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Best Buy Co., Inc. (BBY), J.C. Penney Company, Inc. (JCP): Bullish Upgrades Keep Rolling In for This Company

As the turnaround effort at Best Buy Co., Inc. (NYSE:BBY) began to pick up steam earlier this year, a slew of analyst upgrades followed. Now it seems that even more analysts are jumping on the bandwagon. On July 1, with the stock up 145% from its 52-week low, Credit Suisse resumed coverage of Best Buy Co., Inc. (NYSE:BBY) with a price target of $40 per share. The stock rose nearly 9% that day, flirting with $30 per share.

Best Buy Co., Inc. (NYSE:BBY)

Credit Suisse thinks that Best Buy Co., Inc. (NYSE:BBY) could produce earnings of $5 per share within the next couple of years, making the current stock price seem like a bargain. Two days later, Goldman Sachs upgraded Best Buy Co., Inc. (NYSE:BBY) to a “Buy” rating, citing much of the same reasoning put forth by Credit Suisse.

Can Best Buy Co., Inc. (NYSE:BBY) really be worth $40 per share? Let’s take a look at the numbers and find out.

Real profits

One of the common arguments made against Best Buy Co., Inc. (NYSE:BBY) is that the company is unprofitable. Indeed, if you look at the numbers from 2012, EPS came in at $(0.73), well into negative territory. The first quarter of 2013 also revealed loss of $0.24 per share. Many people look no further than this, writing off Best Buy as a shipwreck waiting to happen.

These people are missing a great opportunity.

Earnings, or net income, is a tax number. It includes things like asset and goodwill write-offs which have nothing to do with day-to-day operations. Free cash flow is often a better number to look at, but it has its shortcomings as well. A good example of this was displayed during the quarter ending in October 2012. Through three quarters of the year, Best Buy had a free cash flow of $(643) million, and its cash balance had fallen to just $309 million. People began claiming that bankruptcy was inevitable, that Best Buy would run out of money and die like Circuit City had years ago.

The problem with that argument is that it doesn’t consider where the cash went. If you look at the balance sheet, inventories increased nearly $2 billion from July to October. Why? The holiday season, of course. Retailers build up inventory leading into Christmas as sales are elevated during that time. That’s retail 101.

Free cash flow includes changes in things like inventory. This caused the free cash flow to turn negative after the third quarter because cash was converted into inventory. Of course, once the holiday season was over and that inventory was sold, free cash flow turned positive again, to the tune of $750 million or so.

In order to remove these issues I like to look at owner earnings instead of net income or free cash flow. Owner earnings don’t include fluctuations in the working capital which skew free cash flow, so it paints a better picture of the operational profitability of the company. In 2012, Best Buy recorded owner earnings of about $1 billion.

2012 was a bad year for Best Buy and the company still made $1 billion. That’s about $2.95 per share in owner earnings, making the 52-week low price of $11.20 per share seem ludicrous.

Two things to consider

There are two big factors which will affect profitability going forward. The first is Best Buy’s price matching policy along with price competitiveness in general. Best Buy has been lowering prices to better compete with online retailers while promising to price match as well. This will have a negative effect on margins and drive profits lower, and the first quarter of this year has already shown this to some degree.

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