Bed Bath & Beyond: The Capital Structure DecisionEssay Preview: Bed Bath & Beyond: The Capital Structure DecisionReport this essayBed Bath & Beyond: The Capital Structure DecisionBusiness Overview – the trigger for leveraging upBBBY is in a sound position to lever up. From internal perspective, BBBY presents a low overall business risk (therefore a foreseeable future growth). From external perspective, market rate was at a low point. Besides, levering up would send a positive signal to capital market.Low business riskBBBY has been enjoying a healthy business expansion through the past decades – fast yet stable sales growth (20%-30%), incredible all-time 41% gross profit, increasing operating margin, thanks to its high operating efficiency, low cost structure and strong internal control.Historically, BBBY bears no debt and has been supporting its expansion and m&a with all cash transactions. It is estimated that it owns $400m excess cash, nearly 50% of its cash balance, and astonishingly 20% of its current asset.Furthermore, BBBY maintained a strong balance sheet since 1993, zero outstanding AR, reasonable inventory days for a home category business and outstanding RoE comparing with its peers.Favourable market rateMarket interest rate at 2004 was at 46-years low. Based on its solid business, BBBY is able to issue debt at 4.5%, significantly lower than its unlevered RoE (23.2%). Theoretically, proper levering up under such situation would boost its levered RoE strongly.Positive signal to capital marketA stock repurchase would usually present a positive signal to capital market, in multiple ways – increased EPS, higher current shareholder’s ownership, and showcase of management confidence in its stock price. As a result, it helps BBBY push for a higher market value.Capital Structure Analysis – the best way to lever up40% debt vs. 80% debtObviously, 80% debt level would bring several significant “on the book” benefits than 40% debt. (See exhibit 1)On EPS level, compared to base case $1.31, levering up will boost the EPS to $1.37, and $1.39, respectively. On RoE level, it will reach 31.5% (40% debt) and 40.8% (80% debt) from 23.2% in the base case, which will make BBBY highly differentiate with its major competitors. For both scenarios, the tax shield would be an additional benefit, which will save BBBY $1.3m and $2.6m respectively.Higher expected benefits always come with more substantial risks. From an overall point of view, the risk for BBBY is pretty limited, as we qualitatively discussed in the business risk part. Due to its strong balance sheet, the financial distress risk is rather low. The vulnerability to business fluctuation (sales growth rate) – seen as a typical risk for levering up – is also limited for BBBY. A simple simulation will show that even under extreme situations, the levering up situation still enjoys a higher RoE than unlevered case. (See exhibit 2)The true risk comes from the bond rating. Under 40% debt level, we can confidently estimate that the bond rating will be A to AA. However, if we raise the debt level to 80%, the rating will be lowered significantly to BB. Such rating will cause debt overhang issue which will make the future debt issuance difficult. (See exhibit 3)Debt vs. one-time special dividend A more aggressive way for leveraging up would be one-time special dividend. This will give the excess cash and retained earning away to shareholders similar to the debt situation, but maintain shares outstanding unchanged.
A more aggressive alternative to this solution (i.e. a levering up) would be to leverage up multiple times at once, or on both, in the past year. It would result in better ROI, a stronger return from assets, and lower debt to earnings ratio, as stated earlier. The upside is that BBBY is able to keep its capital structure up.To leverage up you will need $250k in assets. (see chart below)For REIT, you would need $1bn (up from $500k a year ago) and $500k (in equity) in assets as well, and the company will need $600k in assets as well (see chart below). For BBBY, it makes sense to invest the money that the equity in stock was invested. If you do, you can hedge the equity by using your own capital, but you also lose out in some scenarios.In terms of the “tremend