The Changing Story of Build-A-Bear Workshop
It's not your typical mall-based retailer anymore
New analysis is posted every Monday at 10 am ET. Subscribe to Theta Thoughts to get posts that give you a premium for your time directly in your inbox!
Disclaimer: As of the time of writing I hold 100.44 shares of Build-A-Bear Workshop stock and a covered call against those shares. This piece is my thoughts alone and is not investment advice.
Acronyms: DPT = Dollars Per Transaction | SSS = Same-Store-Sales
Build-A-Bear Workshop. Everyone knows the company, but almost nobody knows it’s a stock. Hell, for the few investors that remember the latter, it’s probably bad memories from when it was a value trap in 2015. But Build-A-Bear isn’t the same company as it was in the 2000s when it relied on unit expansion to grow despite poor SSS metrics. It’s not even the same company as it was in 2015 when it had no countermeasure to the Mallpocalypse and didn’t have a customer base outside of kids. Today’s Build-A-Bear Workshop is no longer just a mall-based retailer. It’s a growing brand with a growing customer base, evolving use case, and properly positioned to capitalize on changing trends. A company that used to be rigid and slow to adapt is now making proactive efforts to innovate and stay ahead of the curve. Once a value trap, Build-A-Bear has all the signs of being a real value stock this time around.
Evolution of the Physical Footprint
From its founding, Build-A-Bear was a mall-based company. Almost all its stores were in malls, and the value proposition of the business required a substantial physical presence so their target customer, kids, could have the full Build-A-Bear experience. Over time, this led to material weaknesses for the company as the company did not position itself properly in the 2010s with malls fading from relevancy. People were changing where they were going, but they had not changed where their stores were to match that. As a result, the company was slowly bleeding out revenue, with declines measured each year from the start of 2015 to early 2019. For any chance at continuing as a business in the long-term, the company had to change its physical footprint and begin to lean away from the mall-centric focus that it had for its entire life.
While the pay your age disaster in the summer of 2018, (which coincidentally showed the strength of the brand), was unfolding, the company had been working behind the scenes to begin diversifying its real estate portfolio to better align with changing foot traffic trends. They went from over 90% of their stores being in traditional malls in 2015 to slightly over 75% being such by the end of 2018. This was spearheaded by quickly making 3rd party locations a larger part of their portfolio such as Great Wolf Lodge locations, but also contained a broader shift in strategy to close unprofitable locations in malls and open new ones in locations that people were going to instead of the mall.
Part of the strategy shift included partnering with businesses to conduct pilot programs of having Build-A-Bear locations inside of their larger store location, essentially, a shop inside of a shop. While some of these pilot programs, like the one with Chuck E’ Cheese, were shelved during the onset of the pandemic, (though should be revisited alongside others like amusement parks in my opinion), others were much more successful. Primarily their pilot program with Walmart that started in October of 2018. Starting with only six test locations, these were wildly successful, and have expanded to 25 locations as of the time of writing with the potential for further growth in the future. A unique aspect of these Walmart locations is that they are less prone to shifts in consumer foot traffic behavior during the pandemic. This is because while people may be less comfortable going to tourist locations temporarily during a surge of cases, (like right now with omicron), they will still need to get food for their household, leading to smaller fluctuations in foot traffic during covid surges at Walmart locations.
The consistent foot traffic is a plus for a company that’s evolving its locations away from malls. Despite the pandemic softening Capex in the short-run, this real estate revolution has continued for Build-A-Bear. Today, just 65% of North American locations are in traditional malls, down from over 75% at the end of 2018. This marks a continued intent to move away from malls that is emphasized by new and upcoming initiatives. In the past week, the company has announced that they’re expanding their vending machine pilot program with Hudson from just 1 location today, in JFK International Airport, to 25-50 locations within the next two years. On top of this, the company is launching a new store concept called “Build-A-Bear Adventure” explicitly in non-mall locations. Even the newly announced unit expansion, (15-20 corporate and third-party locations in North America within the next 3 years), is specifically focused on tourist locations and not malls.
A benefit that comes from the evolving physical presence’s emphasis on more 3rd party locations and vending machines is the cost structure. Both methods have almost no startup capital to open locations, (near zero for 3rd party and under $100,000 per vending machine), as well as very limited overhead, (no direct rent or labor for 3rd party and very limited rent and labor for vending machines). The result of this is a model where as soon as an attractive location or partnership is found, unit expansion can occur quickly at little cost. At the same time, the return on capital is extremely attractive for the business. Take my thoughts on the vending machines from my analysis a few weeks ago as an example.
If you assume that the machine costs Build-a-Bear $75,000, it will take under two years to have that cash back. From a net present value perspective that makes these ATMs extremely attractive.
With almost no startup costs for 3rd party locations, the cash flow situation for the company is undoubtedly just as attractive as well.
Part of what is enabling such an aggressive shift now is the company’s uniquely high lease-optionality, with over 70% of locations having a lease event within the next three years. Interestingly, this has been a feature of the company’s real estate portfolio since before the pandemic, indicating that nimbleness in their real estate position has been a priority for some time in negotiations and is beginning to take center stage now. It’s definitely a contributor to the near 30% change in location composition since 2015. I find this particularly important because one of my concerns with the company, (and the stock), is that management might get complacent with the status quo of current success.
Despite the positives of today, the company must keep reorienting itself to succeed in the long-term, and the structure of their board’s election cycle being made to limit activist influence did bring some concern to me that they may be content making this a personal cash cow at the expense of shareholders in the long run. However, after seeing their new announcements and visiting their JFK vending machine myself, it is clear to me at this point that management’s objectives are to continue repositioning the business for future success and growth. With under 60% of 2021 sales likely coming from in-person sales at mall locations and an evolving physical footprint, Build-A-Bear won’t be a mall-based retailer for long.
E-commerce was not traditionally a significant part of Build-A-Bear’s business, in part because their value proposition used to be geared specifically to the in-person experience for kids. This was an additional detriment to the company as the Mallpocalypse unfolded since they didn’t have a non-mall sales system to fall back on. Facing this reality, the company began to invest in its e-commerce capabilities, which were slowly gaining traction. By the end of 2019, the company had seen nine straight quarters of 10%+ growth in online sales since bringing their e-commerce experience more up to par with modern expectations. Despite the growth, it was still under 10% of sales, and the long-run objectives were still far off as there wasn’t enough invested in it at the time. At least there wasn’t until the pandemic.
While the onset of the pandemic posed an immediate risk to the stability of the company, it also forcibly accelerated their online initiatives as they were had to generate sales online with all in-person locations closed. Incremental investments to improve first-party data collection in early 2020 quickly became vital to the company’s future. The pivot had to happen immediately, and pivot they did.
Online offerings quickly became the centerpiece of the company, and preannounced product releases would generate large amounts of online demand. So much traffic that an online waiting room system had to be created to prevent overloading their site’s capabilities. When they released a “Baby Yoda” plush in April 2020, it completely sold out in two hours. The same thing happened when the company released an “Animal Crossing” product line earlier in the month, giving the business staying power as stores slowly reopened.
With the reopening, online demand remained strong, and an interesting dynamic revealed itself to the company. The type of customer that would shop online was different than that of one that would visit stores in person. While some signs from pre-pandemic product releases were there, this was the glaring evidence. While the in-person customer tends to be kids or families looking for the experience, the online customer is mostly adults and teens that are collectors or buying gifts. The opportunity this offered to Build-a-Bear is one of the key reasons their business is breaking its past mold. After all, why do you need to just cater to kids when you have a massive adult audience that also wants to buy?
Monetizing pop culture and attracting the “collector customer” is something brands like Funko have shown can be successful with an adult audience, and Build-A-Bear has just begun leaning into that. Knowing that the significant majority of online sales from product lines like Animal Crossing, Pokémon, and Star wars were coming from teen and adult customers has enabled the company to meaningfully expand the age demographic of its customers and begin releasing online items specifically targeting adults, such as Valentine’s Day exclusives and their new HeartBox subsidiary.
And believe it or not, there’s real synergy between the e-commerce and physical parts of the business. With over 300 store locations in the US typically located near higher population density areas, each store can fulfill online orders during store hours. This is how 70% of online orders are fulfilled today and the impact from this is massive. Not only are there far fewer miles traveled to deliver, providing major savings on transport costs, but variable costs in production are substantially cut by using existing store staff to fulfill this demand.
And on top of the reduced shipping expenses, the proximity to customers means the window of when online sales can be delivered before major holidays like Christmas is days longer than competitors, providing a major advantage. This previously ignored part of the business not only saw double-digit growth in 2021 is now 20% of retail sales, (likely approaching $75 million in revenue for the finishing fiscal year) and doing so at EBIT margins of over 20%.
All of this comes without the expense of harming the in-person business because the target customer is different, making it even more impressive. That’s not to say everything’s perfect with their e-commerce; their CRM/first-party data collection tech should be improved, and their new 3D Bear Builder is quite poor, it looks more like it comes from 2005 than today. Furthermore, their social media platforms have large followings, but posts from the company should be more oriented toward driving engagement than just advertising. But the fact that they’re doing so well despite those points speaks to the potential that leveraging e-commerce and the expanded customer age demographic bring to the business
The Collaboration Strategy
Build-A-Bear has historically been a business driven by licensed product collaborations with brands like Disney, Nintendo, Warner Brothers, and more. It’s where some of their biggest evergreen product offerings come from and typically ranges from 30% to 50% of their sales. The ability to monetize pop culture is a powerful one, attracting both young customers that are fans of a certain character and re-engaging adults who may have been a prior customer but now see something from a show or videogame that they want to have for themselves. The ability for the company to expand upon this in the future as the definition of “pop culture” grows gives a real runway for the business to create new licensing deals with content creators.
Content creation has become an increasingly relevant portion of everyone’s media consumption, so partnering with content creators seems like a logical licensing step. And Build-A-Bear is beginning to dip its toes into this opportunity. The company has made licensing partnerships with the WeWearCute TikTok channel as well as with one of the biggest kids YouTube channels, Ryan’s World. But if I had to make a suggestion, there’s much more potential in this space. Look at Youtooz, the Funko of content creator merchandise. Coordinating with content creators to announce licensed product releases alongside new videos or live streams from the creator being partnered with, sellouts can happen in just minutes. And with and with a following that is loyal to a creator, this would be tapping into a base of repeat purchasers looking to collect merchandise from all their favorite creators.
The collaboration strategy does have its downsides in its current form for the company. Mainly that it’s reliant on the content production of third parties, and slumps in their performance or delays in releases can harm Build-A-Bear as a result. This is what happened to the toy industry in 2018 with a myriad of poor releases and continues to pose some cyclicality risk. However, the key benefits it brings from bringing adult customers back to Build-A-Bear and its overall track record of success make it more than worthwhile.
Build-A-Bear IP & Upselling Strategy
While collaborations and licensing serve an important role in the business, Build-A-Bear is also working to develop its own intellectual property and product lines to give existing customers a reason to be loyal to the Build-A-Bear brand, as well as having greater control over development and release timing. Their strategy in approaching this is something worth talking about as they’ve taken a more aggressive stance in both developing their IP and producing content recently.
In 2018, the company launched Build-A-Bear Radio. Becoming available on iHeart Radio in 2019, the channel produces music and podcasts. As of a few months ago, the channel already had over half a million monthly listeners, an impressive feat for a company people associate with teddy bears. More importantly, it’s showing a broader change in marketing from generic ads to immersive content. Not only is this more successful in driving sales but creates more engaged customers that have an increased willingness to buy more.
Other than audio, the company has also moved into film production to drive sales on its owned product lines. Partnering with Sony and Hallmark to make films so far, the strategy is to split costs in production while using the hype from the movie itself to drive sales for their owned product lines. And after the “Honey Girls” movie released in October, it’s clear that this strategy works with a direct and measured impact on the company.
We launched Honey Girls back in 2015. I want to say it's been one of our successful lines and re-envisioned it as a live-action film starring LI Ashanti and launched it at the very end of the third quarter. Our sales rose 20% during that, and our DPT on the Honey Girls line is at $90. (Third Quarter Conference Call)
The $90 DPT, (driven by significant accessory purchases that a peer like Funko doesn’t have), is a standout when knowing the company’s average DPT is just $54 and will be important in driving future affinity from customers to the brand. So far, it’s already resulting in customers purchasing more accessories and addons, leaning into one of the core strengths in Build-A-Bear’s business model, the ability to upsell customers during the shopping experience.
As part of my research into the company, I visited five Build-A-Bear locations during the month of December, most of my notes on this can be found here. At one of these locations, I went through the process of making a bear myself to see what the experience was like. And while I was able to take away that the in-person experience is strong and can create a particular attachment for kids, the upselling opportunities in the experience were insane. This is incredibly reliant on well-trained staff that can be both engaging during the building experience and convince people to buy more add-ons. From my experience, training in this seems strong across the board.
Even before you start stuffing your bear, they can already upsell you by encouraging you to put a sound effect of your choice in the bear. While your bear is being stuffed, you’re offered the opportunity to put a beating heart and custom scent inside the bear. After your bear is stitched, you’re immediately faced with many accessories and clothes that you’re encouraged to get for your bear to wear. They even upsell you at checkout by giving you the chance to spend a few bucks to get a special cardboard box for your new friend. While more limited, the online bear builder also gives you these upselling steps to push up the number of items bought.
Through impressive training of staff and introducing new upselling points, Build-A-Bear has been able to steadily push up the average DPT (despite production efficiencies allowing for deflationary pricing on evergreen products like “Baby Yoda” which is $20 cheaper than its initial release), as well as steadily growing the number of items bought per transaction to above four in North America. The ability to leverage upselling in both the physical and online experience is particularly important for merchandise margins, as driving up the units per transaction and average DPT increases operating margins for the business as it reduces incremental variable costs. Success in this area is one of the key reasons why the company has seen an expansion in profitability and efforts to increase average DPT and units per transaction should continue to be prioritized.
The story of Build-A-Bear is nice, but what does it matter if it doesn’t translate into results? The answer is that it has… big time. To start, margins have seen massive improvement due to limiting discounting, lowering incremental variable costs, production efficiencies, and leveraging existing locations for e-commerce fulfillment. Starting an uptrend in 2019 that was only temporarily halted by Covid, the trailing 12-month gross margin has grown at a CAGR of 7.65% in the 11 quarters since (not 765bps a year to be clear but 7.65% annualized improvement from their 2018 fiscal Q4 gross margin of 42.58%). A similar trend of improvement has occurred in SG&A as a percent of sales, all despite economy-wide inflationary pressures that would make this improvement seem less likely in the past year.
On a store-level, this has led to some extraordinary profitability. in North America where the vast majority of sales are generated, 98% of stores are profitable with an average contribution margin of over 25%. This year’s EBITDA margin is expected to be over 15%, the highest the company has achieved to date by a longshot. And their strong net cash position allows for large returns of cash flow to shareholders relative to the enterprise value. The over $45 million in dividends and buybacks announced before the third quarter’s results are equal to over 17% of the company’s enterprise value today.
Topline momentum also remains strong. Driven by a larger age demographic, expanding use case, sustained online growth and reopening, the midpoint 2021 sales forecast from Build-A-Bear represents 21.7% growth on a two-year stack from 2019’s sales. Notably, the two-year stack has seen an acceleration in growth during the back half of the fiscal year despite stimulus being less of a factor in consumer spending. As a result, 2021 will be the highest annual sales number for Build-A-Bear since before the Great Recession.
On top of this, the company just raised its sales forecast for its fiscal fourth quarter, which ends at the end of January, by over 13%, and its EBITDA forecast by over 30%. This is particularly important because it shows far stronger than expected demand and profitability despite most of the quarter having a massive covid surge that would be assumed to threaten their business. If a covid wave with over a million daily cases in the states can’t dampen their demand, they’re clearly in a strong position.
And before someone has comments about last week’s retail sales number, I would consider it in a broader context. Virtually all retailers that released Q4 data or updated guidance last week beat or raised. It’s quite possible that the bad retail data is related to a temporary dent in services demand due to covid and that goods providers have not seen the same level of impact.
What matters for a stock isn’t the past though, but rather the future. And I have some thoughts on this. I’ve visited five stores in person, been the only person covering the company to see their JFK vending machine in person, and have gathered information on six other locations. I’ve had conversations with both employees and investors on top of my independent research and spent a lot of time analyzing their business. At the end of the day, these are just my own opinions and nothing else.
The business is good. Near universal consumer recognition combined with the structure of future growth being capital-light with high returns on capital and free cash flow are incredibly attractive in my mind. Just the vending machines have the potential to provide $1.18-$2.36 million in incremental EBITDA over the next two years with 25-50 machines in airports according to my estimates for example. HeartBox has the potential to drive similar incremental gains. The third-party model is attractive in a similar vein, and both get the brand in front of more people to drive repeat purchases in the future.
The expanding use case and age demographic are both also compelling arguments for further organic growth. Giving more people more reasons to buy simply allows for more potential customers to be engaged, driving growth in areas that were not as pronounced before. You see this with HeartBox and Valentine’s Day, and it will be relevant year-round as generalized gifting has successfully become a use for the company with teens and adults. The company’s ability to identify that its target customer is different for online vs in-person is particularly important for capitalizing on the larger age demographic and is something they have down pat.
The changing real estate portfolio is vital to the company’s future success, and the part I have the most concern about. Management must stay proactive in evolving the physical presence of the company and cannot get content with the status quo simply because stores are profitable now. Unprofitable stores must go and a continued focus on rotating out of malls is a must.
The new “Build-A-Bear Adventure” store concept is something I also view as a plus. While likely not as capital-light as the rest of the business, it shows a desire from the company to innovate and adapt. That’s a requirement for future success.
The development of fully-owned IP and content is another positive driver. It leverages the brand to generate heightened sales and limits exposure to the cyclicality of the movie/game industries. If I were to point at an area of improvement, it would be a bit less rigidity in how they develop content. I understand the core brand is family-friendly, but the risk to try more immersive plots in future movies and make more social media content that isn’t just advertising could be useful in bringing better overall engagement.
Add on the return of parties in locations at some point in 2022 as an additional boost and I believe both the immediate and long-term future of the company is set up for success. At this point, my estimates call for sales in the upcoming fiscal year to grow by 14.45% to $475 million and for EBITDA to grow by 23.03% to $79.97 million. With a combination of tailwinds on the idiosyncratic level and new streams of income, I believe this to be achievable.
The result of this is what I view as an incredibly positive reward/risk skew in the stock. According to my estimates, the stock currently trades at under 3x its next fiscal year EV/EBITDA, (yes, I’m excluding operating lease liabilities because there’s no solvency risk on this balance sheet and it’s still a primarily retail company). That would imply a company in cyclical decline, something I believe Build-A-Bear is not. As it becomes more obvious that the current market assumption of the company being just in malls and that it’s only benefitting from a post-covid rebound is wrong, I believe a re-rate of the stocks multiple towards its historical mean will be warranted. In my estimates, I have this multiple at 6.5x.
Combined with my expected end of next fiscal year cash balance of $70 million (assumes $25 million in authorized buybacks but no additional buybacks or dividends) The resulting price target I have at this time for the end of the next fiscal year is about $39 per share. Compared to my downside scenario with an EBITDA of $57.5 million and a multiple remaining at 4x, There’s a positive skew in the reward/risk ratio of 4.8:1 in my opinion.
At the end of the day, price targets are never absolute and virtually never fully correct, they tend to be a sentiment gauge in my mind. And my long-run sentiment is very bullish. If my current projections are accurate, I would view a $100 million EBITDA run rate by the end of 2025 as more likely than not, something that would bode strongly for future return potential. While I view management complacency, wallet-share shift, and inflationary pressures as valid risks, I view Build-A-Bear as a potential success story in the years to come.