The Crowd is Wrong About this Well-Known Retail Stock

Please excuse me for sounding like a broken record, but in today's market, you need to look at adding stocks with a high margin of safety to your portfolio. The S&P 500's stunning six-month surge should have you thinking about capital preservation as much as capital appreciation.

Simply put, it's hard for me to get behind a stock that has already had a strong recent run, knowing that a shift in the market mood could leave me holding the bag if profit-taking kicks in.

This isn't to suggest that poorly-trading stocks are the only ones that hold appeal. Indeed many of these relative duds are likely to remain as laggards while they address internal operational challenges. Yet even in this group, you need to scour the landscape for potential gainers.

  In that light, I was pretty intrigued to read a recent bullish report by Credit Suisse on beleaguered retailer Best Buy (NYSE: BBY). This consumer electronics chain should have benefited from the demise of bankrupted rival Circuit City, but instead saw its own market share recede in the face of Amazon.com (Nasdaq: AMZN) and Wal-Mart (NYSE: WMT). 

Best Buy's sales grew just 0.1% in fiscal (February) 2011 to $49.8 billion, and just 1.9% in fiscal 2012 (to $50.7 billion). Considering employment levels look better than they did a year earlier, that's pretty anemic growth. Perhaps even more damning, Best Buy is making less profit on each sale. EBITDA margins have historically hovered in the 6% to 7% range, but fell to just 4.1% in fiscal 2012.

Yet even with those dismal metrics, Best Buy is a cash cow. The retailer generated a hefty $2.5 billion in free cash flow in fiscal 2012. That's more than the prior three years combined. In effect, this isn't a broken business, just one that needs some resuscitation. More to the point, that prodigious free cash flow gives a booster shot in terms of valuation support: Best Buy is valued at less than $9 billion on an enterprise value basis, meaning its free cash flow yield is 27% ($2.5 billion / $9 billion = 27%).

I'm not the only one who sees the potential here. Credit Suisse's Gary Balter sees roughly 35% upside to his $32 price target even as he takes management to task. First, he thinks the retailer is mistaken by treating its stores and its website as distinct entities. Retailers such as Wal-Mart and Target (NYSE: TGT) are doing a much better job of leading customers to focus on both sales channels, allowing one effort to leverage the other.

He also says management remains a bit myopic in trying to address weak same-store sales trends. The company recently announced it would close 50 of its 1,100 stores, and analysts say it should close more. Balter even suggests Best Buy move more quickly to close marginally profitable stores and reinvest funds and energy into improving remaining stores.

Yet Balter gives credit where it's due. "It would be unfair to imply management is fiddling. They have made some brilliant moves, growing BBY Mobile, shutting China and Europe large stores, growing private label, etc... but our comment above is that they can do more."

To be sure, many investors think Best Buy is in the midst of a long-term decline, as super-efficient retailers like Amazon will never relent on price. Yet Balter thinks Best Buy remains as the "largest of its breed" and does not have to become a dinosaur.

In fact, profit-sapping price wars between Best Buy and Amazon and Wal-Mart may eventually sharply diminish. Samsung and Sony (NYSE: SNE) announced a new policy on April 1 that forces all retailers to adopt a unilateral pricing policy on many higher-end TVs. "Our ongoing pricing study shows that the policy is helping BBY close the pricing gap with AMZN on televisions in general," notes Deutsche Bank's Mike Baker. That gap stood at 7.3% in mid-March, but is now 3.5%. 

Risks to Consider: Amazon goes for the jugular when it senses a rival has been weakened. Best Buy remains in a very strong financial position, but that still may not stop Amazon from adopting irrational pricing just to beat out Best Buy.

> I like this analyst's call a lot. He's correct in noting that Best Buy's management deserves more credit than it has been getting. And the stock's current valuation borders on the absurd. While the free cash flow yield remains around 27%, Best Buy should be buying stock back at a prodigious clip. Balter's $32 price target isn't all that aggressive, as it equates to just nine times the consensus fiscal 2013 earnings forecast of $3.60 per share. (The fact that the stock currently trades for just seven times that forecast is another point for the value crowd.)

I also like Best Buy for a far more prosaic reason. Even assuming zero improvement in this business model, the cash flow strength and a stock price below $24 offers tremendous downside support. That's a key consideration in today's fast-rising market.