Best Buy a Retail Health Read

Its earnings report will serve as an indicator of consumer spending.
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Best Buy's

(BBY) - Get Report

fiscal fourth-quarter earnings report Wednesday will provide a much-needed checkup on the health of the retail sector.

The consumer electronics giant's earnings report will include results for the vital month of December, as well as January and February. That makes Best Buy one of the first major retailers to report results for the first two months of the calendar year; most other retailers close their fiscal year at the end of January.

Furthermore, if Best Buy comments on its fiscal first quarter, which includes March, it will offer a peek into the retail landscape for the first three months of 2007. In other words, it is an important "tell" for the group, which has been subject to concerns that the subprime lending debacle and ongoing housing downturn will hurt consumer spending.

According to Thomson Financial, Best Buy is expected to ring up $12.67 billion in sales in the first quarter, up from $10.7 billion a year earlier. We already know that Best Buy had a good holiday season; the company reported same-store sales growth of 7% for December, with total sales growth of 15%.

Merrill Lynch's Danielle Fox says Best Buy, along with competitor

Circuit City

(CC) - Get Report

, was "extensively promotional" in January and February. She expects the heavy promotional activity to boost sales, particularly of TVs and computers, but compromise margins. Both Best Buy and Circuit City saw their margins hurt by this issue in their fiscal third quarters.

Now that

Microsoft's

(MSFT) - Get Report

Vista is available and receiving a cool reception, it's unlikely that PCs will see the major spike in sales that was previously anticipated. Also, Best Buy's sales growth in TVs is expected to slow considerably from the torrid 35% pace in 2006.

Without these significant boosts that could skew sales, Best Buy's results could provide a clearer signal about how the rest of the retail sector will perform.

You know that Best Buy will bring in the customers, but if it is continuing to discount heavily to do so, that could have implications not only for Circuit City but also for

RadioShack

(RSH)

,

GameStop

(GME) - Get Report

and even

Amazon.com

(AMZN) - Get Report

and

Wal-Mart

(WMT) - Get Report

. The latter two have been actively trying to grab share in the consumer electronics space.

I also want to get a sense as to whether the spike in gas prices over the past few weeks has hurt traffic and/or sales. That could be an important tip-off as to what to expect from consumers this summer. If Best Buy feels the pinch of higher gas prices, one can only imagine the effect on restaurants, discounters and apparel retailers.

Focus on the Bigger Picture

Best Buy is expected to post earnings of $1.52 a share for the fourth quarter and $2.76 a share for the year. Looking ahead, Wall Street sees earnings of 54 cents a share for the current first quarter, with sales of $7.96 billion.

For fiscal 2008, traders will be looking for Best Buy to provide guidance around Wall Street's forecast of $3.18 a share in earnings and $39.8 billion in revenue. Investors also hope to hear more about the company's initiatives in China as well as last week's acquisition of Speakeasy.

Normally, margins are a critical component of the analysis of a company's financials. Given Best Buy's discounting, those numbers will certainly be scrutinized in this report as well. Investors, however, should consider the big picture.

Best Buy is expected to report declining gross and operating margins for the full year, yet still post earnings per share near the high end of its guidance of $2.65 to $2.80. Bernstein Research's Colin McGranahan wrote in a recent report that should Best Buy hit its earnings guidance, it "speaks both to the company's ability to execute in volatile times and to what is likely somewhat conservative guidance that BBY can achieve in several different ways."

Moreover, McGranahan says that considering the year is so back-end loaded, the guidance is most likely cautious, giving the company ample opportunity to hit the target. Bernstein doesn't have a banking relationship with Best Buy.

I agree with McGranahan. Management teams such as Best Buy's that find a way to get it done, especially when all does not go according to plan, are to be treasured. In a climate where excuses are the norm, it appears that Best Buy will reach its goals despite less-than-optimal conditions.

Circuit City a Nonevent

Circuit City also reports earnings Wednesday morning, but I believe this will be a nonevent that offers no indication as to the health of the retailing sector. Circuit City is dealing with an internal mess. Last week, the company unveiled plans to shut stores and lay off thousands of employees, including some of its more highly compensated (and theoretically highly skilled) sales associates.

If Best Buy posts a significant miss, I suspect the retail sector will feel the reverberations meaningfully. Investors will likely shoot first and ask questions later.

But a solid quarter and outlook should give investors some comfort (at least until next week, when chains' same-store sales numbers are released) that the retail group will continue to thrive despite headwinds.

If all goes according to plan and Best Buy offers guidance in line with expectations, I believe the stock, currently trading around $49, should have a $60 price target. At $60 the stock would trade at 18.9 times forward earnings, less than 1.2 times its projected growth rate of 16.2% -- an appropriate valuation for a best-of-breed retailer.

In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.

Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;

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