%, but value compounding return is 24% as the company grows.
  2. Steady Growth: Growth from 108 stores to 888 stores between 1997 and 2007. The steady growth phase was still accompanied by > 100% reinvestment rates, but the reinvestment was falling relative to the hypergrowth period as rate of new store growth decreased. I've highlighted the rate of decrease commencing in 2001. ROIC is around 14%, but value compounding return has dropped to 17% as company growth slows.
  3. Mature to no Growth: Growth from 888 stores to 1530 stores between 2007 and 2016. Here, the reinvestment rate has fallen to 27.5% vs. > 100% in the previous comparative periods. ROIC has dropped to around 9%, and value compounding return has dropped to 2.5% as the company matures
I think the clues here as to whether or not BBBY has any sort of moat (and accompanying opportunities for reinvestment) is a) the use of capital over the last decade, and b) the consistently low ROIC. In the context of John Huber's framework, management are sending a clear signal that there is a real dearth of reinvestment opportunities because they choosing not to redeploy capital into expansion any more. Instead, they are engaging in massive share buybacks.

Concluding Thoughts

Arguably, there is no legacy moat (and certainly no reinvestment moat) as the returns on capital are slowly eroding and there's nothing to prevent price competition from eroding margins going forward. It's doubtful there's a long runway of growth here. Back in 1992 however, a shrewd investor might have picked up on the growth potential of the big box housewares concept at the time the company only had 30 stores. At +1500 stores, and slowing rates of growth in terms new store openings, the likelihood of +3000 in a decade seems a stretch.

The counter argument is that the runway lies in either global / international expansion outside of the US as BBBY is predominantly US based, but this would be a huge about face from the company's established market.

Now I understand why BBBY is cheap.