BIG - Big Lots: Top 5 Most Shorted Stock May Soon Follow Bed Bath & Beyond

2023-06-28 17:59:58 ET

Summary

• Following the collapse of Bed Bath & Beyond, the entire furniture industry is facing strains as high inventories and growing costs are met with falling consumer demand.
• Consumer demand for furniture will likely fall through 2024-2025 due to low consumer confidence, high furniture prices, and excessive "demand pull forward" in 2020.
• Big Lots' financial condition mirrors that of Bed Bath & Beyond last year, but it could benefit from its competitors' recent demise.
• I expect Big Lots will face significant losses in Q2 as Bed Bath & Beyond's liquidation sales siphon sales away from BIG.
• In the long run, I believe Big Lots will only survive if Wayfair faces bankruptcy liquidation first, removing a key competitor from the market.

The collapse of Bed Bath & Beyond ( OTCPK:BBBYQ ) has created an earthquake throughout the retail sector. I had warned about that company's impending demise last fall , and it has lost nearly all of its value since after declaring Chapter 11 bankruptcy. Bed Bath & Beyond wants to sell its more valuable digital assets to Overstock ( OSTK ) while liquidating its existing physical stores . That company's fate is now sealed; however, its largest competitors, like Big Lots ( BIG ), remain afloat, fueling speculation regarding its survivability and how Bed Bath & Beyond's collapse will impact it.

Big Lots could face multiple headwinds and tailwinds due to losing its most significant competitor. For one, Big Lots is accepting Bed Bath & Beyond coupons to attract "dislocated" shoppers. Indeed, Big Lots could face a rise in sales as more shoppers flock to its store than Bed Bath & Beyond. However, in the short-term, the opposite is likely true as massive liquidation sale discounts cause customers to flock to closing Bed Bath & Beyond stores. Problematically, Big Lots does not necessarily have the capital base to suffer another significant quarterly income loss. Further, while Big Lots could benefit from losing its competitor, Bed Bath & Beyond's demise signals a systemic market issue threatening all physical retailers selling larger items. Of course, while the online competitor Wayfair ( W ) is the major negative catalyst for both BB&B and Big Lots, it, too, may not survive .

Big Lots is one of the most short-sold stocks in the US today, with a substantial short interest of ~41%. Wayfair is not far behind, with a short interest of 29%, just below the level necessary to be in the top ten. If BIG can recover, investors could earn a considerable profit as BIG is down 63% YoY and over 85% from its 2021 peak. Indeed, many analysts and investors see a strong deep, value investment in the stock, while relatively few are outright bearish. The company's dividend is in suspension, a strong signal that it is taking all potential steps to avoid bankruptcy. Accordingly, I believe it is an opportune time to take a closer look at Big Lots' potential and that of the retail furniture industry.

The "Furniture Apocalypse" Has Arrived

The US furniture industry is in terrible condition today and may be the worst sector in the entire economy. The wave of the collapse of furniture retailers and manufacturers has a few prongs. In 2020, many people purchased furniture and related items due to surging home sales, excess personal savings (due to stimulus and "lockdown savings"), and increased free time at home. Since then, all those factors have reversed as home sales crashed, driving furniture demand lower . Further, personal savings and real income levels are a bit lower, causing many to reduce spending on discretionary items. Of course, because many people bought new things in 2020, they do not need items today. However, many retailers and manufacturers increased production in 2020 to keep up with the demand surge, creating excess inventory levels in 2022 and pushing prices well below costs.

One of the second most significant challenges facing Big Lots and its peers is the sharp rise in manufacturing and transportation energy costs and commodities in general. Furniture items are bulky and heavy, so increased oil and gas prices significantly increase the shipping costs for furniture goods and the freight costs of underlying commodities as raw materials. Labor costs have also increased due to the lack of high-quality skilled workers . Furniture companies could push those costs onto customers if demand were strong enough. However, because demand is weak, they're cutting prices while their input costs rise, creating negative cash flows.

Total US furniture inventory levels have risen tremendously following the surge in industrial furniture production. More recently, high inventories have been matched with slight declines in consumer furniture prices. See below:

In all likelihood, very few furniture manufacturing or retail companies will manage to get through the current environment unscathed. Consumer confidence levels are also extremely low amid real income and savings strains, indicating that macroeconomic demand for these products should continue to slide over the coming year or two. Thus, I expect that many weaker companies in this market may not survive this period as the most significant challenges have likely not yet been seen.

Big Lots' Capital Position is Alarming

The impact these multiple negative headwinds have had on Big Lots is enormous. The company has seen immense deterioration in its income to -$400M annually, with $116M in negative operating cash-flows. Further, its inventory levels remain elevated, indicating that it may see greater price cuts, particularly considering Bed Bath & Beyond is likely siphoning some demand through liquidation sales. See below:

In 2020, when the company's profits surged on higher demand levels, many people believed it was a substantial turnaround investment. However, most of those positive catalysts were artificially created by the situation in 2020, essentially "pulling demand forward," resulting in lower demand today. Further, much of the chronic commodity, labor, and general manufacturing issues exacerbated in 2020 remain today, creating extreme negative headwinds for Big Lots.

Big Lots' revenue is now well-below pre-COVID levels, while its gross margins have deteriorated tremendously as it struggles to push higher costs onto customers. I expect its gross margins will continue to slide due to high inventory levels in the company and the furniture industry at large. To make matters worse, Big Lots' operating expense-to-sales has increased tremendously to 58%. See below:

As long as Big Lots' operating expenses are greater than its gross profits, there is no potential for the company to earn a positive income. Indeed, the most significant issue facing Big Lots is the sharp rise in operating expenses. Some of its operating costs are due to one-off impairment factors; however, its "adjusted" operating expense rate was still 45.4% in Q1 , well above its gross margin rate. That indicates that the company is trying to offload inventory quickly by increasing marketing spending; however, that effort is not paying off favorably for the firm. In Q1, the company saw an 18% total decline in comparable store sales, with a staggering 27% decline in its furniture comp. Sales and losses in all other categories. Its inventory excess did fall, but far more than would be expected given the substantial price cuts, indicating the firm's survivability potential is definitely in question.

Big Lots' working capital position is slightly lower than usual at ~$390M. More importantly, that comes after a half-billion-dollar debt increase in 2022, as I would typically expect working capital to be strong after a financing deal. Further, its working capital is nearly -$700M after removing inventories. See below:

According to the company's last annual report , it can borrow up to $900M through its 2022 credit agreement. Its existing borrowings have caused its interest costs to rise to $9M per quarter, or $36M per year, impairing future earnings potential. That deal has a covenant requiring the firm to maintain a fixed charge coverage ratio over 1.0X. Since the company has a negative EBITDA of $350M and over $2.3B in operating costs per year, its fixed charge coverage ratio is likely much less than the required level today. However, Big Lots convinced its lender, PNC Bank ( PNC ), not to test its coverage ratio covenant last year. While we could speculate on this issue, the objective fact is that Big Lots is in terrible financial condition today; additionally, with banks facing greater strains since the rise in interest rates, many would likely wish to avoid pushing their loans into the " criticized loan " category. At any rate, investors should not assume Big Lots will be able to continue borrowing from this debt deal indefinitely, based on its current financial conditions.

The Bottom Line

I believe Big Lots must achieve signs of a turnaround in Q2 if it wishes to survive. The company is trying to improve efficiency by closing weaker stores and attempting to streamline its supply chain. However, I firmly believe it should have made these changes years ago when it began to face new financial strains. Instead, it is taking small measures to fight a relatively massive wave of headwinds, most of which are beyond its control. In all probability, based on the company's Q1 balance sheet and its hugely negative adjusted operating income, I do not believe it will survive through year-end, particularly considering that macroeconomic strains on the sector are likely still growing.

While I am very bearish on BIG and believe it will lose its remaining value, I would not short the stock today. For one, the stock has an excessive short interest level of over 40%, so it could quickly rise dramatically in a "dead cat bounce," particularly if it has a better-than-expected Q2 report. I believe its Q2 report will likely be very negative since it coincides with liquidation sales from Bed Bath & Beyond, which should end this week. In Q3, its prospects may improve as its competitor is finally out of the market; however, Wayfair and others remain under significant headwinds. I doubt BIG has sufficient capital to recover after its potential Q2 losses.

There is one condition where I could eventually become bullish on BIG - the bankruptcy of Wayfair. Wayfair's financial situation is terrible and is comparable to that of BIG and Bed Bath & Beyond (last year). Hypothetically, BIG and Bed Bath & Beyond may be in a much better position today if it were not for the online competitor Wayfair. Further, my analysis suggests that Wayfair's online business model is no better and potentially worse than its offline competitors due to its excessively low prices and rising shipping costs. Thus, should Wayfair collapse first, BIG could have a more straightforward path to survival as two of its larger competitors are out of the market. While I would not bet on this occurring, I believe it is sufficiently possible that BIG should not be sold short today.

Still, Wayfair is currently benefiting from a short squeeze, a potentially positive factor that could allow the company to dilute equity and raise cash to try to extend its life. However, I believe W will be an excellent short opportunity to BIG once W begins to make a more apparent peak since its squeeze has little fundamental backing. I am bearish on BIG, but I would not bet against the stock due to its short squeeze risks and potential survival if it can outlive its competition and the macroeconomic storm (which I believe will last until 2025).

For further details see: