You have to spend money to make money. That's a maxim investors understand well, and it is one reason individual stocks frequently rally even as their profits decline. Spiking short-term costs are acceptable if they're helping build a stronger long-term market position.
Wall Street isn't as forgiving when earnings drop in the context of shrinking sales, or when the profit slump lacks a clear ending point. That's essentially the situation Bed Bath & Beyond (BBBY 2.81%) investors find themselves in today.
A tough quarter
The retailer recently announced fourth-quarter earnings results that paired reduced revenue with plunging profitability. Sales at existing locations fell in the mid-single-digit range as customer traffic declined. A boost in the e-commerce channel, and slightly higher spending per visitor, only partially offset that slump. As a result, overall comparable-store sales slipped by about 1% for both the quarter and the full fiscal year.
Meanwhile, Bed Bath & Beyond endured painful declines in core profitability metrics. Gross margin dropped to 36% of sales from 38% thanks to price cuts. Higher expenses, including labor, tech spending, and advertising, pushed operating profits down to $337 million, or 9% of sales, from $430 million, or 12% of sales a year ago.
The good news
It wasn't all bad news in this report. Inventory levels declined sharply, which means the retailer entered the new fiscal year unburdened by aging merchandise it needs to unload through the heavy use of coupons. Instead, CFO Sue Lattmann said in a conference call with analysts that current inventories are "tailored to meet the anticipated demands of our customers and are in good condition."
Conservative capital spending and reduced stock buybacks combined to lift cash balances, too. Cash on hand was $744 million, up from $578 million at the end of fiscal 2016. This healthy financial position means Bed Bath & Beyond has time to work through its growth strategy. It also has the funds to support a deliberate and modest shrinking of its store base. The retailer is planning to close about 40 locations over the next year to keep its footprint at roughly 1,500 locations.
Testing investors' patience
CEO Steven Temares and his team have detailed plans to transform the business over the next few years, mainly by shifting toward favorable product niches like home furnishings and doubling down on the digital sales channel. After a multiyear increase, costs will decline over time thanks to a lighter inventory footprint and improved merchandise sourcing, executives say.
Yet shareholders are being asked to endure a long period of falling profits before these trends begin lifting the bottom line. Operating margins are likely to drop in each of the next two fiscal years, management predicted, although at a moderating rate. As a result, Bed Bath & Beyond is targeting earnings of just over $2 per share in 2018 compared to $3.05 per share last year and $4.58 per share in fiscal 2016.
The retailer is aiming to return to slight sales growth this year, mainly thanks to gains in the e-commerce business. But that success would mark just the first, tiny step in a three-year transformation initiative that -- if all goes according to plan -- will begin delivering modest earnings growth by fiscal 2020. Given that weak and uncertain outlook, it's hard to see how this cheap stock doesn't continue drifting lower from here.