Is this the next great retail turnaround?

After Best Buy's stunning renaissance, investors are hunting for the next big gainer.

By StreetAuthority Oct 4, 2013 3:38PM
Image: Teenage boy behind a stack of books © Jupiterimages, Brand X Pictures, Getty ImagesBy David Sterman

Identifying a great turnaround opportunity can be hugely profitable.

When investors become universally negative about a company's prospects, you've got the chance to spot early signs of improvement, and latch on before the crowd does.

Of course, it's impossible to perfectly time a turnaround, even if your analysis is roughly on the mark.

Roughly 18 months ago, I saw signs that struggling consumer electronics retailer Best Buy (BBY) could get its act together, but it took several quarters for that scenario to play out.
Though shares slumped further in subsequent months, Best Buy is on track to deliver one of the best gains in the S&P 500 in 2013.
I was fortunate enough to identify two other stocks in this group of big gainers, having profiled Micron Technology (MU) and Delta Airlines (DAL).

The sharp gains for Delta and Micron were due to a new perception among investors about airline stocks, and a profound change in the computer memory market, respectively. Yet Best Buy's upturn was the closest to what we could call a true turnaround. And you'll often find turnaround plays in the retail sector, simply because of a subtle shift in strategy.

In the case of Best Buy, the retailer is "taking out costs faster than expected, while tightly managing the spending needed to deliver the turnaround," noted analysts at Merrill Lynch.

Of course, Best Buy was left for dead by investors as many concluded that huge price pressures from (AMZN) and Wal-Mart (WMT) left the company at a terminal disadvantage. The reality: Many consumers still like to shop for consumer electronics at brick-and-mortar stores -- as long as the prices are good enough.

That logic explains why I am looking very closely at Barnes & Noble (BKS) these days. This is yet another category where a consumer browsing experience is going unappreciated by investors.

It's certainly been a brutal stretch for the nation's largest bookseller. Here's a quick recap of major 2013 events:
  • In early March, Barnes & Noble delivered surprisingly strong fiscal third-quarter results, leading analysts to raise their sales and profit forecasts. At the time, the retailer also announced the formation of a committee to look at a possible buyout offer from company Chairman Len Riggio. The company also said to would look at ways to reduce losses in the disappointing Nook e-reader division.
  • In late June, Barnes & Noble delivered a lousy fiscal fourth quarter at its retail stores and even steeper losses in its Nook division.
  • In early July, Barnes & Noble fired CEO William Lynch, replacing him on an interim basis with Michael Huseby, a turnaround-focused financial executive, signaling that the era of branching out beyond the core of book-selling might soon end.
  • In late August, Riggio suspended his plans to acquire the company. "While I reserve the right to pursue an offer in the future, I believe it is in the company's best interests to focus on the business at hand," he said.

Riggio's decision against buying the company was surely a disappointment for investors. But Huseby's comments in late August that Barnes & Noble had no plans to abandon the Nook has led to further waves of selling. Investors now fear that Nook will keep generating losses that drag the whole company down.

But the company emphasizes that it will stop making the devices, and instead merely support other firms' e-readers in order to remain relevant in the area of digital downloads.

Huseby (or his successor) is likely to focus in coming months on shoring up the retail store base, which likely means closing the weakest 5% or 10% of the company's stores, most of which are likely generating negative cash flow.

Even before that happens, Barnes & Noble is not as sick as it may appear. Sure, the company is expected to generate a roughly $50 million net loss in fiscal (April) 2014 and again in fiscal 2015, according to consensus forecasts. But the retailer is still expected to post solid earnings before interest, taxes, depreciation, and amortization (EBITDA) of around $200 million in each of those years. That means that shares trade for less 4 times EBITDA on an enterprise value basis.
Yet here is where the Best Buy analogy comes into play. Barnes & Noble sells products (books and magazines) that will always be in demand. Yes, digital downloads have taken some wind out of those categories. But for many, perusing a hard copy in a comfortable retail environment is still the preferred method of buying.

The challenge, as was the case for Best Buy, is to show that its prices are competitive with online retailers, and if you're going to pay the same price, you may as well enjoy the retail experience. Frankly, having a financial executive in charge of a retail turnaround has drawbacks. Barnes & Noble needs a fresh focus on its retail efforts, deploying creative ways to generate fresh buzz for its stores. But as Best Buy proved, you can't simply write off a well-known retail chain that has made strategic missteps but still has a strong resonance with a core of repeat customers.

Risks to consider:
Though there is considerable buzz around the upcoming holiday season for book launches, that may only help same stores sales trends in the January quarter, implying that sales in the October quarter could again disappoint.

Action to take:
Though shares hold intrinsic value simply based on current EBITDA trends and the coming stabilization in same store sales, the company is still likely keen to unload the Nook division for the right offer. Last spring, TechCrunch noted that Microsoft (MSFT) would be a strategic fit (Microsoft currently owns 17% of Barnes & Noble). The Nook business has deteriorated since then, but is still likely worth hundreds of millions of dollars. (Microsoft owns and publishes Top Stocks, an MSN Money site.)

Separating out the Nook from the core retail business would allow investors to more squarely focus on the still-impressive EBITDA metrics of the core business. That would also likely set the stage for Len Riggio to finally take the rest of the business private, which he has contemplated several times in the past.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority

Oct 5, 2013 10:44AM
Too bad it all depends on the buying power of the U.S. consumer who just so happens to be the same person as the U.S. middle class laborer "streamlined" into the poorhouse. Good luck with that!
How can corporate America seriously expect us to "buy American" when they show contempt towards providing livable compensation? If you break the middle class, how is it you expect the middle class to support your businesses?

Oct 4, 2013 8:58PM
I didn't get past "Best Buy". No... it isn't a turnaround, it's more Kool Aid. Drink up... fools.
Oct 8, 2013 9:47AM
It is great to know that retail sector is doing well; retail sector accounts for lots of sales and creates lots of jobs. It means that investors can be confident in their spending. So, in a way, growth in retail sector is an indicator of growth in economy. It reflects that consumers have earnings and savings to spend from and they are looking at brighter future.

Oct 5, 2013 11:31PM

I for one don't want them to go out of business...

We (my buddy) bought a new flat screen yesterday, seem several employees around to offer help.

I like that..

And store was mildly busy, and shoppers were being taken care of.

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