Will Price Matching Slash Best Buy's Profits?

Nov.16.12 | About: Best Buy (BBY)

Earlier this week, an alarmist report from InvisibleHand (a firm that specializes in real time price checking) stated that Best Buy's (NYSE:BBY) decision to match competitors' prices this holiday season is likely to dent the company's profits by more than $400 million this quarter. The price matching program is primarily designed to combat the "showrooming trend": consumers coming to Best Buy to browse and test products, and then finding the cheapest price online. (Target (NYSE:TGT) announced a similar program around the same time.) Not surprisingly, internet retail powerhouse Amazon.com (NASDAQ:AMZN) is the most fearsome competitor here. However, the price-match program has inherent risk, insofar as matching online competitors' lower prices will damage gross margins. The total financial impact depends on the amount of incremental sales generated by price matching (i.e. customers who otherwise would not have made a purchase at Best Buy) versus the margin loss for sales that would been made without the price match offer.

It's likely that Best Buy's profits for Q4 will trend below last year's level; while the company posted adjusted EPS of $2.47 in Q4FY12, analysts only expect profit of $1.75 in Q4FY13. However, I believe that InvisibleHand's report vastly overstated the likely impact of Best Buy's price matching program. While the description of the methodology in the report was not entirely clear, the study does not appear to have facilitated fair comparisons.

The first apparent methodological flaw was inherent to InvisibleHand's technology; it facilitates real-time price comparisons. However, retail prices vary seasonally, and so the correct comparison would have been to last year's holiday season. A quick look at Best Buy's Black Friday deals (or any other retailer's, for that matter) would demonstrate that gross margins will always be tighter during the holiday season. Last year, Best Buy generated gross margins of 23.1% in Q4, whereas the company's gross margin tends to hover around 25% for the rest of the year. Now, it is also likely that Amazon's prices would be lower on average during the holiday season. Nevertheless, for the 30% (or $5 billion) of Best Buy's sales that InvisibleHand assumes will involve price matching, Best Buy's regular selling prices would already be 2% ($100 million) lower, on average. Thus InvisibleHand's estimate of the loss could be overstated by as much as $100 million from this item alone.

Secondly, given that the firm appears to have worked only with public data, it's not clear that any information about sales mix was taken into account. The analysis appears to jump from the insight that 75% of items were cheaper on Amazon (by an average of 17%) to the conclusion that customers utilizing price match will save 17% on average. But many hot ticket items will be only slightly cheaper on Amazon: or not at all. For example, Apple (NASDAQ:AAPL) has released a slew of new products in the past few months, many of which are likely to be top sellers. Yet Apple has a unilateral pricing policy which limits the extent to which Amazon (and others) are permitted to discount. Since Apple products make up a disproportionate amount of Best Buy's revenue (compared to SKU count), InvisibleHand's methodology overstates the extent to which Best Buy would have to cut prices. In other words, the items with the biggest discounts on Amazon are probably lower volume. It's worth noting that other sellers of big ticket items have moved toward unilateral pricing policies as well. It's also ironic to note that one can pick up a Kindle or Kindle Fire at Best Buy for the same price offered on Amazon.com!

Lastly, the assumption that 30% of customers will utilize the price match is probably too high. For one thing, on the very high volume (and big discount) days of Thanksgiving weekend, Best Buy won't be matching prices. The stores will already be mobbed due to the usual slew of Black Friday weekend deals. Moreover, Best Buy is reportedly only matching prices in 2 of its 6 business units: consumer electronics and appliances. Last year, only 42% of Q4 total sales fell in those two categories, so if other categories are excluded, then the number of purchases subject to price matching is likely to be much lower.

Best Buy certainly faces a very challenging road. That said, I do not think the management team is incompetent, and a price-match strategy that led to a more than $400 million reduction in profit would imply extreme management incompetence. For the reasons I noted above, I think it is much more likely that the InvisibleHand study used shoddy methodology and grossly overstated the potential harm. While Best Buy is a speculative investment at this point, I think many of Wall Street's concerns are overblown. Price matching this holiday season could very well be a catalyst for Best Buy to get back into the game as a big-time retailer.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short AMZN.