News Analysis date published New: 
Tuesday, August 2, 2011 - 11:00
New Date created: 
Tuesday, August 2, 2011 - 11:03
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Tuesday, August 2, 2011 - 11:00

My Top 3 Comeback Picks for this Sector

Tuesday, August 2, 2011 - 11:00am

In the past year, I've been keeping a close eye on a specific group of stocks that could really take off when the economy improves. The stocks all toil in the retail sector, and they've all stumbled badly as a result of the reduced sales during the economic downturn. But while investors continue to shun the retail sector, management has been making the right moves to fix what's broken -- so much so, that their just-released quarterly results show a much-improved picture.

With shares trading at bargain prices and the bullish prospect of a strengthening economy, this might be the perfect time for value investors to enter the retail scene. These three names are my top picks...

1. RadioShack (NYSE: RSH)

In late June, I suggested this electronics retailer was poised for a comeback in the second half of the year. I have consistently marveled at the company's solid cash flow, even as the retailer has lacked any new hot products that could drive foot traffic.

Well, RadioShack may have just found the right bait. The company is dropping its sales contract with lagging wireless service provider T-Mobile, replacing it with industry leader Verizon (NYSE: VZ), which has a 43% market share. The change, which goes into effect in mid-September, should yield an immediate and tangible upturn in traffic to its stores. The potential advantage of increased traffic is that customers can come in to activate, renew or upgrade phone service, and leave the store with a number of accessories.

Shares initially surged on the news in the last week of July, but have since cooled off again. They remain a verifiable bargain, trading for less than four times projected 2011 EBITDA (earnings before interest, taxes, depreciation and amortization) -- even as the Verizon benefit will really only be limited to just one quarter this fiscal year. If the Verizon deal drives more traffic, as I suspect, then 2012 results are likely to be even more robust.

Analysts at Goldman Sachs are on the same page, having added RadioShack to their "Conviction Buy List," early this week. The timing behind the move: They "expect earnings trends to accelerate off recent trough levels," though they caution September results may still be choppy before RadioShack delivers more impressive results in the last quarter of 2011. They figure shares, trading at about $14, may climb to $18 as RadioShack's improving quarterly results take root.

This price target seems conservative when you consider that Goldman also expects free cash flow to surge from $0.58 a share this year to about $2.30 next year. A free cash flow yield of 10% appears to be a more realistic target, which would push shares up into the low $20s. As I noted back in February, the stock traded up to $24 last year when buyout rumors circulated. This still looks like the perfect stock for private equity firms, but the fundamentals alone support a nicely higher share price.

2. Office Depot (NYSE: ODP)
This office supply retailer has been stuck in the shadow of industry leader Staples (Nasdaq: SPLS) while the entire group has had to cede market share to mega retailers such as Wal-Mart (NYSE: WMT).

About a year ago, I compared the various valuation metrics between Office Depot and Staples, and suggested a pair trade. At the time, Office Depot shares traded for roughly $4, against Staples' $19.55. Shares of Office Depot have been roughly flat since then, while shares of Staples have dropped more than 20% to about $16 currently. I still think a paired trade should remain in place, since Office Depot remains quite cheap.

To be sure, Office Depot is struggling with anemic foot traffic and sales won't likely rebound until the economy looks healthier. But below the top line, management is doing a solid job. Gross margins are firming (thanks to fewer discounts) and operating expenses are shrinking. "Efforts to improve profitability through better analytics and an ongoing cost-cutting effort is gaining traction," notes Goldman's analysts, who have modestly raised profit estimates on the heels of second quarter results.

EBITDA now looks set to exceed $100 million this year, up from $50 million in 2010. Analysts at Citigroup think EBITDA can approach $200 million in 2012 on just a 1% gain in sales. Looked at another way, Office Depot generated EBITDA margins of just 1.7% in 2009, but this metric rose 60 basis points in 2010 and should keep rising to 3.6% by 2012, according to Citigroup. Results should power yet higher if the economy is on a firmer plane by 2013. Meanwhile, shares trade for less than book value and around five times projected 2012 EBITDA.

3. Supervalu (NYSE: SVU)
This grocer has been saddled with too much debt (about $6 billion), but has also looked like a deep value play, which was the point made by my colleague Ryan Fuhrmann in February.

Since then, Supervalu has continued to post solid cash flow and an improved debt load. The grocer is on track to generate $475 million in free cash flow this year and another $1.5 billion between 2012 and 2015, according to analysts at Guggenheim Securities. This should help Supervalu pay off roughly $2 billion in long-term debt. As this process unfolds, bearish investors will likely stop looking at the retailer as a bankruptcy candidate, while the low multiples shares currently sport will start to rise.

As management makes balance sheet progress, it may also look to lure in investors with a juicy dividend yield. As I wrote back in May, "Supervalu could triple its dividend, which currently yields 3.1%, and still have plenty of cash flow left for store remodeling or stock buybacks." The fact shares trade for less than seven times projected (February) 2012 profits has clearly not been much of a lure as of yet.

Action to Take --> These three retailers share several key traits. They are struggling with an anemic top line, thanks to subpar consumer spending, but their respective management teams are finding ways to boost cash flow anyway. In addition, shares are very inexpensive, likely ensuring relative safety should the markets drop further. As these companies deliver improved quarterly results, look for stock market observers to start taking note. So before share prices start to climb again, savvy value investors should take an interest now.

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.