Shares of Best Buy (BBY) have fallen about 5% over the past two sessions as analysts and competitors have raised concerns over margins. These concerns came to a head after hhgregg (HGG) said the holiday season was extremely promotional. While investors have been selling the stock on this news, Best Buy has been an incredible performer over the past year:
While investors may be wise to take some profits after this incredible run, any investor who is surprised by shrinking margins is woefully uninformed. The stock has soared over the past twelve months, not because of expanding margins, but because solvency is no longer a pressing issue. Sales have found a footing with same store sales hugging the flat line after several challenging years that saw the company cede share to the likes of Amazon (AMZN) and Wal-Mart (WMT). The company has also been closing unprofitable stores and trimming expenses by over $500 million under the "Renew Blue" initiative, which is accretive to margins by 1.5-2.0%.
In 2005, Best Buy could afford some bloated spending, but in today's price-transparent environment being low-cost is critical. BBY has properly cut the fat from its budget, which has helped to ensure that the company can be profitable at a lower sales rate. Now, Best Buy faces serious competition, and as a consequence, margins have been depressed for two years. Margin compression isn't a new issue. Operating margins have been running in the 1.4-2% range on a non-GAAP basis for some time, which is well below the pre-crisis norm of 5-5.5%.
Frankly, we will never see that margin level again for two reasons. First, the growth in e-commerce has made the brick and mortar business less profitable. Online retailers have less fixed costs, giving them the capacity to sell goods at very low prices, pushing margins lower. Second, with the internet, there is increasing price transparency. I can visit a Best Buy and see the price of a TV, go on my phone and see the price at Wal-Mart. If Wal-Mart is cheaper, Best Buy will match the lowest price. Before the mobile internet, price-checking was more difficult and intensive. To avoid being a showroom for competitors, virtually all major retailers will match the lowest price, which perpetually depresses margins.
In the most recent quarter, Best Buy even told investors to expect a 60-70bp margin compression over the holiday season due to promotional activity and price matching. Margin compression has been the trend, and management has guided to it. This is a known negative for the stock, and any investor unaware of the phenomenon has simply not been doing their due diligence. In a world of transparent pricing, margins are structurally lower.
As such, I was unsurprised that hhgregg said margins were weak; Best Buy's management already told us that. Fortunately, the company has the balance sheet to sustain low margins with a .44 debt to equity ratio. The company has also been cutting expenses and weak locations to ensure that Best Buy can be the low cost operator and absorb price cuts. Finally, the company has worked to differentiate itself on service with higher margin support and warranty offerings that provide solid ancillary revenue.
Any investor who was surprised by reports of lower margins needs to do better research while any others who had hoped for a return to 5% margins are going to be disappointed. Operating margins of that level are impossible with price transparency. With some further expense cuts and flat same store sales, I believe the company can earn about $3.00 in operating income in calendar 2014. There is room for some lift to operating margins, but I believe 2.5% is the new upper bound. At a little less than 13x operating income, Best Buy shares aren't cheap. With limited pricing power and strong competition from online retailers and discounters, I would be hesitant to pay more than 10-11x operating income or $30-$33. Best Buy will survive, but margins are not coming back to pre-crisis levels. As investors finally recognize this, I expect shares to continue to trend lower.