Big Lots Stock Downgraded: 3 Reasons to Sell Before Earnings on Friday?

By Markets Fool.com

Just two short months ago, clearance merchandise retailer Big Lots blew away Q4 earnings estimates and made Wall Street analysts look like chumps. Revenue for the fiscal fourth quarter may have come up a few bucks short, but on the bottom line, Big Lots produced $1.91 per share in pure profit-- $0.02 ahead of consensus estimates.

Continue Reading Below

Big Lots stock soared in response to the earnings news, gaining nearly 9%in two days of trading, but in the days and weeks since, Big Lots has given up most of those gains. Heading into earnings this week (they're due out on Friday), Big Lots stock sells for not much more than it cost back in early March. And here's the worst news:

Deutsche Bank just pulled its buy rating on Big Lots stock ahead of earnings.

Why is that, and should it get you nervous heading into Friday's earnings report? Here are three things you need to know.

Image source: Wikimedia Commons.

Thing No. 1: Deutsche Bank does not hate Big Lots

Continue Reading Below

Although the headline today is Deutsche Bank's downgrade of Big Lots stock, and its cutting the price target to $47, it's important to note at the outset that Deutsche Bank actually likes Big Lots quite a...lot. Quoting from StreetInsider.com here: "BIG has been transformed over the past few years to a steadily positive comp growth story with a strong and unique furniture and home assortment coupled with an improved consumables offering."

That being said, though, Deutsche does worry that competition from a resurgent Wal-Mart could threaten Big Lots' ability to grow profit margins in the future. Wal-Mart, warns Deutsche, is accelerating "price investment" (translation: It's "rolling back" prices) to steal market share from the few bricks-and-mortar rivals that have survived Amazon.com's onslaught, and to ensure that Wal-Mart survives even if everyone else fails.

Wal-Mart reported strong sales and respectable earnings last quarter, by the way, and Deutsche sees Wal-Mart's success as one source of "weakening retail traffic trends" at Big Lots, which may force the company to rely more "on a healthy furniture business for BIG."

Thing No. 2: $15 an hour is a big deal for Big Lots

Another point of concern for Deutsche is Congress' -- and the states' -- moves to make $15 an hour the de facto standard for retail wages. Deutsche points out that as "labor wage inflation accelerates," Big Lots' costs are going to rise, squeezing profit margins on the costs side even as Wal-Mart's price competition squeezes them on the revenue side.

Thing No. 3: Memo to Big Lots -- You're not Amazon.com, so don't try to imitate it

Deutsche's third and biggest worry about Big Lots, though, is that the company appears to be drifting away from its core business as a treasure-hunt destination for shoppers looking to score a deal and be surprised by something amazing that they didn't know they'd find there.

Instead, Big Lots is moving to compete more with Amazon.com by investing in its BigLots.com website, and "may get more promotional online through free shipping and other offers not originally planned in order to get mindshare," warns Deutsche. Worse, the money Big Lots is investing to compete with Amazon (and Wal-Mart, which is also beefing up its online presence) may be wasted. Laments the analyst: "On the latter point, we have been disappointed with visit count to Biglots.com ... given the launch of the new e-commerce transactional site."

And one more thing...

Deutsche isn't mad at Big Lots just because it's trying to compete with Wal-Mart and other e-commerce sites. But the analyst does worry that Big Lots may be overoptimistic about its chances of success.

Last quarter, Big Lots told investors to expect $3.20 to $3.35 per share in earnings this year, based partly on its hopes for e-commerce success. Meanwhile, Deutsche says that its fellow analysts are taking Big Lots at its word and "looking for a 2.2% comp for both 1Q and FY16 which will be difficult to achieve" (Deutsche thinks 1.8% gains in same-store sales are more likely).

So how big of a risk are investors looking at, heading into earnings Friday? If management's guidance numbers are right, Big Lots stock is currently selling for about 13 times the midpoint of this year's earnings guidance. Analysts polled on S&P Global Market Intelligence, however, are projecting only 10% long-term earnings growth for the company, which gives the stock a somewhat pricey-looking 1.3 PEG ratio.

That suggests there is some risk in the shares. On the other hand, Big Lots boasts very strong free cash flow ($216 million worth of cash profits generated last year, versus just $143 million in reported earnings), modest debt, and it pays a respectable dividend of 1.9%. All in all, I think there's still some potential for Big Lots to outperform.

Call me a crazy optimist, but even admitting the truth of Deutsche Bank's objections, I actually would not sell before earnings on Friday. So long as the company delivers on its promised earnings, I think there's still a bargain to be found in Big Lots stock.

The article Big Lots Stock Downgraded: 3 Reasons to Sell Before Earnings on Friday? originally appeared on Fool.com.

Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 299 out of more than 75,000 rated members.The Motley Fool owns shares of and recommends Amazon.com. The Motley Fool recommends Big Lots. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.