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.

However, Best Buy is also aggressively cutting costs. There are two areas where costs cuts are being implemented: administrative costs and costs of goods sold. Best Buy believes that there are $400 million in SG&A costs which can be cut from the North American business, and the company has already achieved $295 million of those cuts so far this year. The second area, cost of goods sold, will see cuts come more slowly. The company believes that it can reduce these costs by $325 million through making its supply chain more efficient and revamping how it deals with returned items. I wrote about this effort in previous article.

These cuts total $725 million, which if added to the $1 billion earned in 2012, leads to $5.05 per share in owner earnings. Now, the effect of lower prices will drive this number down a bit, but $5 per share in earnings is absolutely realistic. If Best Buy can succeed with its online initiatives to drive internet sales, then I believe the company can reach this goal within a few years.

If Best Buy can earn $5 per share, then the stock would be worth a lot more than $40 per share. Even based on just 2012 owner earnings $40 per share, it isn’t even all that expensive at just 13.5 times owner earnings. I think that people have greatly underestimated Best Buy’s earnings power.

Why Best Buy is different

Retail turnarounds seem to be all the rage these days, with Best Buy joined by companies like RadioShack Corporation (NYSE:RSH) and J.C. Penney Company, Inc. (NYSE:JCP). But Best Buy is different than these other cases because Best Buy never became unprofitable.

RadioShack Corporation (NYSE:RSH) saw every measure of profitability turn negative in 2012 as the company struggled to stay relevant. Back in December, I wrote an article entitled A Rare Value Opportunity which pointed out that at the time the stock was trading well below its current assets minus total liabilities. This is what’s called a net-net, and since then, the stock has risen nearly 50%. I would only buy RadioShack Corporation (NYSE:RSH) at this point if the stock price fell back into net-net status, as the company is continuing to lose money and the prospects of a turnaround are dim.

J.C. Penney Company, Inc. (NYSE:JCP) is also losing money, and a lot of it. The turnaround effort led by now-fired CEO Ron Johnson failed as the company alienated much of its loyal customer base, and a multi-billion loan backed by its real estate was required to ensure liquidity in the near future. J.C. Penney Company, Inc. (NYSE:JCP) is not unique, as there are plenty of discount department stores like Kohl’s Corporation (NYSE:KSS) which have been far more successful. Best Buy is the only major nationwide consumer electronics chain left, giving the company an advantage. J.C. Penney Company, Inc. (NYSE:JCP) has no such advantage and had to resort to begging its customers to come back in a series of ads.

The bottom line

The $40 price target put forth by Credit Suisse may turn out to be conservative if Best Buy’s plans play out. With huge cost cuts making the company more efficient and strategies in place to drive online sales, Best Buy could soon be earning $5 per share or more, leading to a stock price many times the 52-week low. Those still claiming that Best Buy is doomed need to look past the most basic numbers and see that Best Buy is getting stronger every day.

Timothy Green owns shares of Best Buy. The Motley Fool owns shares of RadioShack. Timothy is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

The article Bullish Upgrades Keep Rolling In for This Company originally appeared on Fool.com is written by Timothy Green.

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