Maxine Clark, CEO, founded the company in 1997 and grew BBW from scratch to a company that continues to generate well over $400 million in revenue and generated $30 million in profits in its peak year. At a market cap of $90 million and an enterprise value of $60 million, the market is effectively assuming this company has no future. Boiling it down for anyone who doesn’t want to read past the first two paragraphs: the good news is that even with conservative estimates, BBW should be able to generate enough earnings to justify double the current share price; the bad news is that stores were underperforming before the recession could be blamed and the margins are narrow, making an estimate of value sensitive to our assumptions (to the downside as well as the upside).
Build-a-Bear has a pretty straightforward business. They open stores, mostly in malls, and sell teddy bears that are assembled on-site in short order for anxiously awaiting 7-year olds. The experience is part of the fun, and bears are currently being promoted for $30 a piece. Stores cost around $400k to open, as discussed each year in the annual report, and the net income per store has ranged from $137k in 2005 to only $13k in 2008. Average NI/store has been $77k. When I say net income, I mean for BBW as a whole, so this includes corporate administrative expenses (and taxes) that aren’t attributable to any specific store. Using these numbers, we can calculate an after-tax RoI ranging from 3% to 34% on new stores.
Because management was kind enough to tell us exactly what the average cost per new store was each year, we can somewhat accurately guess what maintenance CapEx is on a per store basis. The average over the time period I analyzed was around $80k, but I modeled it as closer to $50k because a) management expects to spend $9k on CapEx (with only one store opening) in 2009 which translates to around $25k/store, and b) some CapEx is from corporate growth. Of the $9mm of CapEx in 2009, $2mm is being spent on repurposing failed experimental concept stores, indicating that real maintenance CapEx might actually be even lower than $9mm for 245 stores.
Management has repeatedly stated that they believe there’s a market potential for 350 stores in North America, and 70-75 stores in the UK and Ireland. This compares to 291 stores open in North America, and 54 in the UK, Ireland, and France. BBW also has franchised stores in other international areas totaling 61 stores out of an estimated market potential for 300. In terms of owned and operated stores, if management’s estimates are correct, they are currently operating at 81% of carrying capacity. The weak economy in 2009 might have forced management to put the breaks on a little early, but it looks like this might prevent them from driving off a cliff. Slower store growth means more FCF will be available for management to return to investors in the form of dividends or share repurchases. The risk exists, of course, that management will pursue an aggressive acquisition strategy and destroy shareholder value with unprofitable expansion. However, Clark has a pretty strong track record for not being overly aggressive. In 2006 BBW purchased The Bear Factory, which provided 40 stores in the UK and Ireland for $40 million. These stores perfectly fit into the BBW business, and are now effectively Build-a-Bear Workshops. BBW tested a doll-making concept called “friends 2B made”, eventually operating 9 stores in or around existing BBW stores, and decided this year to scrap the concept. BBW also owns a 25% minority interest in Ridemakerz worth $7.7million, part of which was paid for in exchange for support services. Otherwise, investments have all focused on expanding the Build-a-Bear Workshop store base.
The reason for the low share price is weakness in same store sales. If we look back a few years, we see that BBW has had same store sales problems for a long time.
I’m aware of the downward trend in same store sales, but I’m optimistic that BBW will be able to maintain revenue per store of at least $1,400 for a few reasons:
1) The most obvious explanation for SSS declines is cannibalization. Growing the store base beyond carrying capacity would increase fixed costs and decrease sales per store. This is exactly what we’ve observed. But management always has the option to close stores as leases expire if SSS don’t naturally improve. Total revenue would decline, but existing stores would have an easier time meeting fixed costs, which would boost the bottom line. Cannibalization alone shouldn’t prevent BBW from returning to historic levels of profitability, and that’s all investors need to see windfall gains on BBW shares. Reducing store count is a difficult decision for any management team to make, but I really get the sense that Clark isn't trying to build an empire so much as a profitable business. If her goal was to build an empire, annual reports wouldn't claim a North American store limit of 350.
2) The fad risk is low because customers continue to love the store. Sales aren’t declining because customers are unsatisfied. You can spend a few minutes browsing reviews, video reviews, or reviews of the online store to get a sense of how much people love BBW. I struggled to find negative reviews of any sort. Even buildabearville.com, the virtual reality companion site, has gotten good reviews and is generating traffic according to alexa.com.
3) Ignoring the recession we’re in as a non-permanent contributing factor to recent sales weakness is a mistake. I’m not sure exactly how much we can blame on the economy, but I do think that once conditions improve we’ll see BBW recover to some degree with the general economy. I find it difficult to imagine that 2009 won’t be the low point for sales/store.
The simplest back of the envelope way to estimate value is to assume the stores are worth what BBW paid. At $400k each BBW’s enterprise value should be around $139 million, compared to $65 million today. This also compares to PP&E of $113 million.
Same store sales is the crux of the problem. Effectively, an investment decision is a bet on same store sales. Using a very simple linear regression I tried to estimate what the fixed and variable costs are on a per-store basis. This allows me to take an educated guess at how profitable store will be at a given the revenue per store, and where the breakeven point is. The numbers indicate fixed COGS per store (which includes lease expenses and D&A) of $400k, and fixed SG&A per store (which includes payroll, advertising, and corporate expenses) of around $70k. For a rough comparison, these numbers compare to a lease expense per store of around $141k, so we know we’re at least accounting for the most important fixed cost.
The math shows that $1.2 million in revenue per store translates into an EBIT of -$2.7 million, and $1.3 million in revenue translates into EBIT of $10.8 million. This confirms what we’ve observed. BBW generated EBIT of $7.2 with $1.35mm revenue/store. However, LTM revenue per store is at $1.24mm, which puts us right on the long-run breakeven point.
Using the same math, we can get an idea for what EPS might look like given the revenue per store:
If you believe that 2008 same store sales won’t recover from $1.35mm, then BBW will probably only generate about $0.50/share, and it might actually be worth only $5. If you think that the economy is partly to blame and stores will eventually begin to generate between $1.4-$1.6mm again, compared to a 7-year average of $1.57, then you’re looking at shares that will be worth between $7-18. A scenario where BBW generates even lower revenue per store isn’t impossible. LTM revenue/store is $1.24mm. But the probability of a recovery and the appreciation shareholders would see outweigh the risk that this is the end for BBW.
In part because of economic weakness, BBW might have an opportunity to renegotiate leases on more favorable terms. Leases in North America are generally signed for 10-year periods, with the option to cancel granted to both parties every 3-4 and 6-7th year. International leases seem to have been signed over longer periods of time and under less favorable terms than those in North America. At the end of 2008, BBW had operating lease obligations of $48.656 million in 2009 (or $141k/store), decreasing by 2.3% in 2010, 8.3% in 2011, and 10% in 2012. So if this recession is extended and stores continue to underperform, renegotiation (or closing stores) is a possibility.
My model is pretty straightforward. Sales per store and the store count drive revenue and margins. I assume that shares are worth 10x 2013 earnings plus the cash balance, and I discount that back each year at 15%. All the FCF is saved on the balance sheet, no share repurchases or dividends are assumed. I assume that BBW continues to build new stores at a growth rate of 2%, but the model isn’t sensitive to this. Using my base case, a growth rate of 0% indicates a PV of $10.25, compared to $11.14 at a store growth rate of 10%.
Using these assumptions, I can get a sense for what shares might be worth based on the long-term sustainable revenue/store. My base case scenario is for sales per store of $1.41mm, which is an average weighted more towards recent poor performance. This yields a current share value of $10.25. If I use an unweighted average of $1.57, shares are worth $15.85. I also ran through my model assuming 10% store growth and using a 10% discount rate. These assumptions could be reasonable given the opportunity for international franchising and the possibility that management will return value to shareholders in the form of a dividend or share repurchases sooner than 2013. It looks like $5/share is the proper value if we expect $1.25mm/store to be the long-term run rate. But with more reasonable assumptions, BBW could easily be worth 2-3x the current share price.
Disclaimer: I have shares in my kaChing portfolio, and I plan on buying shares for myself if the price doesn't move too far away before I can finish building my kaChing position.