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The Science of Hitting
The Science of Hitting
Articles (553) 

'No Options at All'

Some thoughts on the capital allocation issues faced by businesses with structural headwinds

July 16, 2019 | About:

At the 1997 Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) shareholder meeting, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were asked whether the risk associated with writing super catastrophe (super cat) insurance policies would impede their ability to make significant investments in marketable securities or acquisitions, particularly during a correction.

In his response, Charlie said something that’s worth discussing (bold added for emphasis):

“The beauty of our situation is that it has enormous flexibility built into it. If something were large enough and cheap enough, we could stop writing super-cats. We’re measuring opportunities one against the other, and we understand the way the numbers interplay. We have a lot of different options. And that’s a huge advantage. There are so many places in business life where you have practically no options at all. You’re just in a channel that you have to waltz down and you don’t have any options to do anything else. We have enormous options. We may not exercise them. But we have enormous flexibility.”

As I was listening to Charlie speak, one company that came to mind was Bed Bath & Beyond (NASDAQ:BBBY). Over the past five years, the home furnishings retailer has seen its revenues languish around $12 billion. The store count is largely unchanged as well. Comparable store sales (comps) have declined by roughly 1% in each of the past three years, with the pace starting to accelerate (in the most recent quarter, comps declined 6.6%).

I don’t think I’m going out on a limb when I say the company is not in a great spot. Management’s own actions indicate that continuing to expand the footprint is not the best idea. At the same time, their digital efforts have a long way to go. To be blunt, there’s no reason to believe that Bed Bath & Beyond’s success in an earlier era will translate to success in the years and decades to come.

At the same time, the financials are far from dire. Over the past three years, Bed Bath & Beyond generated $2.8 billion in cash from operations (cumulatively) and $1.7 billion in free cash flow.

The problem, as I see it, is that the company has few good options for how to spend it. One route it has pursued is share repurchases, with $950 million spent over the past three years. But if you are concerned about the core business, that’s not a great solution. You’re just increasing your stake in what appears to be a structurally challenged business. Bed Bath & Beyond’s own experience shows how painful that can be if you’re wrong: The company repurchased 29 million shares over the past three years at an average cost of $32 per share. Today, the stock trades below $11 per share.

I’m not sure what the appropriate course of action is.

What I can say with some confidence is that the digital platform as a standalone venture probably wouldn’t garner much interest from outside investors. Based on the company's recent results and where they're starting from, I don’t see any reason to believe that Bed Bath & Beyond is likely to emerge in a few years with a high-quality quality business in e-commerce / omni-channel retailing (by which I mean they'd be able to generate attractive returns on invested capital). Said differently, I think that investments are being made because they appear to be a reasonable course of action given the hand they’ve been dealt not because they are attractive investments on their own.

In theory, management could accept reality and stop trying to reinvent the company. Take the cash that remains after maintenance capital expenditures and distribute it to owners as special dividends. But that’s a tough pill to swallow. For one, 62,000 employees will come to work everyday knowing that their company is inevitably headed for extinction. In addition, a handful of the people among the 62,000 employees – like the CEO and the CFO are the ones responsible for making the decision. You’re essentially asking these people to liquidate the business, which means firing thousands of people (including themselves) and doing a bunch of other unpleasant things. Unsurprisingly, that’s not a path many willingly pursue.

Instead, they will probably watch their revenue base evaporate due to structural pressures while simultaneously investing the cash flows from the legacy business into efforts that are unlikely to generate attractive returns. In addition, as noted in its fourth quarter earnings slide deck, they plan on continued repurchases in the coming years as well. In case it’s unclear, I’m not enthusiastic about this plan. But at the same time, I don’t really blame management for what they’re doing at this stage in the game (that’s not to say they can abdicate responsibility for falling well behind peers like TJX Companies over the past decade). At this point, given who they are and who their shareholders are, their hands are largely tied. That’s the reality of being in a position with few (or no) good options.


I want to caution against reading too deeply into the example selected here. What I’m focused on is the capital allocation of a struggling business, not the specific factors or decisions that led Bed Bath & Beyond to its present condition (I'm not in a position to opine on that topic). Sometimes, companies in this state will still have a legacy business that is throwing off free cash flow. But what they often lack are attractive options to reinvest that capital. If management does not accept reality – that the business may not have intelligent reinvestment opportunities – it won’t matter if you pay a “cheap” price. As Warren Buffett (Trades, Portfolio) once said, “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

I’ll close with something Munger said at the 1998 shareholder meeting that captures the dilemma faced by companies like Bed Bath & Beyond:

“I’ve heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make. Is this really going to work? Is it worth the money? If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management [easy decisions] time after time after time. It’s not very hard for us to decide to open a new See’s store in a new shopping center in California that’s obviously going to succeed. On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don’t work very well.”

Disclosure: Long Berkshire Hathaway B-shares.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.9/5 (10 votes)



Stephenbaker - 1 month ago    Report SPAM

Good thoughts, Science - on a subject rarely addressed. Ultimately, management has a resonsibility to create shareholder value. If they can't do it, subpar options are not the answer. If remaining shareholders believe the business is viablle, they can replace existing management. Otherwise, if the business is truly not viable going forward, it should be dissolved. Buffett learned this (the hard way) when he acquired Berkshire Hathaway. He has not repeated this mistake and neither should anyone else.

Praveen Chawla
Praveen Chawla premium member - 1 month ago

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

― Upton Sinclair, I, Candidate for Governor: And How I Got Licked

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Thanks for the kind words and thoughtful comment Stephen!

The Science of Hitting
The Science of Hitting - 1 month ago    Report SPAM

Praveen - You've got it :)

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