You're Better Off Selling Bed, Bath, & Beyond and Buying Lululemon

NEW YORK (TheStreet) -- All successful specialty retailers sooner or later encounter margin pressure from Walmart (WMT), Target (TGT), Macy's (M), J.C. Penney (JCP), and Sears/Kmart (SHLD).

Two specialty retailers recently reported earnings, Lululemon (LULU) and Bed Bath & Beyond (BBBY). Bed Bath & Beyond reported Wednesday after the close. Both companies disappointed investors and both experienced margin pressure, but only one, Lululemon, is a buy because, among other reasons, it is a potential takeover target.

BBBY Chart

Here's why it's time to cut Bed Bath & Beyond loose and use the capital to buy Lululemon (or another appropriate stock) for your portfolio. I'll explain why using Whole Foods Market (WFM), another retailer, albeit in food, as a road map investors can use to anticipate the trajectory of Bed Bath & Beyond's stock.

At first glance, the similarities between Whole Foods and Bed Bath & Beyond may not be readily apparent because two entirely different products are sold, and the only commonality is food bought at Whole Foods can be prepared using Bed Bath & Beyond kitchenware.

However, if you look at the two companies through the eyes of Sears, Walmart, and Target, the only difference between the products sold at Whole Foods and Bed Bath & Beyond is the SKU number. Sears/Kmart, Walmart and Target sell everything from avocados to zero-turn lawnmowers. The big three retailers are in a constant state of inquiry to find products -- almost any products -- with higher margins to replace lower-margin items.

Case in point: on April 10, Walmart announced its further expansion into organic foods, claiming consumers will save at least 25% compared to competing national organic brands. About a month later, on May 7, I wrote Surviving Whole Foods In a Walmart World to explain the challenges facing Whole Foods.

WFM Chart

The above chart says it all for shareholders hoping for a quick bounce recovery. Almost two months later and the stock continues to trade near 52 week lows.

The problem remains the same for Bed Bath & Beyond -- margin compression.

During the previous quarter, the company reported a 5.8% drop in net sales and comparable-store sales growth of 1.7% compared to the same one-year-ago period. During the latest quarter, net sales increased 1.7%, and comparable-store sales increased only .4%.

However, in order to obtain its sales growth, the company needed to entice shoppers with greater discounts and promotions. Gross margins dropped to 38.8% compared to 39.5% during the year ago period. Lower gross margins along with a surprising increase in administrative expenses compressed the profit margin, and investors shouldn't expect a quick relief from declining share prices.

BBBY Price to Free Cash Flow (TTM) Chart

In fact, it usually takes a full two or three days of selling before the stock reaches a short-term bottom. After the third day, value buyers and traders will often step up for a dead-cat bounce, but even that is short lived as you can also see in the Whole Foods price chart.

Bed Bath & Beyonds' financials are strong, and I have no reason to believe the company will turn into a Radio Shack (RSH). Essentially zero debt and 93 cents per diluted share of profits suggest it's a buy, just not at this price. I would look to buy in the $49-$50 range if margins and sales hold steady. Don't fall for the cheap price-to-earnings trap, it's cheap for a reason, and absent renewed growth and pricing power, it will remain low.

Lululemon, on the other hand, is another specialty retailer with a similarly strong balance sheet and profitable.

Lululemon is further along the recovery process and is a potential takeover target as well as a short squeeze candidate because of its massive short interest.

At the time of publication, Weinstein had no positions in securities mentioned.

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This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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TheStreet Ratings team rates BED BATH & BEYOND INC as a Buy with a ratings score of B-. TheStreet Ratings Team has this to say about their recommendation:

"We rate BED BATH & BEYOND INC (BBBY) a BUY. This is driven by some important positives, which we believe should have a greater impact than any weaknesses, and should give investors a better performance opportunity than most stocks we cover. The company's strengths can be seen in multiple areas, such as its notable return on equity, attractive valuation levels, good cash flow from operations, largely solid financial position with reasonable debt levels by most measures and expanding profit margins. We feel these strengths outweigh the fact that the company has had sub par growth in net income."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • The return on equity has improved slightly when compared to the same quarter one year prior. This can be construed as a modest strength in the organization. When compared to other companies in the Specialty Retail industry and the overall market, BED BATH & BEYOND INC's return on equity exceeds that of the industry average and significantly exceeds that of the S&P 500.
  • Net operating cash flow has increased to $781.25 million or 33.41% when compared to the same quarter last year. The firm also exceeded the industry average cash flow growth rate of -3.54%.
  • BED BATH & BEYOND INC' earnings per share from the most recent quarter came in slightly below the year earlier quarter. This company has reported somewhat volatile earnings recently. But, we feel it is poised for EPS growth in the coming year. During the past fiscal year, BED BATH & BEYOND INC increased its bottom line by earning $4.81 versus $4.58 in the prior year. This year, the market expects an improvement in earnings ($5.05 versus $4.81).
  • BBBY's debt-to-equity ratio is very low at 0.03 and is currently below that of the industry average, implying that there has been very successful management of debt levels. Even though the company has a strong debt-to-equity ratio, the quick ratio of 0.47 is very weak and demonstrates a lack of ability to pay short-term obligations.

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