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The warranty business is a little like the insurance business - people pay upfront for the chance that something might break in the future. And with the law of large numbers on their side, warranty providers can reasonably predict their return on investment. That's why it's a business that investors would love and Best Buy Inc. (NYSE:BBY) should embrace to stem its decline.

Warranties Generate Profits

In its latest 10-K filing with the SEC, Best Buy noted that the sale of extended warranties represented about 2.8% of its FY 2013 revenues, or about $1.3 billion. These top line figures may seem paltry compared to the rest of its business, but their extremely high margins mean that they contribute significantly to the firm's bottom line financial results.

Many analysts believe that these margins could range between 50% and 60%, but even a modest 40% margin would equate to operating income of $520 million. With the electronics retailer reporting an operating loss of $125 million in FY 2013 and a gain of just $772 million in FY 2012, it quickly becomes clear that warranties are a very big deal for the retailer.

But, just like Blockbuster misjudged the threat of kiosks for DVD and online streaming, Best Buy appears to have misjudged consumer appetite for overpriced and underserviced warranties. Customer dissatisfaction with these warranties has led to competitors springing up and growing sizeable businesses like SquareTrade has done over the past seven years.

Instead of fixing its margin leader, the retailer seems to have ignored it to focus on revenue projects that haven't worked yet. Case in point, the company's latest conference call highlighted a new store prototype and cost cutting initiatives. While these initiatives might improve the top line, the commoditization of consumer electronics will keep the bottom line under pressure.

Expanding the Warranty Business

SquareTrade is an extended warranty service provider for consumer electronics and appliances that began insuring devices in 2006. Just six years later, the company raised $238 million in the second largest VC deal of the year and posted 90% revenue growth. The banker behind the deal, Bain Capital, was "attracted by the high satisfaction levels among customers and retailers."

While the privately held company doesn't reveal full financial statements, it has approximately $2.8 billion in devices under protection, with a network of channel partners that sell its warranties both in the U.S. and abroad. Most notably, eBay Inc. (NASDAQ:EBAY) offers its warranties in its many auctions with a logo where buyers can purchase them at the time of sale.

Best Buy may offer extended warranties already, but only on products that it sells. With its household brand name and nationwide physical presence, the company could expand its service to third parties, which it could service on-site instead of by mail. And picking up a replacement locally could be a significant competitive advantage compared to companies like SquareTrade.

Best Buy also has relationships with a number of different suppliers that it could leverage to rapidly build out its network. While SquareTrade has likely been built largely on eBay, Best Buy has the opportunity to tap into mobile phone partners, like Samsung (OTC:SSNLF), as well as leverage its existing advertising infrastructure to encourage its customers to insure their other devices.

Potential Impact And Execution

According to Ty Shay when he joined SquareTrade, "Warranties are a $20 billion category with high dissatisfaction." Best Buy could significantly improve its bottom line by capturing only a modest portion of that $20 billion market beyond its $1.3 billion now. And the margins on those revenues could impact its bottom line even more dramatically.

While SquareTrade may be taking market share now, Best Buy's built-in advantages of on-site repair/replacement and household brand name could prove invaluable. The older demographic in particular may be hesitant to purchase warranties online and/or send in their products by mail, creating an opportunity for Best Buy to capitalize on the other products they own.

In the end, Best Buy's turbulent financial results and risky initiatives deserve a second look and strategies like these should be analyzed to tackle what will really help turn around the business.

Source: Refocusing On Warranties Could Save Best Buy