I hate Best Buy.
Wait. Let me qualify that. As an early-adopter, tech-savvy introvert who lives pretty much on the internet, I am not a fan of Best Buy (NYSE:BBY) as a company. I do not like shopping there. I do not like their business model. I do not like the services they provide.
But when it comes to evaluating how much a business is worth, we have to leave all these biases behind. We have to adopt an objective viewpoint and see it for what it is, rather than through our personally and ideologically constructed filters. A guy like me thinks Best Buy is silly and has no place in a world where I can find a better mix of goods at better prices from other retailers, especially ones like Amazon where I don't have to deal with obnoxious salespeople.
Plenty of the world thinks Best Buy is perfectly awesome. We educated elitists who hang out in the financial industry and throw stones at increasingly-irrelevant businesses like Best Buy from our ivory towers frequently forget one thing: never bet against the lowest common denominator in the U.S.A. Spend some time observing who buys stuff at Best Buy and you'll see what I mean. These are not bad people -- they're simply very different from me (and maybe you). Before we make an investment decision, we need to understand that difference and the bias that can arise from it.
It's possible Wall Street has forgotten Best Buy's core customer and has gone a little bit too far too quickly in writing off the relevance of such a business.
The stock has been going straight down for three years. That kind of movement generates momentum of its own and typically carries valuations too far beyond a reasonable mean (or target price).
I always like to ask two major questions when evaluating how much a business is worth:
What will their sales be?
What kind of EBITDA margins will they have?
I know. Those are gigantic questions. Why don't I just ask what the meaning of life is, while I'm at it?
But it's important to think about these things because whoever knows the answer stands to make a boatload of money in the coming years. Those questions may be impossible to answer exactly, but we don't have to guess randomly.
Let's break down some of the key data.
In the last twelve months, Best Buy reported $1.1 billion of EBITDA on nearly $50 billion of sales. That's a margin of 2.4%, which stinks.
During the last decade they've averaged around a 6% EBITDA margin which, for a business like theirs, isn't so bad. For sake of comparison, Target (NYSE:TGT) averages around 10% and Wal-Mart (NYSE:WMT) averages around 6.6%. RadioShack (NYSE:RSH) -- hold your nose! -- averages around 9%. If those goofballs had to shoulder the burden of Best Buy's big box footprints, there's little question that number would be lower. In fact, I'm of the belief one of the biggest reasons RadioShack is still around is because of their relatively efficient infrastructure. Sneaky little buggers.
A turnaround is underway at Best Buy! Best Buy has finally started doing some fairly radical things to reverse its somnambulic shuffle toward irrelevance. They're closing down stores and they've adopted an aggressive new price matching policy.
This is both good and bad. The good news is that rational consumers -- to the extent that Best Buy shoppers are rational, and I'm not convinced they are because a lot of them buy extended warranties -- will have a much easier time shopping at Best Buy. Why get it online when I can get it right now at the same price? This is powerful stuff. As a gamer, I like this strategy a lot.
But, look: if Best Buy is going to be matching prices with Amazon, whose retail raison d'etre is to leverage their unmatched logistical infrastructure and economies of scale to give you the lowest price possible, it's hard to imagine how they'll be able to recapture 6% EBITDA margins. But who really knows? Maybe they'll keep closing non-performing locations and shuffle their product mix around to focus on higher margin items and maybe it'll work. Maybe they will recapture those old margins, if on less total revenue. Maybe at that point this is a business that can grow at GDP.
Amazon, by the way, has been rocking a 5% EBITDA margin during the post-crisis years. Impressive, given its valuations. Bezos is officially the Honey Badger of retail, the most fearless creature in the wild kingdom that is Wall Street. If Amazon wasn't too busy not giving a s--t about their margins, how much higher could they be? This is one of the (many) reasons Amazon commands an 80x earnings multiple while Best Buy gets stuck with an 8x.
So what's reasonable here?
Let's look deeper. Here's a chart of Best Buy's total revenue plotted alongside total sales.
It's Peak Best Buy!
If you think about it, a business like Best Buy has two dials. The first is the number of stores. Each new store in each new market will add to the top and bottom lines. This is growth, simple and pure. But this dial has been turned about as far as it'll go. I know that Wall Street is really excited about their plans to close down locations, but that has a significant impact on the top line. Not that anybody is paying attention to the top line at Best Buy right now (as we'll see later in this analysis).
The second dial is profitability per store. This dial is substantially more difficult to turn. Any chump CEO can turn that first crank. But raising margins in each location is tricky business. In fact, this is the very essence of Best Buy's turnaround strategy and they are attacking this problem on multiple fronts.
To get a better handle on this, you can relate the two and calculate total sales per square foot per year. I know you were dying to relate those two data points after seeing that first chart anyway.
That chart is moving in the right direction.
One of the things I was surprised to discover is that Best Buy has probably been better managed during the last decade than I would have guessed. This isn't Blockbuster, at least not yet. They are doing things behind the scenes and there's more to the story than simply defending their business model against Amazon's.
Best Buy doesn't break out online sales, so it's tough to tell how much of this efficiency growth is simply being layered on top via BestBuy.com or through their teensy-footprint standalone mobile stores. Obviously, they have all this data answer internally. I'm guessing that these new growth elements are a big enough piece of the pie that the true trend in physical retail sales/sqft is concerning enough to get them serious about packing up those big boxes.
The best glimpse that investors like us can get is same store sales data, which Best Buy does report. Same store sales dropped -0.8% in 2010, -2.1% in 2011, and -3.1% in 2012.
Now you can really see why a turnaround effort is underway.
Anyway: back to our original questions. What will sales and margins look like?
Step 1: A Simple DCF Study
I'm not sure if a discounted cash flow analysis is the most appropriate way to value a business like Best Buy. But I do know that it's not inappropriate. We're not talking about trying to value Facebook here.
As usual, getting the initial forecasts is the toughest part. I honestly have no idea what to properly forecast for Best Buy in terms of sales and margins and cash flow, so I used some baselines that felt very conservative and left a lot of room for flexibility.
Here, we assume:
- Top line sales decrease at -2% per year, indefinitely.
- EBITDA margins slowly improve to 5% by 2016
- Operating margins and income stay low the way they've been in the last 12 months with the turnaround underway as opposed to the ~$2.2 billion operating income BBY averaged in the previous decade.
- Free cash flow doesn't change a whole lot and looks more like recent periods instead than the good ol' days of easily generating $1+ billion of cash.
As I said, these are relatively conservative assumptions.
Now for the easy part!
(Geek's Note: To get our discount rate, I used a WACC approach assuming a 3.25% 30yr Treasury yield as our discount rate, a 7.5% equity risk premium, and a capital structure featuring 25% debt and 75% equity. I assumed BBY can borrow at 7%, which may be high or low, but won't move the needle much given their equity-heavy capital structure. The result was 10.3%, which felt low, but whatever.)
Sorry, here's the easy part:
Thank you, Excel. You make calculating net present value fun!
There is a huge range of potential valuations here. This is where you get to tweak everything based on your own assumptions.
Personally, I'm more interested in the upper right corner of that matrix. I feel like a 10% discount rate is a bit low and would rather use something closer to 12% for a stock like this. And I like the idea of a 5x-7x EBITDA multiple for this kind of business rather than something richer.
Based on cash generation and enterprise value, Best Buy should be worth $22-30 per share.
Even with these very conservative assumptions, the intrinsic value of Best Buy's business is quite a ways above where the stock is currently trading. There's still some room, even given the recent run from $12 to $19.
Don't forget, though, that the stock is trading at a big discount to intrinsic value because there's a lot of risk here. This turnaround may not work. Best Buy may indeed be a dinosaur.
Any way you slice it, investing in Best Buy requires some kind of faith that management will figure out a way to keep the business relevant.
If you do not have faith that Best Buy will succeed at justifying its existence, you stay away. Simple.
This where the hidden catalyst sneaks back into the picture. There could be a takeout down the road or a move to go private. These radical transitions are much, much easier conducted when they can be executed outside the auspices of the public markets. Just take a look at J.C. Penney (NYSE:JCP) if you need convincing. And imagine how happy Dell (NASDAQ:DELL) is going to be to not have to answer to public shareholders anymore as while they carve out a different niche for themselves.
If Best Buy does get taken out in the next year or two, I would be shocked if it's less than somewhere in the mid 20's. Worst case scenario, Best Buy could make some minor tweaks and tread water and the amount of cash this business generates -- $2.5 billion of free cash flow in fiscal 2012 -- could pay for a purchase in relatively short order.
Step Two: Alternate Valuation Methods
No sensible analyst slavishly relies on discounted cash flow analysis, so let's look at some other ways to value the stock.
I like the Benjamin Graham method, if for no other reason than it is simple and clean.
The original version of this formula comes from the legendary Security Analysis, the bible of fundamental analysis. This approach is what made Warren Buffett Warren Buffett. He's been using techniques from this book for 60 years. Those of us who aren't total analysis wonks can get just as much value out of The Intelligent Investor, a substantially more approachable read that hits all the same concepts.
Here's the revised version of his original formula:
Instead of 8.5, which is where the PE of a supposed "no growth" stock is supposed to go, I'll be conservative and use 7. I also prefer a more conservative growth multiplier of 1.5 instead of 2. And I'm using a 3.8% low risk corporate yield as the Y denominator.
Here we calculate a value of $17.67 for Best Buy
That's below today's price. But it's also based on a forward-year EPS ($2.18) that is probably depressed for short-term reasons. If you think Best Buy can earn closer to $3 per share before too long, still less than Best Buy earned at its peak, then this valuation quickly jumps into the low/mid 20's. It doesn't leave a huge margin of safety, but it does suggest that there's some degree of under-valuation.
Lastly, what about its peers?
Now that Circuit City is extinct, I'm not sure if Best Buy really has any pure peers. Amazon (NASDAQ:AMZN) is obviously a competitor, as are Wal-Mart and Target . There are smaller competitors like Aaron's (NYSE:AAN), Conn's (NASDAQ:CONN), and H.H. Gregg (NYSE:HGG).
If you think that Best Buy deserves a forward multiple of 11-13x the way that Target and Wal-Mart do, the stock should again belong somewhere in the mid 20's.
Conn's has a forward PE of around 16, but this is a company with substantially brighter growth prospects than Best Buy. They'll also do less than a billion in total sales this year, so how appropriate a competitor are they? Aaron's and H.H. Gregg each will do a little more than $2 billion in sales vs. Best Buy's $50 billion.
Aaron's in particular is an interesting case. Even with just $2.4 billion of projected sales this year, their market cap is a full third of what Best Buy's is. Yes, you read that right. With $50 billion in sales Best Buy's market cap is only $6.5 billion.
What is an appropriate Price/Sales valuation for Best Buy? Probably not the 0.5x of a Target or Wal-Mart, and definitely not the 1x+ of a growth store like Conn's.
Again, this is another question that ultimately comes back to margins. If you think the turnaround strategy works and they can improve their margins through a modified product mix, then this is a business that could effortlessly command a 0.25x sales valuation. Even at a 0.2x sales valuation, there is 50% appreciation in the stock from these levels.
If the knock on Best Buy is inefficient infrastructure and price competition, I'm not sure why someone would want to go with one of these smaller names. Still, each of those competitors command a higher valuation than Best Buy and for somewhat defensible reasons.
Depending on where you fall on the idea of big box retail in general, there may be relative value opportunities here, going short a name like Aaron's while getting long Best Buy.
OK. Best Buy is cheap. Even I must concede that point with my blue & yellow bias.
To suggest otherwise is to ignore the data. No, the stock is not as cheap as it was at the end of last year. But it's still rather cheap today, undervalued by at least 25% and perhaps as much as 50%.
There also exists the possibility that the stock might be cheap for a reason. The current price is skewed more towards the earnings-based Graham Model than a discounted cash flow business valuation. That could suggest that earnings aren't going to grow very much and don't have a chance at ever getting back to what they were in recent years. The asteroid could indeed be barreling down on the Best Buy dinosaur.
The corollary to this skew suggests that cash flow will continue to shrink, that this is not a business that can generate $750m - $1 billion in annual cash flow. The stock is currently priced as though this were a business that generates something more like $200 million of free cash flow.
The extent to which you disagree with these data-driven assumptions correlates with the extent to which you are bullish on the stock.
I don't really want to be a long-term investor in Best Buy. Ultimately, I do buy into the theory that big box retail will be a progressively more difficult space in which to justify one's existence and stay afloat. But that's me and those are my biases.
That said, there is unquestionably potential for short- or medium-term appreciation. I think there's a decent risk/reward opportunity of hanging onto Best Buy for a little while as the rest of the market figures out that this is a business that's probably worth a bit more than its current market cap of $6.5 billion.
Before concluding all of this analysis, I really need to reference what I wrote yesterday, about the 10 Virtues of Successful Investing. Getting long Best Buy right now is going to require all ten of those, particularly fortitude and independence, while you wait for the market to come to its senses or for an external catalyst to arrive.
And you're going to need a bit of faith, too.
I hate to reduce all of this fancy math and analysis to something as simple as "if you believe big box retail has a place and the turnaround will work, Best Buy is undervalued and presents attractive opportunity," but it's really the critical point here.
Perhaps that faith-based distinction is why there's so much wild disagreement about the stock right now.