Articles tagged as


  • Signal from Noise
Nov 13, 2019

-Hated stock; years of poor results, negative s/s sales; appears a victim of Amazon -Still popular brand; activists and new CEO instilling new retailing culture; lots of value -Bad news discounted; cost cuts, store closings, modern approach could double price In decades covering Wall Street, I don’t think I’ve seen a stock as hated as Bed Bath & Beyond (BBBY), the beleaguered home goods retailer—except for Best Buy (BBY). That’s relevant, as I’ll show below. To call it a dog stock would be an insult to canines the world over. Yet hated stocks are particularly interesting when the problem has been mainly unimaginative management, but especially where the short position is over 50% of the float, as in BBBY.  If the shorts are wrong the stock could rise substantially. BBBY stores and brands are well known. In a recent Yougov survey it was the eighth most popular specialty retailer, ahead of CVS and Ikea. Many investors know this $1.7 billion market cap retailer has struggled mightily for years, missing EPS expectations quarter after quarter and posting continual negative same-store sales (-6.7% in the second quarter ended August). Consequently, the stock price has plunged to a low of $7.40 recently from $80 in 2015. It’s rebounded to $13.60 when a new CEO came aboard last month. I’ll get to that, too. There are problems aplenty and space limits me to the most egregious: BBBY is late to the online challenge, with a weak Internet strategy; prices are too high, requiring constant couponing; high SG&A costs; too many stores in the U.S. and not enough customers.  Activists who got involved last March accused previous management of too high compensation, and self-dealing regarding some BBBY acquisitions from related parties. Sentiment is poor; just 25% of the Wall Street analysts who follow it rate it Buy. Yet, it seems that most of the bad news is in the price. Contrary to the bear case, BBBY’s problems, though deep, are fixable. Bears say BBBY is a dead retailer walking because its products are particularly susceptible to the “retail apocalypse” of Internet sales and Amazon (AMZN). But if that were true why then is home décor rival Williams-Sonoma doing well, and why has BBBY’s sales remained relatively steady at about $12 billion over the past five years, even as annual EBITDA has more than halved to about $750 million over that time? Years ago Best Buy (BBY), once derisively called Amazon’s show room, was thought dead, but through some imaginative retailing by a new CEO it has come roaring back, with much improved results and a sevenfold increase in price, after dropping 80% previously. One important BBBY catalyst has already arrived, activist hedge funds Legion Partners,  Macellum Capital and Ancora Partners, which hold about 5% of the stock and have an established turnaround track record. They helped push previous management into retirement, revamped the board with independent directors, and aided in the hiring of a potentially brilliant choice for a new CEO, Mark Tritton, formerly Target’s (TGT) chief merchandising officer. Target is one of the few general retailers thriving in the age of Amazon. Expect Tritton to instill that culture at BBBY.  He doesn’t have to reinvent retailing just put in modern practices already adopted by peers.  There are significant changes coming that should lead to improved results, and I expect the stock price will reflect that. For starters, BBBY is cutting 7% of staff, slashing inventory by some $1 billion, and closing 60 underperforming stores, out of about 1000 or so. Expect more of that. This should allow BBBY to price competitively against Amazon. SG&A as a percent of sales soared to 30.6% of sales in fiscal 2018 from about 25% seven years before, but every 1% cut translates into roughly 50 cents of EPS. BBBY owns other brands, such as buybuyBaby, World Market and Christmas Tree Shop, amounting to several hundred stores. It’s also possible BBBY will divest itself of some or all these non-core brands with a relatively low hit to EBITDA. A recent Wedbush Securities broker report valued those assets at $1.7 billion, equivalent to BBBY’s current market cap, so the market would appear to be giving little or no value to the main brand. BBBY holds about $1 billion in cash and marketable securities (or $7.75 per share). That compares to $1.5 billion in long term debt and $1.8 billion in operating leases, as well as $1.7 billion in property, plant and equipment assets.  According to a recent report from Bloomberg, some 400 leases are up for renewal in the next few years. New Constructs, an independent forensic accounting investment research firm, notes that BBBY’s return on invested capital (ROIC) has fallen to about 5%-6% from a robust 17% in 2014, even as 117 other retailers have managed to increase theirs over the same period. (So much for the “retail Apocalypse.”) BBBY’s problems appear company specific, which means they can be fixed. Getting ROIC right is important and if BBBY were to match Williams-Sonoma’s 13% ROIC, the stock would be worth $107, argues New Constructs. See table. Even with its troubles, BBBY’s ten-year ROIC average is 15%.  Those are big numbers, but if ROIC rose less, the stock could still rise substantially. Currently, BBBY trades at a price/earnings ratio of 7 times fiscal 2021 (ending Feb. 2021) EPS estimates of $1.93.  BBBY has guided to about $2 EPS for fiscal 2020, ending next February. The activists assert BBBY can earn over $5 EPS in 2022, but again if it were $3 EPS, with a slightly expanded P/E, the shares could be worth $24-$27, roughly a double from here. New Construct points out Best Buy’s ROIC rebounded to 16% from 7% in 2012 and has done enormously well: “BBBY has become so cheap that the potential upside, even with slight operational improvement, is enormous.”  Don’t forget a short squeeze is possible. And there’s also a 5% dividend yield while you wait. Where Could I Be Wrong: If Tritton fails to turn it around, BBBY shares could return to lows. There is downside protection in the form of potential acquisition interest. Bottom Line: Wall Street doesn’t believe there’s any hope and I take solace from that. A turnaround is a process but two years from now, if Tritton is successful, many will say it was obvious. Prior “Signals” Date Topic Subject / Ticker The Signal 10/30/19 Stock GW Pharmaceuticals Epidiolex, Pipeline Look Promising 10/23/19 Stock Sherwin Williams (SHW) Sherwin Williams Paints a Pretty Profile 10/16/19 Stock Eyepoint (EYPT), Sonova (SONVY) Both cater to the increasing vision, hearing needs of seniors 10/9/19 Stock Skechers U.S.A (SKX) Volatile Skechers stock could be ready to roll higher 10/2/19 Stock Arcos Dorados (ARCO) Arcos Dorados Shares Undervalued; Turnaround In Sight 9/25/19 Stock Peloton (PTON) Peloton IPO Offers Growth, Scarcity Value—For Now 9/18/19 Stock Oshkosh (OSK) For investors with a long term horizon, OSK looks cheap. 9/5/19 Market BBB bond mkt implosion overdone Don’t sweat the BBB market so long as market chugs along 8/29/19 Industry Soybean/Tariff Impact on Trump 2020 If tariff wars continue, auto – not farm – states could hurt Trump 8/21/19 Stock We Co. (WE) Fast growing company but poor governance 8/14/19 Market M&A to Accelerate? Ultra-low rates could spur accelerated M&A 8/7/19 Stock Caterpillar (CAT) Cyclical stock could benefit from recovering growth 7/24/19 Stock Mowi (MHGVY) Salmon fish farmer could benefit from BYND trends 7/17/19 Market Earnings Recession Look Through the EPS Recession to 2020 EPS 7/10/19 Stock Weight Watcher (WW) Battered Weight Watchers Stock Looks Cheap 7/3/19 Industry Why SaaS Isn’t Cheap SaaS stocks improved models create value 6/26/19 Market 2H Mkt Gains After Strong 1H19, Potential for More Gains        

Arcos Dorados Undervalued; Turnaround In Sight

– Macro issues like forex and regional instability hurting shares this year – ARCO changes to improve sales, profitability evident in strong 2Q – Introducing marketing and digitalization initiatives; stock looks cheap; 50% upside? “Brazil é o pais do futuro e sempre será” is a phrase Brazilians sometimes say with a shrug. Translated it’s “Brazil is the country of the future and always will be.” It’s well known on Wall Street, too.  Despite being blessed with many natural resources, fertile land, and a large population, Brazil remains a sleeping economic giant, if you will, punching below its weight. Stocks in the general region suffer from a discount.  So if you scratch your head at Arcos Dorados Holdings (ARCO), which trades on the NYSE, I can’t blame you. But you might miss an undervalued stock. ARCO is a smallish midcap, $1.3 billion, admittedly with some hair on it. It’s the largest McDonald’s (MCD) franchisee in the world and Latin America’s biggest restaurant chain, with over 2,200 stores in 20 countries. Some 50% of revenue and about 75% of earnings before interest, depreciation and amortization (Ebitda) come from Brazil.  Wait, don’t turn away. That’s where the opportunity might lie. The company is making a concerted effort to turn things around, and, as we’ll see on the next page, ARCO’s results are showing significant improvement. In particular,  same-store sales and margins are rising; costs are being rationalized; new menus with healthier items and marketing initiatives have been introduced, including delivery in some areas; and increased digitalization and omnichannel sales. Here are the negatives, nearly all macro and out of the company’s control. It’s an emerging market stock, which are out of favor with U.S. investors. Problem No. 2:  Most of Arcos’ business is done in weak currencies like Brazilian reals and Argentinian pesos, yet the company reports in U.S. dollars.  So even if local revenue soars, in USD it could look less impressive if the greenback rises, which it has been doing of late. Last year, there was a long truckers’ strike in Brazil, and this hurt results significantly. ARCO is a British Virgin Islands-domiciled stock, with most of its business in Brazil and Argentina, and headquarters in Uruguay.  Got that? It’s a stock hard to classify and isn’t  in a major index, making it difficult for some institutional investors to buy. Finally, the latest insult was the surprise primary election setback Aug. 11 for Argentina’s President Mauricio Macri, whose pro-market economic reforms are unpopular. There is a good chance a Peronist will be elected Oct. 27, with all the dirigiste economic changes that entails.  Though ARCO doesn’t break out Argentina separately, it gets a not insignificant 15% or so of revenue there. Indeed, the shares rose 15% to $8.16 when second quarter earnings results came out on Aug. 7 (more on this below), but they are down nearly 20% to around $6.53 since then. The truckers’ strike is over and I don’t suggest ignoring the macro issues, but they could blind investors to the corporate changes going on under the radar that should serve ARCO well longer term. The free market positive things that appear to be happening in Brazil—a tax overhaul, improved economic growth and the government’s privatization agenda—should help drive ARCO’s stock. Good things in Brazil can more than make up for what might happen in smaller Argentina. As noted, numerous positive changes are being made by new CEO Sergio Alonso. In 2Q19,   consolidated revenues decreased 1.8% to $721.0 million from 2Q19, primarily due to currency depreciations. On a constant currency basis, they grew 15.8%.  More importantly, systemwide comparable sales rose a strong 14.2%, above blended inflation. As the nearby chart shows, S/S sales are improving in all major regions. Net income increased 2.5% to USD$11.0 million, or 5 cents per share, from $10.7million or 1 cent. Meanwhile, adjusted Ebitda increased 15.9% to $56.6 million compared with the prior-year quarter, as the Ebitda margin expanded 120 basis points to 7.8%, thanks partly to cost controls, but also on marketing initiatives. Sales momentum appears to have accelerated substantially in the second quarter. The stock is cheap, and should the turnaround continue quarter by quarter, expect the stock to eventually reflect the improvements, says Greg Lesko, a portfolio manager at Deltec Asset Management, which owns an ARCO stake.  For example, it trades at about 6.5x enterprise value to Ebitda, while rival Brasil Operacao e Assessori, which operates Burger Kings in Brazil and is growing a bit faster, trades at an EV/Ebitda of over 10 times.  That’s too big a spread.  ARCO’s price/earnings ratio of 16 times 2020 EPS is significantly below its historical median P/E of 27.  While a few quarters don’t necessarily mean a permanent improvement, the valuation is below that of its peers and its own historical mean.  JPMorgan’s analyst calls ARCO, with its recovering Brazil same-store-sales and “attractive” valuation, a good vehicle to gain exposure to the Latam restaurants industry. While recognizing the currency constraints, Moody’s wrote recently that ARCO has a solid capital structure and comfortable debt amortization schedule. It expects ARCO to pursue growth across Latin America. The potential for regional improvements as well as internal corporate changes could lead to a nice pop in the stock eventually.  At a minimum the latest stock slide looks over done based on macro factors, and if the company continues on the current track the stock could rebound nicely, as much as almost 50% to $9 or $9.50 the bulls say. Where could I be wrong?  Macro issues could worsen more than expected, making life difficult for ARCO. The turnaround could fall flat, though I don’t think this will happen. Bottom Line:  ARCO share price looks significantly undervalued given that the macro problems are likely already discounted in the price and that it’s becoming increasingly clear that a turnaround is in the offing.

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