Electronics retailing giant Best Buy (NYSE:BBY) is set to report its Q3 2014 earnings on November 19. Revenue growth has been negative for some time. The growing competition from retail giants including Amazon (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT) and the company's decision to exit its European joint venture have produced the short fall. Moreover, the fiscal year end change from February to January last year introduced 11- month stub years in its reported results. However, in a welcome turnaround, and with its restructuring initiative well underway, Best Buy has reported encouraging financials in recent quarters. Despite its ongoing price matching policy, the company generated $9.3 billion in revenues in Q2 2013 (almost flat year to year) and saw its gross margin increase from 24.2% to 26.5%.
Best Buy has shut down under-performing stores and is in the process of revamping existing stores to enhance the customer buying experience. It reported its third consecutive quarter of better-than-forecast earnings and posted its first quarterly profit in a year with the July quarter (ended August 3rd). A stabilizing revenue base and improving margins increased Best Buy's Q2 2014 net income from continuing operations to $237 million compared to $31 million an year ago.
While the strong turnaround strategy and improving financials are encouraging, we remain cautious on the company's outlook until we see a sustainable improvement in its remaining revenue base and profitability. Our price estimate of $26 is at a significant discount to the current market price of $43, which has nearly tripled year to date. We will update our price estimate after the Q3 2014 earnings release.
Declining Revenues From Europe
In 2008, Best Buy entered into a joint venture with Carphone Warehouse, Europe's biggest independent mobile phone retailer, to tap the growth potential in the region. However, Best Buy announced its decision to sell its 50% stake in the venture in April this year back to its partner for GBL 500 ($775 milion), including GBL 410 million in cash and 80 million in stock. Marking its exit from the European market, the deal signals that the retailer is more keen to focus on enhancing its competitiveness in the domestic U.S. market, where it is facing formidable challenges from players like Wal-Mart and Amazon.
Best Buy needs a strong balance sheet to meet its expansion targets in the U.S., and this deal seems to be a step in that direction. We think that the cash from the Carphone Warehouse transaction will be used to further expand Best Buy mobile store format and make investments in altering the product mix at its outlets.
Prior to entering into this agreement, U.S. GAAP revenues for Best Buy Europe in the ongoing fiscal year were expected to be in the range of $5.5-$5.6 billion. So the hit to revenue is sizable.
Price Matching Policy & Partnership With Microsoft To Impact Revenues Growth In The Short Term
In March 2013, Best Buy put in place a permanent "Low Price Guarantee" policy under which it will price match all local retail competitors and 19 major online competitors in all product categories and on nearly all in-stock products, whenever asked by a customer. This guarantee is available on Best Buy's website, at more than 1,000 Best Buy big-box stores, at more than 400 Best Buy Mobile standalone stores in the United States, as well as by telephone.
Best Buy is focusing on making its pricing more competitive though improved analytics over the next several quarters. Though the lower prices enhance its competitiveness in the market, it puts pressure on both its top and bottom lines. The key here is dynamically tracking competitors' pricing.
To enhance store space optimization and merchandising, Best Buy in June entered into an agreement with Microsoft (NASDAQ:MSFT) to open store-within-a-store locations in the company's brick-and-mortar outlets for the software giant's products. Microsoft is the third tech giant after Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF) to have a dedicated selling space within Best Buy stores. Best Buy reports a good response to these stores so far. However, the company indicates that the deployment of the Microsoft stores is more disruptive than the initial work on the Samsung Experience shops. Thus we expect them to work to offset and impact top line growth until Best Buy fully completes these deployments.
Gross Margins To Remain Under Pressure
As a result of Best Buy's "Low Price Guarantee" policy, its gross profit margin declined year to year from 24.9% in Q1 2013 to 23.1%. Excluding non-recurring items, the non-GAAP gross margins declined by a more modest 0.6% annually in Q2 2014. Nevertheless, the company believes that gross margins bottomed out this quarter.
Best Buy has pledged to improve its cost structure and is aiming to reduce its cost of goods sold by $325 million through increased supply chain efficiencies and the modification of its return and replacement policies. To date, it has managed to generate savings worth $30 million. Best Buy had also pledged to reduce its SG&A costs by $400 million in North America this year, and claims to have made good progress so far.
Additionally, in order to improve gross profit per square foot, Best Buy is focusing on stocking more higher margin merchandise. To this end, it has reduced the stock of CDs and DVDs in its stores and is allocating more store space to mobile and computing products. Despite these initiatives, we expect the intense competition in the industry to keep margins under pressure over our review period.
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