I Was Wrong
At Least For Now
In the monthly update I sent out two weeks ago, I said this
While I hope my “hit-rate” can remain impressive over time as I grow my analysis skills further, expecting perfection to remain is wholly unrealistic. The best stock-pickers are wrong almost half the time and I strongly anticipate that at some point the names I already have a stance on will prove me wrong
And like clockwork, I’ve been proven wrong, for now at least. Build-A-Bear Workshop reported its earnings on Thursday morning, and the market was not a fan. The result? A stock that’s down 19% since releasing its fourth-quarter numbers.
I wanted to spend this week diving into why my optimism was wrong in the immediate term. Some professors that are former portfolio managers stressed how it’s always better to be precisely wrong rather than being cluelessly correct in this space, and that’s a lesson I’ve taken to heart. The fact of the matter is that new information will rarely be the cause of a stock-picker being wrong, it’s almost always a miscalculation of existing facts. So let’s dig into the facts and see what we can learn.
Why I Was Wrong
After going through the 8-K filing and reading over the conference call transcript, there appear to be two key reasons why my immediate optimism on stock-price appreciation has not played out. Those are:
The citing of inflationary pressures and build-up of inventory
Ambiguity in guidance, in part due to assessing impacts from stimulus lapsing
We’ll discuss these in order, so inflationary pressures come first. I see this as being a point that the market does not like because it has changed the company’s balance sheet and because one of the company’s key commodity inputs is facing heightened volatility.
Historically for companies that have substantial seasonality like retailers, inventory on the balance sheet shrinks after the holiday season when compared to before it. This is because companies will stock up for the spending rush beforehand and unwind inventory afterward as demand normalizes. For Build-A-Bear, this has been the case historically, until this year that is.
Total inventory at year-end was $73.6 million, an increase of $26.7 million from fiscal 2020 year-end and an increase of $20.2 million from fiscal 2019 year-end. The majority of the increase was related to in-transit inventory due to strategically planned accelerated purchases used to partially mitigate inflationary and supply chain COVID-related pressures and anticipated continued increases in product and freight costs. (Build-A-Bear Workshop 8-K Filing)
Not only did inventory increase by over 50% from the past year, but it also grew by almost 20% from the prior quarter despite the holiday season passing. There are a few reasons the market may have perceived this negatively
This could have been viewed as saying margins can’t be held
This lengthens the operating and cash conversion cycle
There are material impacts to cash available to return to shareholders
The first one is the most obvious. As has been the case for the past several quarters, the company has been facing inflationary pressures across its inputs alongside the rest of the economy. To date, they’ve been able to more than offset this with efficiencies and operating leverage.
However, what can be argued as a change in strategy to frontload inventory orders could be viewed by the market as saying there are more pressures on margins than before. On top of this, it deliberately lengthens the operating and cash conversion cycle of the company, which can constrain financial flexibility. Lastly, this change causes a major shift in the balance sheet. I estimated that the company would have $50 million in cash at the end of the fiscal year, assuming some unwind of inventory as is typical. This was off by over $17 million, which not only impacts the enterprise value of the firm but also means there is less cash on hand than I or the market had expected before an immediate return to shareholders through the buyback program. Together, this is a component I did not forecast accurately and one that the market is not happy with.
The other point that the market was displeased with was the ambiguity in the company’s outlook. Despite no real coverage of the company, the market was requiring more confidence to consider any re-rating of the stock, which didn’t occur. This was what was said instead:
The Company noted that its positive momentum has continued into its fiscal 2022 first quarter and is providing guidance for total revenues and profit for the period. The Company expects to provide guidance on these metrics for the fiscal year at a future date as it monitors the evolving external environment, assesses ongoing inflationary pressure and the potential impact of stimulus on consumer spending in the prior year. For the first quarter of fiscal 2022, the Company currently expects:
Total revenue to exceed first quarter of fiscal 2021; and
Pretax income and EBITDA to exceed the record profitability of first quarter of fiscal 2021.
While the company is expecting year-over-year growth in sales and profits in the first quarter despite lapsing of stimulus taking up half the quarter, ambiguity in guidance for the full year has left the market unhappy. Despite management’s history of conservatism, (their first sales estimate for the last fiscal year which was issued after Q1 called for revenue and EBITDA 21.5% and over 100% less than what they respectively generated), the perceived uncertainty was viewed very negatively.
The potential impact of the stimulus lapse is of note other than just inflation. The stock has a history of being a value trap (cc unpreparedness for mallpocalypse in 2015). With the lack of coverage on the company, this has remained the prevailing sentiment baked into the valuation, currently 3.5x TTM EV/EBITDA. Anything that rattles this sentiment can and will put pressure on the company, especially if the market is concerned about the company possibly having just temporarily over-earned.
To be clear, these are valid risks that a market should price into a company’s stock price. And admittedly, I was over-optimistic in some of my initial perspectives, discounting how the market may react to risks in the process. Despite this, my conviction in the company and the stock is actually up after the earnings print.
Price vs Execution
The obvious question is, how can I have higher conviction after seeing the stock drop up to 39% from its 52-week high at its worst point? If you’ve been on Fintwit at any point this year you’ve seen price aggressively control narrative after all. The answer to this is execution. In particular, there are three components of execution that have been strong for the company. These are:
Delivering on its operational promises
Capital allocation to both combat external pressures & invest in growth
Shift in management to become more aligned with shareholders
To the first, the company delivered on its promises for operations. Fourth-quarter numbers were in-line with their raised guidance which was 15% higher on sales and over 30% higher on profits than the guidance they gave at the start of the quarter. If it were not for temporary closures in January due to the omicron variant, the company would’ve exceeded the upper range of its raised guidance for sales.
The Company noted that the surge in COVID cases in the latter half of January 2022 led to constrained store labor and resulted in temporary store closures in 67 of its locations reducing store operating days in the month of January by 4.0%. The Company estimates its total revenues for the quarter were reduced by approximately $1.0 million as a result. (Build-A-Bear Workshop 8-K Filing)
Secondly, capital allocation has continued to be strong in fighting external pressures like inflation. While the inventory build has its negatives, it also limits the total inventory turns the company has, lowering the volatility of input prices. Considering their two key inputs are cotton, which is actually down quarter-to-date, and oil, which is facing weighted volatility, this is a responsible decision to minimize risk and provide better clarity for the business.
Simultaneously the company has been able to invest back into the business to drive future growth and profitability. This is a list of initiatives the company is currently invested in
Expanding ATMs from 1 unit to 25-50 in airports in the next two years and entering into children’s hospitals
New HeartBox subsidiary for online gifting
Store-count expansion: 15-20 new North America locations in the next 2-3 years
New retail format: Build-A-Bear Adventure has its first location open next week
Pets: outbound licensing deal in the works, awaiting a consumer-facing release
This is all being done while being less capital intensive than I anticipated, the company guide for Capex this year is $10-$15 million vs my expectation of $15 million.
Lastly, management has become increasingly aligned with shareholders. This is of particular importance to me since the management team was viewed to me as the largest risk to the stock. Language from the team has become increasingly oriented around driving shareholder value, and the actions with the buyback program show this isn’t just for show.
Of the $4.4 million in stock bought back in the fourth quarter, the average repurchase price was $17.91, near the lowest prices the stock traded at during the quarter. To me, this shows discipline and a desire to maximize shareholder value rather than just throwing some money into action to attempt to appease activist investors, especially since another $600k in stock was bought back in the first quarter before the earnings release.
While I’ve trimmed my estimates somewhat, what I perceive as a decrease in execution risk with management has caused my conviction in my thesis to rise. With no debt, the ability to return even more cash to shareholders on top of the 11% of the enterprise value already given back since December, responsible decisions to fight external pressures, and multiple avenues to drive sustained growth, my confidence has only gone up.
Could I be proven wrong in the long term as I have in the past week? The answer to this is yes. But I’m excited to continue learning and refining my process along the way.
This article is not investment advice and only represents the thoughts of Strat Becker. You can reach me by email at RealStratBeckerYT@gmail.com, on Twitter @StratBecker, or on Commonstock @Strat. This article is for subscribers of the Theta Thoughts newsletter. If this was shared with you please consider subscribing to receive free stock analysis like this every Monday.
Disclaimer: I hold 160.44 shares in Build-A-Bear Workshop and a covered call against 100 of those shares. I received no compensation to write this article.
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