Quick Look: Shopping for Specialty Retailers

In a continuation of my "quick look" series on stocks in selected sectors, today I'll review a number of specialty retailers. I like this area of the market, but it's not an easy area to work with. Off balance sheet arrangements are the rule, not the exception, and thin margins can result in wide swings in profitability.

When working with specialty retailers, concentrate on looking at only the No. 1 and No. 2 companies in a given space. Also, focus on companies with strong balance sheets that have room for domestic store expansion. International expansion efforts are generally met with frustrating operating results for these companies.

Below, I've compared and contrasted the stocks of the top two leaders in selected segments of specialty retail:

Turn the Page

Between book retailers Barnes & Noble (BKS - commentary - Cramer's Take) and Borders (BGP - commentary - Cramer's Take), Borders is the class act on several fronts. Compare several years of financials and you'll see that Borders consistently generates higher returns on equity and higher operating and net margins. This is not a complicated business model. It's hard to conjure up a rationale for the poor relative operating metrics at Barnes & Noble other than the obvious reason: inferior management.

The superior operating performance at Borders vs. Barnes & Noble is already discounted in the respective valuations: The companies are valued at roughly $1.5 billion each, but Barnes & Noble has almost double the sales base.

For traders, Barnes & Noble may be the best opportunity of the two. It's now trading at around $24, and I have a fair valuation calculation in the high $30s. For long-term investors, however, the incremental spread in operating performance will be magnified. All things being equal, the better-managed business always wins, so Borders is the better choice. It's around $19 now, and its current fair value is in the mid-$20s.

Between the Balance Sheets

Bed Bath & Beyond (BBBY - commentary - Cramer's Take) is one of the most impressive specialty retailers around, with one of the strongest balance sheets of any retailer that I can remember reviewing. But I think the best that Bed Bath & Beyond shareholders can hope for is that the current business value ($8 billion, according to my calculations) will catch up to the company's $11.7 billion market capitalization. I expect it to do just that over the next couple of years. All retailers eventually hit the wall when their concept saturates the market. Bed Bath & Beyond should bump up against saturation pressures in about four to five years.

Linens 'N Things (LIN - commentary - Cramer's Take) is an embarrassing runner-up to Bed Bath & Beyond. Its operating metrics are light years behind the market leader -- including dramatically lower operating margins, return on assets, return on equity and sales growth. This can't be justified, given the level of consumer interest in this segment and the strong financials at Linens 'N Things. It has to be blamed on inept management. Its stock is trading at half of its underlying business value, but that assumes a normalized level of profitability that, while modest, is above the current level. I can see one catalyst that could unlock value here: a major management overhaul followed by significant operating improvement.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, Alsin and/or ACM was long TJX, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.