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A tale of two tickers

| September 28, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Despite having very similar tickers, the credit stories of Best Buy and Bed, Bath & Beyond could not be more different. Best Buy fundamentals have continued to improve, and in its short-term debt trades through that of peers. However, its new 10-year issue lingers wide, making it a good candidate for spread compression. The reverse is true of Bed Bath and Beyond issues: shorter-maturity debt appears to have priced in the risk of downgrade, but longer-maturity issues are poised to under-perform.

A solid turnaround at Best Buy

Best Buy Inc. (BBY – Baa1 (p)/BBB/BBB) has proven the success of its turnaround, underscored by growing margins and strong same store sales (SSS) growth: LTM EBITDA margin was 6.3%, flat to year end and up from 6.1% in fiscal 2016 and 5.5% in fiscal 2015; and SSS growth on average for the last four quarters was a strong 6.7%.  Ratings have not only stabilized but Moody’s recently placed its Baa1 rating on positive outlook based on its view that BBY “is strongly positioned and is a leader in the rated retail universe of transitioning online”.  In the most recent quarter, online revenues on a comparable basis were up 10.1%, off of a strong 31.2% growth in the year ago period.  Furthermore, BBY remains in a net cash position with $2.3 billion of cash on hand relative to $848 million of total debt.

Best Buy metrics and new debt attractive compared to peers

The company issued $500 million of a new 10-year earlier this week which priced at +140 bp.  While BBY has no pure play comp, the new 10-year looks attractive relative to similarly rated peers AutoZone Inc. (AZO – Baa1/BBB/BBB) and Dollar General Corp. (DG – Baa2/BBB).  BBY’s lease adjusted leverage currently stands at 1.4x which compares favorably to AZO which is at 2.4x and DG whose leverage is currently 3.2x.  Coverage of 35.5x is more than double AZO’s 14.2x metric and roughly 10 points better than DG’s 25.6x.  From a SSS perspective, BBY’s average 6.7% growth over the past four quarters has outpaced both AZO’s 1.8% growth and DG’s 3.4% comp.  The stronger fundamentals of Best Buy are not fully priced into the new debt issue. The BBY 4.45% 10/1/28 is currently trading at +138 bp, which is 11 bp wide to the shorter maturity AZO 3.75% 6/1/27, and 16 bp wide to DG 4.125% 5/1/28 (both on a g-spread basis). The situation is reversed in the shorter end of the credit term structure, where the BBY 5.5% 3/15/21 trades 15 bp through AZO 3.7% 4/15/22 and 39 bp through DG 3.25% 4/15/23 (both on g-spread). The new Best Buy is likely to outperform both the AutoZone and Dollar General issues in the long end of the curve.

Bed Bath and Beyond’s struggles may not be fully priced into debt

On the flip side, Bed, Bath & Beyond Inc. (BBBY – Baa2 (n)/BBB- (n)) reported another weak quarter of negative SSS and significant margin deterioration, leading the investment community to doubt the company’s turnaround story.  The days of solid double digit EBITDA margins appear to be in the past as BBBY posted a LTM EBITDA margin of 7.6%, down from 8.7% at year-end, 11.7% in fiscal 2016 and 13.8% in fiscal 2015. Furthermore, the street is forecasting BBBY to end the current fiscal year with an EBITDA margin of 6.3%.  The quarter marked BBBY’s sixth consecutive quarter of negative SSS with an average of -0.5% over the last four quarters.  With the drop in EBITDA, lease adjusted leverage has spiked to roughly 4.1x, which is above the threshold for investment grade (IG) ratings and on par with L Brands Inc. (LB – Ba1/BB).  BBBY is currently in capital preservation mode and has backed off considerably on shareholder remuneration in an effort to build cash on the balance sheet.  While the balance sheet and liquidity appears to be good as the company has roughly $1.1 billion of cash on hand relative to $1.5 billion of total debt and an untapped $250 million revolver, we believe current ratings are at risk given the lack of stabilization to margins and SSS.

Currently, Bed Bath and Beyond’s bonds already trade as if they are a fallen angel, but the longer-maturity BBBY 4.915% 8/1/34 and BBBY 5.165% 8/1/44 may have more downside risk should they fall below IG.  The shorter-maturity BBBY 3.749% 8/1/24 trades roughly 80 bp wide (g-spread) to peer LB 5.625% 10/15/23, but the BBBY 4.915% 8/1/34 and BBBY 5.165% 8/1/44 are trading considerably through LB on a g-spread basis.  While part of the reason BBBY longer dated bonds trade through LB is due to the deep dollar discount trading levels (BBBY 2034 at $74 and BBBY 2044 at $70 relative to LB 2035 at $85 and LB at $83), we think these longer dated BBBY spreads could be under further pressure on a downgrade to high yield.

An overview of same store sales growth across retailers is available here.

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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