If you have a strong balance sheet, and you aren’t shipping out most of your profits to shareholders, you can withstand an extended period of challenging business conditions and still create shareholder value.
Even though keeping adequate cash reserves and running a business with a hyper-focus on prudence remains out of fashion, the value of financial strength occasionally reveals itself.
It comes to my mind every time I take a look at Bed Bath & Beyond (BBBY) stock. For the past ten years, the company has become yet another victim of Amazon as customers learned that they kind find the exact same home furnishings at a cheaper price than they’d get if they visited a physical Bed Bath & Beyond retail location.
That is why, even though Bed Bath & Beyond has opened an additional 700 stores and nearly doubled its store count over the past ten years, company-wide profits have only grown from $610 million to $700 million. Net profits per location have been nearly cut in half.
In 2006, each Bed Bath & Beyond store made an $675,000 in annual profits. It was earning 10% net of expenses on everything sold. It was a dream business. As people learned they didn’t have to pay those traditional prices anymore, profit margins came down all the way to 5.7%. Today, there are 1,550 stores making $700 million in net profit. Each store only makes around $451,000 in annual profits. It is actually much less than that because Bed Bath & Beyond has an online sales arm that didn’t contribute to profits in 2006, so my estimate is that each store probably make around $300,000 and the rest comes from online purchases (though Bed Bath & Beyond doesn’t give investors the specific breakdown).
Under these circumstances, you would expect only 1.39% annual returns–a terrible figure that would cause you to lose power to inflation over time.
Fortunately for the firm, it had $400 million in cash back in 2006 and no debt. It allocated nearly all of its cash flow that wasn’t being used to reinvest back into the business to go towards extremely large share repurchases. Over the past ten years, Bed Bath & Beyond has reduced its share count from 277 million to 145 million.
Each share of Bed Bath & Beyond today represents a 47% larger ownership claim on the business than existed ten years ago. For this reason, the per share earnings have grown from $2.15 to $4.80 over the past ten years. That is 8.36% earnings per share growth during a time when the core business itself only grew 1.39%.
Fiscal prudence throughout the years had a create payoff. Even while the core business was languishing with only 1% annual growth, the prudent stewardship of shareholder assets meant that each share of the business came to grow by 8% each year.
Earlier this year, Bed Bath & Beyond initiated a $0.125 quarterly dividend. Most likely, it did this because management is sick of seeing its stock trade at 9x earnings and wants to stimulate interest in the shares.
I disagree with this strategy. What Bed Bath & Beyond should do is use its free cash flow to aggressively repurchase stock and keep the earnings growth coming even as the core business stagnates. Earnings per share grew at 8% annually when stock was getting repurchased at 14x earnings. Imagine how much more they will improve when you repurchase the stock at 9x earnings.
The rest of the cash should be used to come up with a strategy to ward off Amazon rather than pay off cash to shareholders. The 20% off cards are a good start, but more innovation is required. Dividends should be paid out once your competitive position is secured rather than as a salve to cure current stock price woes. Personally, when a stock is at 9x earnings, I’d rather see all free cash flows go towards buybacks. And a dividend shouldn’t be considered until the business model comes up with an innovation to gain momentum and improve its competitive position. However, I do applaud the Bed Bath & Beyond management team for maintaining the financial strength to build shareholder value these past ten years while the core business faced significant obstacles.