3 Funds Are Loading Up On This Cheap Stock

David Sterman's picture

Tuesday, May 27, 2014 - 9:45am

by David Sterman

In search of new investment ideas, it pays to run through several checklists every month. 

What stocks are hitting 52-week lows? Which ones sport low price-to-earnings (P/E) ratios? Which ones are being added to the portfolios of leading hedge funds and mutual funds?

The reason for this digging is to see if any companies start to pop up in multiple areas. In my recent scans, the same name kept popping up everywhere...

Bed, Bath & Beyond (Nasdaq: BBBY)

It's a well-respected retailer that's currently out of favor due to a temporary slowdown in profit growth -- and it's suddenly become a favorite of value-oriented gurus. In just the past few weeks, we've learned that:

•  Investment firm Brown, Brothers Harriman (which will have its 200-year anniversary in four years) just took a 5% stake in the retailer.

•  In the first quarter of 2014, Robert Olstein, who runs the Olstein Funds, doubled his stake in Bed, Bath & Beyond by acquiring 78,000 more shares at an average price of $67 a share. 

•  Also in the first quarter, Westport Asset Management bought a starter position of 90,000 shares at an average price of $67.

Those funds are not happy to know that shares have since fallen further to a recent $61.50. But the drop simply makes this stock even more appealing, as it now trades for around 12 times projected (February) 2016 profits, the lowest forward multiple for this retailer in recent memory.

Make no mistake -- this isn't just another mediocre retailer with dubious merchandising skills: Bed, Bath & Beyond is "one of the best operated companies in the retail industry. It possesses a best-in-class decentralized merchandising strategy, a solid omnichannel presence, intriguing international growth opportunities, and widely recognized retail brands like the namesake Bed Bath & Beyond and Buy Buy Baby concepts," writes Morningstar's Jaime Katz. 

   
  Flickr/fanofretail  
  Right now, Bed, Bath & Beyond is one of the few top-notch operators you'll find that sport solid value.  

The numbers tell the story. Gross margins hover around 40% every year. This retailer never gets caught with the wrong merchandising mix, which can lead to profit-sapping markdowns.

Investments in growth have been kept at a measured pace, ensuring that free cash flow is maximized. It has steadily risen from $370 million in fiscal 2009 to $800 million in fiscal 2011, to more than $1 billion in fiscal 2014. 

Yet it's that last metric that is now causing concerns for this retailer. Free cash flow is expected to drop below $1 billion this year, as management takes the unusual (but necessary, in its view) step of boosting investments in the store base at a higher-than-usual pace.

That approach led Wall Street analysts to hurry for the exits. Merrill Lynch recently noted that "in the nearer term, we believe relatively modest comp growth, (earnings) margin pressure and no visible catalysts to reaccelerate earnings will constrain valuation, and thus we believe a Neutral rating is warranted."

In effect, these analysts are saying that the current period of investments -- which is expected to lead to earnings per share (EPS) growth of just 5% this year (to around $5 a share) -- means that shares "lack timeliness," to use Wall Street parlance.

It's true that there are few catalysts in place to provide shares with an imminent boost. In fact, the two greatest catalysts for this stock -- a boost in consumer spending and an upturn in housing sales -- likely won't be in evidence until 2015 or 2016. 

Yet there is another set of growth factors that investors may now be overlooking. First, the company is finally making major investments in its e-commerce platform. Management was slow to embrace online sales, in large part due to concerns that an ability to buy one or two products online would reduce the need for customers to come into the store and browse, which often leads to impulse buying. 

Management is now doing the heavy lifting needed to build a solid online presence: In a recent quarterly confernce call with analysts, CEO Steve Temares said the company has "enhanced our omnichannel experience for our customers by re-platforming and adding improved functionality to our Buy Buy Baby and Bed Bath & Beyond websites, initiating a selling component to our Christmas Tree Shops website, re-platforming our mobile sites and apps, and growing and developing our IT, analytics, marketing and e-commerce groups to lead our omnichannel initiatives." That should help aid top line growth in the quarters ahead. 

Second, Bed, Bath & beyond is just getting started on a global expansion. Four stores in Mexico City are showing solid traffic, and many retailers typically test the waters in Mexico before venturing on to South America. Look for more news on this front later this year. 

Risks to Consider: Will the consumer remain in a funk? It's hard to know when consumer moods will brighten, and spending trends will improve, so retail stocks may stay at current levels for a little while longer.

Action to Take --> Wall Street analysts and fund managers often have diametrically opposed views on a stock. The analysts are asked to predict what stocks will outperform the market in the next quarter or two. The fund managers are expected to fund great long-term businesses that can be owned for reasonable prices. And right now, Bed, Bath & Beyond is one of the few top-notch operators you'll find that sport solid value. The free cash flow yield approaches 10%, and profit growth is likely to resume in fiscal 2016 and 2017.

P.S. The only thing better than investing in high-quality stocks like BBBY is investing in high-quality companies that return money directly to shareholders. In our latest research, we've found 13 market-dominating companies that have been hoarding billions in cash since the financial crisis -- and they're set to pay out $39.5 billion in dividends in 2014 alone. To get access to the names and ticker symbols of some of these companies, click here to view this special report.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.