After shares nearly flirted with $10 in December, electronics retailer Best Buy (BBY) has seen its stock more than double thanks to moderating sales declines and a store revamping strategy that displayed great promise. However, Best Buy's first quarter fell short of consensus expectations as the Street got a bit ahead of itself in gauging the velocity of the turnaround. Revenue declined 10% year-over-year to $9.3 billion, which was well below consensus estimates. Adjusted earnings per share fell 58% compared to the prior year to $0.32 per share, which was a touch better than consensus expectations. Free cash flow swung to negative $179 million for the quarter, reflecting the firm's inability to earn net income more than anything else.
Although no company likes to sell a business into such weakness, Best Buy managed to divest its 50% stake in Best Buy Europe, so that segment's operations are now quantified as discontinued. As a result, we will focus on analyzing Best Buy's domestic business. We saw no end in sight for the sales decline in the region, so we're happy to see the international operations focus primarily on Canada and China.
Not surprisingly, Best Buy's first quarter reflected weak demand and pricing for consumer electronics, as sales fell 11.5% in the US on a same-store basis compared to a 1.1% decline on an aggregate level. With brisk competition from Amazon (AMZN) and Wal-Mart (WMT), we simply do not see this category materially improving unless some sort of product breakthrough occurs in TVs. Unfortunately this product category accounts for 30% of sales, making it a hard segment to replace. The launches of Sony's (SNE) PlayStation 4 and Microsoft's (MSFT) Xbox One could help boost sales in the back-half of the year, but we are unsure what could help fill the sales void after the releases. Perhaps an increase in household formations could help boost TV sales, but margins on the devices remain subpar at best.
Entertainment sales continue to fall off a cliff, with same-store electronic sales falling 17.2% during the quarter. We're encouraged to see concepts like the Samsung store within a store replace all of this unproductive space left by CDs, DVDs, and Blu-Rays. Luckily video game sales will not move entirely to the digital world, which will be positive for both Best Buy and GameStop (GME). CEO Hubert Joly noted that the store-in-store concept is likely to expand, saying:
"If anything the announcement of Samsung and the deployment of Samsung has triggered more competitions with other vendors who are agreeing that this is a very positive. And the more traffic is attracted to our stores, the better this is for everybody. So there will be more - there's nothing to talk about today, but we are interested in doing more and we see it as win-win-win."
We couldn't agree more that any incremental traffic drivers will be positive for Best Buy, especially with partners like Samsung considering mobile (computing now accounts for 47% of sales). In our view, the biggest risk is that Apple (AAPL) dominates computing to the extent that other OEMs see competition as futile, but we do not feel the odds of this are high.
While sales remain weak, Joly has done a fantastic job of realizing SG&A savings. SG&A declined 9% on an absolute basis in the US, and management remains encouraged the cost reductions in both Canada and China will help lower overall operating expenses. This will become even more crucial as price matching Amazon and other competitors continues to weigh on gross margins, which were 190 basis points lower than a year ago in the US at 23.4%. A further movement towards online sales might also help keep SG&A expenses tempered, as comparable domestic online sales grew 16% year-over-year. Though we highly doubt Best Buy's online business will ever compare to Amazon's robust marketplace, we're encouraged to see the online business improve because an omni-channel experience is essential to all retailers' futures, in our view.
Overall, we thought Best Buy's first quarter was decent, though the Street clearly thought the firm would deliver better sales results. We're never happy to see a company post negative free cash flow, but the first quarter is among Best Buy's slowest, so we're not worried to see one quarter come in light. Ultimately, we think shares look fairly valued at this time, so we won't be adding them to the portfolio of our Best Ideas Newsletter at current prices.
Additional disclosure: AAPL is included in the portfolio of our Best Ideas Newsletter.