Build-A-Bear Workshop, Inc.

Date: December 10, 2024

Summary

Build-A-Bear is a predominantly mall-based retailer that offers an interactive experience where children choose their own animal and then customize it with the help of their parents and Build-A-Bear employees. The brand has 565 stores across the globe with ~70% located in North America. The stock trades ~6.5x NTM EV/Ebitda due to concerns surrounding the business’ earnings quality and declining foot traffic at U.S. malls. We believe Build-A- Bear offers an attractive risk-adjusted return and has the potential to generate 20%+ IRR over the next 4-5 years. Key thesis points:

• Misunderstood Business Model:

The market does not understand or appreciate the company’s new high-margin and capital-light business model; management is using a wholesale model, currently in 123 stores, where the company sells merchandise to third-party partners who then build out and operate the stores. Build-A-Bear makes a ~50% margin on the merchandise sales and does not have to put up any capital. Build-A- Bear’s portion of the revenue is ~30% of a traditional store but Ebitda margins are >2000bps higher. The new model has also expanded the company’s TAM because their partners operate stores in non-traditional locations (cruise ships, theme parks, water parks, etc.).

• Business Quality:

The quality of their legacy business model is underappreciated due to their history of financial difficulties and declining foot traffic at malls.

• Capital Returns:

Management is investing in high return growth projects and is returning capital to shareholders via buybacks and dividends.

Background

Build-A-Bear (BBW) is a discretionary retailer that sells personalized stuffed animals. The majority of their revenue comes from families visiting stores and creating their own toys by stuffing, dressing, accessorizing, and participating in their famous “heart ceremony.” The interactive in-store experience creates lasting memories for both the children and parents.

BBW has an effective monopoly in the “create-your-own stuffed animal” space due to their trademarks that severely restrict competitors¹ . The business operates out of 565 stores, with 362 corporately managed (run by BBW), 123 thirdparty operated, and 80 managed under international franchising agreements. ~65% of stores are in malls, with the remaining ~35% located in non-traditional locations such as vacation destinations (Great Wolf Lodge) and cruise ships (Carnival Cruise Lines).

The business trades at ~6.5x EV/Ebitda due to concerns around the quality and sustainability of their earnings. BBW’s capital structure and historical financials are shown below.

The Situation

BBW’s stock is up from ~$1 at its pandemic low, to ~$40 today; combine this with the businesses’ boom/bust history (2008 & 2015), and most investors assume they’ve missed the trade or another earnings collapse is right around the corner (an inherent risk with discretionary retail). In an attempt to increase the earnings quality and reduce cyclicality, management has made significant changes to the business model over the last decade.

First, they have closed unprofitable locations; management now reports that all their North America corporatelymanaged stores are profitable. They also renegotiated leases to provide more flexibility, using their leverage as a brand that drives customers to their stores regardless of location (~80% of Build-A-Bear trips are preplanned). Next, they diversified outside of traditional malls, partnering with the likes of Carnival Cruise Lines, Kalahari Resorts, and Great Wolf Lodge. This has allowed Build-A-Bear to stay close to the consumer as their preferences change. They also grew their ecommerce offering by concentrating on gift giving, specifically for teenagers/adults; this has expanded their TAM and provided another source of revenue.

Finally, and most importantly, management has grown locations via third-party operated stores (Commercial segment); in this model, Build-A-Bear provides merchandise wholesale to the store operator (at >50% margin), but the store operator invests the capital to run the store. This creates a highly cash generative and capital light model for BBW.

Sharon Price John has been CEO since 2013 and has guided BBW through a financial turnaround, executed a business model change, and aggressively returned capital to shareholders. BBW has bought back >$60mn in stock over the last two and half years at ~$20 a share (retiring ~20% of the float); they have also returned ~$20mn via dividends (special and regular). Management plans to continue returning capital while building out new locations.

Thesis

We believe Build-A-Bear is undervalued due to the following:

1. The quality of the business is misunderstood.
2. The third-party business model allows BBW to monetize their IP using very little capital.
3. Management plans to continue returning capital to shareholders.

Business Quality

The investment community is skeptical of Build-A-Bear’s legacy business model and rightly so; a retailer operating out of shopping malls which are seeing foot traffic consistently decline² does not sound like a growth story. However, BBW is different from most retailers. First, they are a destination for families; ~80% of Build-A-Bear store visits are planned³, meaning people come to a store and end up at the mall, not the other way around. This has created significant leverage for management when they negotiate leases for their stores; malls want to partner with BBW because they drive foot traffic--usually families with multiple potential consumers--that otherwise might not come to the mall. This is extremely valuable given the current macro trends. BBW has taken advantage by structuring their leases to provide flexibility and capture some of the value they create. Additionally, they don’t need much space, normally ~2,000 square feet, creating a win-win for the mall and BBW (the concession from the mall owner is relatively small).

Build-A-Bear’s unique experience-based product creates an offer that is hard to replicate (BBW’s aggressive enforcement of trademarks makes it almost impossible - more on this in the Risks section). This is not a classic fashion retailer that has to stay up to speed on new fashion trends or risk seeing sales and earnings rapidly deteriorate. Its offering is simple and evergreen - create lasting memories for young families via an interactive and child focused experience, all for ~$50 an animal (depending on the accessories).

We do not believe this is going out of style, even if there are valid questions around mall-based retailers. Management has reacted to concerns of changing consumer preferences by partnering with businesses to offer their products in “nontraditional” locations (Carnival, Wolf Lodge, Kalahari Resorts etc.). They’ve also grown their e-commerce offering by focusing on gift giving to adults and teens; online sales now make up ~15% of retail segment sales, up from ~5% in 2019.

Third-Party Stores

This is the most misunderstood part of Build-A-Bear’s new business model. Management’s third-party operated stores create a high margin business that requires no capital investment from BBW. Instead of managing the stores themselves, BBW licenses the concept to a third party (usually a business in the hospitality space) and then sells them merchandise on a wholesale basis; the third party then invests the capital to open and run the stores.

Third-party operators create attractive economics by utilizing smaller storefronts than BBW’s legacy mall locations (increases sales per square foot). The stores also increase guest satisfaction at third party locations by offering a unique and family-friendly activity at a reasonable cost. BBW management has reported ~90% of moms agree that Build-A-Bear is a fun experience for a child⁴. BBW has effectively monetized their IP (the store concept), and the third-party operator can offer a simple, value-add, and cost-efficient activity to guests. This is a win-win for both parties. Estimates of BBW’s economics under both operating models are shown below.

BBW sacrifices topline revenue, but margins are >20% higher and there is little-to-zero capex investment needed. It’s also important to note this operating model does not cannibalize their legacy stores as a significant portion, as mentioned above, are in non-traditional locations. We think the market is missing this as third-party stores only make up ~5% of revenue and ~12% of operating income. Management has increased third-party operated stores by ~40% year-over-year and, while we expect the pace of growth to slow, BBW will continue partnering with high-quality businesses and growing earnings here.

Capital Allocation

Management has aggressively returned capital over the last few years, buying back >$60mn in shares (~ 20% of the float at ~ $20 per share) and paying ~ $20mn in dividends since the end of 2021. We believe this will continue as management is growing stores via their capital-light third-party business model, and capex is expected to be roughly in line with depreciation. Given where the stock is trading (~6.5x EV/Ebitda), we believe the buybacks will be accretive to current shareholders.

Risks:

Market Saturation

Like any retail business, identifying the TAM for stores at maturity is difficult to estimate and very important in determining intrinsic value. Management has hinted they do not plan to grow via their legacy model but see an opportunity to grow internationally; they estimate that at maturity, ~50% of stores could be outside of North America. That would potentially put a total store count of at least 800 (across all business models). We think this risk is limited in the case of Build-A-Bear for two reasons. First, the business trades at ~6.5x EV/Ebitda. The market does not believe BBW will grow stores and earnings; just stable business results will result in an attractive return for shareholders. Second, the third-party business model allows for low-risk growth, where BBW sells merchandise on a wholesale basis; they will still be affected if demand slows, but they do not have to manage the stores and will generate positive cash flow.

Declining Mall Popularity

While management has diversified outside of traditional locations, ~65% of BBW’s stores are still located in traditional malls. If traffic continues to decline⁵, BBW may start to see earnings deteriorate. We believe BBW will significantly outperform other mall-based retailers and has actually benefited in some ways from declining mall traffic. ~80% of visits to Build-A-Bear are planned, so while slowing traffic will have an impact, they are not reliant on people walking past their stores (people choose to come to their stores, not come to the mall and wander in). Where BBW has benefited from declining mall traffic is in their lease negotiations; they’ve been able to extract more concessions from mall owners as the value of driving foot traffic to the mall has increased over the last decade.

Competition

Build-A-Bear has an effective monopoly in the “make-your-own stuffed animal” industry. This is admittedly a small niche, but aggressive enforcement⁶ of their trademarks in the 2000s has ensured there is no real competition. For example, competitors are unable to have a stuffing machine in their stores, or even place a heart inside the bear’s chest. We do not see a significant risk of new entrants impacting our thesis.

Valuation

We’re using a DCF through 2028 for our valuation of BBW. Details behind our key assumptions are detailed below.

Revenue

~ 2.5% CAGR driven by the Commercial segment (third party stores). We expect BBW to end 2024 with ~ 120 third-party stores and then add another 80 by the end of 2028 (~20 a year). This leads to ~$65mn in revenue, up from ~$25mn in FY 2023. We’re forecasting low-single-digit growth in BBW’s other segments driven by new stores and flat revenue per store.

Ebitda

We believe Ebitda will grow ~ 5.8% annually as the Commercial segment becomes a larger portion of BBW’s overall revenue (~12% in FY 28 vs ~5% currently). Ebitda margin expands ~250bps to ~19% due to wholesale business model growth.

Cash Flow

We believe BBW will produce ~$225mn of free cash flow through 2028, with ~$140mn used to repurchase shares and ~$40mn returned via dividends (remaining held as cash buffer).

Exit Multiple

We believe a reasonable exit multiple of 7x, but we believe this is conservative and there is potential upside (~10x) if investors begin to understand and price in BBW’s capital light business model.

Summary

At Kennondale, we believe BBW can produce a ~20% IRR over the next 4-5 years. Management is well-positioned in their legacy business, as their ability to generate foot traffic is creating more attractive lease terms at their mall locations. Most importantly, the third-party store model has expanded BBW’s TAM by being in new locations where consumers are actively looking for fun family activities (vacations); the model allows BBW to partner with high-quality partners and generates cash flow with very little investment.