Shares of Best Buy (NYSE:BBY) dropped 11% after reporting decent quarterly earnings as investors were concerned about fourth quarter guidance (earnings release available here). Still, shares are up 227% over the last year. Should investors pick up BBY on this pullback or is the stock still overpriced? I will first go over results and guidance and then look at valuation.
The story of the third quarter was stabilization. After years of declining share to Amazon (NASDAQ:AMZN) and discounters like Wal-Mart (NYSE:WMT), Best Buy has found some footing. Same store sales grew 0.3% overall and were up 1.7% in the U.S. while they fell 6.4% internationally. The website was an area of particular strength with sales growth of 15.1%. Margins do remain tight with operating income margin at 1.0% and 1.4% non-GAAP. With more transparent pricing thanks to the internet, margins will likely never return to pre-crisis levels.
In response, Best Buy has aggressively cut costs and closed unprofitable locations under their "Renew Blue" initiative. BBY estimates they have cut $505 million in expenses, meaning they are well on their way to the $725 million goal. These efforts should help margins by 1.5-2.0% in coming years. Best Buy is in the process of right sizing its cost structure and refocusing its offerings around services to differentiate its products from those sold at other outlets. These efforts should ensure Best Buy's viability for the foreseeable future, which was far less certain 18 months ago.
However, I was troubled by guidance. Best Buy said it will have to match competitors' pricing to maintain the progress it fought so hard to make. Best Buy feels it has to match the promotions of competitors to keep customers, and margins could be 60-70 basis points lower from last year when the company was still losing share. Investors had been hoping for flat or even somewhat better margins, making this guidance extremely disappointing.
I found this guidance very concerning because Best Buy is basically conceding it is not in control of its own destiny. Best Buy has to match the pricing of its competitors, which is a losing proposition. Wal-Mart can lose money on TVs to get customers in the door for other purchases while Amazon does not have to pay for a network of stores. The BBY transformation had been about differentiating itself from competitors through tech know-how, warranties, and superior service while offering good if not the lowest prices. This upcoming quarter appears to be a deviation from that strategy, which makes one wonder if management thinks it is not a sustainable one. Best Buy can probably survive a price war given a strong balance sheet with 2.25x the equity as debt, but such a battle will leave the company virtually profitless.
While shares took a beating after the earnings, they do remain up quite a bit on the year. BBY now trades at 67% of its all-time high in 2006, which might be surprising given all of the negative publicity the stock suffered. It is worth noting that since hitting an all-time high, BBY has repurchased 33% of its shares outstanding, meaning shares could rally another 110% before hitting an all-time high market capitalization.
Before Amazon became such a fierce competitor, Best Buy generated an operating margin in the 5-5.5%. With a tougher pricing environment, I am looking for margins about half of that level, about 2.3-2.5%. With flat same store sales, BBY can generate revenue of about $43 billion, which gives the firm $3.00-$3.10 in operating income per share. After the drop, shares are trading about 13x operating income. I think this is a hefty valuation for a company that remains extremely exposed to competitors' pricing. I would be more interested around 10x earning or $30-$31 to reflect the risk competitors pose. This quarter showed BBY has stabilized and has warded off viability threats but has work to do before staking out a totally strong position in tech retail. At current prices, the stock is discounting the risk AMZN and WMT still pose. I would still be a seller here down to $30 when shares would be more attractive.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.