Mall-based retailers have been severely impacted by COVID. In states like California, the flare-up of infections in the month of July had malls close their doors once again. And even when malls were allowed to operate, foot traffic has remained below previous years.

The uncertainty about the pandemic plus the avoidance of crowded places adds a layer of risk to mall-based retailers that are above their control. With Build-A-Bear Workshop (BBW), we believe the pandemic, and the way stores can operate following social distancing guidelines, completely disrupts its business model.

Management is doing everything under their control to shift demand towards their e-commerce channel. But doing so, the company loses the in-store experience BBW is all about. There would be no product differentiation with the competition, making their products expensive teddy bears.

The highly competitive nature of e-commerce would also increase BBW’s selling and marketing expenses while having the challenge to capture wallet share. Expanding their e-commerce channel would also require investments in distribution and fulfillment in times when cash flows might come under pressure due to a contracting top-line.

The company looks cheap at a forward P/S multiple of 0.18x, compared to its 5-year average of 0.35x and a section median of 1.07x, as presented by Seeking Alpha’s Value Grade.

That said, we see BBW as a high risk, highly speculative stock, and cannot recommend them as an investment, no matter how cheap they trade. The company’s business model is in jeopardy and falls outside the control of management. Not knowing when the pandemic is going to end, and for how long social distancing guidelines are going to be enforced in a post-COVID world, adds to the complexity and risk of BBW as a possible investment. This falls into the “too hard pile”.

Sequential improvement

BBW reported second-quarter sales of $40M, down 49% on a year-over-year basis, but beating sales expectations by $8.6M. The company also reported non-GAAP EPS of minus $0.82, beating the consensus by $0.19.

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BBW’s retail locations were closed for approximately 60% of the quarter, but the company ended the quarter with 90% of its locations back online. However, they are operating under reduced business hours and modifying their bear-building experience to follow COVID-safety recommendations. While traffic levels remain below the prior year, management noticed an increase in conversion rates and higher spend per transaction.

The company has also seen sequential month-to-month improvements in sales trends with their operating stores recapturing over 80% of sales in August from the 70% they saw in July.

Management is actively managing its SG&A line to anticipate lower revenues. The company has reduced its workforce and shifted marketing costs towards online advertisement. SG&A was down $14.2M for the quarter, or 40% from Q2 of 2019.

Better cash position at quarter-end

To improve liquidity, the company reduced its capital expenditures and is looking for ways to improve its working capital position. BBW ended the quarter with inventory levels down $6.6M, a decline of 11% compared to its prior-year period, and is working with vendors to revise their payment terms. Management also entered a new 5-year asset-based credit facility with availability of up to $25M.

That said, the highlight for the quarter was the successful renegotiation of approximately 95% of their leases. These efforts would result in rent reductions, deferrals, and abatements.

The company is making rent payments upon the new terms as the revised deals are executed. These new contracts have also increased the percentage of leases with variable rent structures to about 1/3 of their store fleet. Additionally, the company has approximately 70% of its leases coming up for renewal in the next 3 years, adding flexibility to its cost structure.

These benefits are expected to be reflected in the income statement in the upcoming quarters, while the cash balance was positively impacted by rent deferrals at quarter-end. Overall, BBW’s cash balance improved by $10M compared to its prior-year period as the result of their actions taken during the quarter.

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A virtual reality

During their second quarter, BBW reported an increase in digital sales of 300% compared to its prior-year period. While the headline number sounds impressive, it is coming from a relatively low base. E-commerce accounted for approximately 10% of total sales in 2019.

The company built a brand image and position in the market as a place where kids, teenagers, and adults can go to create that special teddy bear. The hands-on experience at stores was very unique, with employees guiding the customer through various steps to bring personality and uniqueness to each teddy bear. There were many add-on products that were offered to give a higher degree of customization and increase the in-store experience. For example, kids could add a “beating heart” to their teddy bears coupled with a complete ceremony of the process, adding to the emotional connection. From a business perspective, for BBW, it was a nice upsell opportunity to bring incremental revenues.

That said, the pandemic has really shifted how BBW will interact with its target market. Management is looking for ways to engage and interact virtually with their customers, such as moving their National Teddy Bear Day to a digital format featuring a live streaming virtual store event or having an online party-in-a-box offering for families that want to celebrate a special occasion. The company is also releasing key products exclusively online to promote awareness of its e-commerce channel.

While it is too early to tell if BBW’s new virtual strategy is going to work, we remain a bit skeptical. We believe what made BBW different and why they were able to charge a premium for their teddy bears was the in-store experience they offer to its clients. With stores operating under social distancing guidelines, we don’t see how that hands-on experience could be replicated. Also, these new rules would affect store productivity as it would limit the number of people at their stores.

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With a focus on e-commerce, the in-store experience is gone. Without their product differentiation angle, BBW’s teddy bears become, in our view, just one more among the thousands of products sold online.

The Bottom Line

We believe the pandemic has disrupted BBW’s business model. With stores operating under social distancing guidelines, the in-store experience is affected, which was how BBW built its brand image in the first place.

BBW’s heavy exposure to malls is another risk that correlates with the development of the pandemic. Another flare-up in infections could start another round of state-mandated shutdowns.

While the focus to increase their e-commerce channel could be positive in the short term, as it offsets the decline at their retail stores; on a long-term basis, we believe it could do harm to the company as it loses its identity with the market. By going online, the company would lose its product differentiation angle, which in turn would increase the amount of competition.

While BBW seems to trade at cheap valuation multiples, we believe the risk of disruption to their business model is too high. BBW should go in the “too hard pile”.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.