For some reason, it was one of the more controversial articles I've written here. I'm not personally a fan of the company and what they do, but I never let that influence whether I think a stock is a good investment or not. Suppressing those biases worked out very well with Best Buy. That's still the case today. Make sure all your biases -- many of which are now linked to prior stock prices -- are on the sidelines where they belong.
I don't want to rehash what this guy already did either. Mr. Mintzmyer has done a nice job restating the basic idea of what's going on at Best Buy right now. And for what it's worth, the basic turnaround thesis that he outlines and that I also outlined last year is still intact. Even with the latest drama in the stock, the only thing that may have changed to the operational story is our expectations of how long it'll take.
What I want to do is get back to the heart of the question about valuation. What's the company really worth?
In 2013, Best Buy was the benefit of several factors that all converged for a truly memorable year. The consumer was strong last year, market psychology healed, and investors came in from a harsh winter in Bondville and sat down by the warm equity hearth. The general growth outlook for the U.S. improved and along with it the outlook for cyclical retailers. I thought the stock in the high teens was undervalued by 25-50% and the generally-pleasant environment last year really helped unlock that misunderstood valuation.
Without spoiling too much of the punchline, I hope it's obvious what happened here: The stock got way ahead of itself.
Keep in mind that is NOT the same thing as saying the stock is in the middle of an overdone selloff and should be valued back where it was a few weeks ago. When stocks go too far, all it takes is a simple catalyst to bring them back where they ought to be.
Just because a stock has gotten hammered doesn't mean it's an attractive value proposition. Sometimes assets go up too much and when they fall, sometimes where they land is at fair value rather than below it.
The Psychological Drivers
One of the things that 2013 did was completely re-write the psychology of Best Buy. Before last year, the general perception of Best Buy was that it was a dog at best, and at worst, a company the brink of Blockbuster-style irrelevance. In the stock market, perception influences price, but price can also influence perception. How much of our pessimistic view on Best Buy's business had to do with a stock price that seemed to move only in one direction: down.
I think that's why I got some many tomatoes thrown at me for saying that there was some value here. The psychology surrounding Best Buy was a total disaster and any time you push against a messy psychology, the response is invariably met with skepticism and in some cases anger.
In any case, that's all been flipped 180 degrees. Analysts bought into the turnaround narrative and then the momentum players showed up. As of last Monday, Best Buy was still a beacon of retail hope.
So what they heck are we suppose to do now?
In Search of Value
Any conversation about valuation has to begin with revenue.
This is part of the reason why the specific catalyst here is so disturbing. Sales dropped. While I'd be quick to point out that this doesn't mean the turnaround strategy has failed (how much might sales had dropped if they hadn't adopted these new measures?), one now has to think long and hard about where the long-term equilibrium is for Best Buy.
Maybe this company isn't going to grow its revenues the way we thought they might. Maybe the turnaround is going to years instead of quarters. Maybe the end result is one where they settle for survival rather than a second act of categorical dominance.
I honestly don't know how it's all going to play out. Retail analysts are re-writing expectations for future sales. I doubt even the company itself can confidently project what sort of quantitative effect the turnaround strategy will have on either the top or bottom lines.
I do know one thing, however. Companies that aren't growing shouldn't command large multiples.
And this definitely got a little crazy. Up at $45, the stock was trading at around 20x forward earnings and almost 15x the $3/share the company earned in 2012, which everyone understood would be a high watermark of sorts.
See, part of the turnaround strategy involves fewer stores.
If you think about it, a business like Best Buy has two dials. The first is the number of stores. Each new store in each new market will add to the top and bottom lines. This is growth, simple and pure. But this dial got turned about as far as it'll go. 2012 was Peak Best Buy.
The second dial is profitability per store. This dial is substantially more difficult to turn. Any chump CEO can turn that first crank. But raising margins in each location is tricky business. After the Q4 numbers, investors are clearly less optimistic about how long it'll take before this translates to the bottom line or if it'll even work at all.
That question of net income is the biggest reason they're in this whole turnaround strategy anyway.
Margins in 2013 were pretty depressing. I think we all understood from the get-go that the 6-7% EBITDA margins of yore would never be recaptured, or at least not for a long, long time. Maybe something in the 4-5% range is a better target, in between the glory days and the murk here in the middle of the turnaround.
I updated my basic DCF analysis, which is admittedly tricky with Best Buy given the lack of clarity not just about top line revenues but also what sort of margins to expect. Seriously, do you have any clue what operating margins are going to look like? It's a whole new ballgame for this company. So take this with the requisite grain of salt.
This model assumes that the top line doesn't grow and that EBITDA margins ultimately trend back towards 4% in a few years.
When you think about it, not much has changed since this time last year. Why should it have? The new operational strategy wasn't just a 2013 thing; it was a next decade thing. The stock still has a fair value somewhere in the mid 20's.
The only reason that's worth pointing out is because of what's happened with the stock during the same period. This time last year the stock was undervalued and we were anchoring our expectations to the years before where the stock was going straight down, non-stop. Today it's fairly valued but we've anchored our expectations to last month when the stock was sky high by comparison.
You can do a crude reverse Graham analysis and come up with something similar.
Even if you tweak your assumptions, it's tough to make a case that the stock is anything better than just fairly valued right here. It's only cheap if you believe that their EPS is really gonna grow and after the latest earnings announcement, I'm not sure how many rational people are still on board with that idea.
We can also look at the simple metrics of the present.
In the best of times, BBY traded around 0.6x sales. In the last few years, it's been down around 0.25x sales. That sounds low, but keep in mind this company isn't growing, and a well-established big box retailer like Target who is trades only around 0.5x sales.
What kind of earnings multiple do you want to hang on Best Buy? Even if the turnaround effort is successful, I'm not convinced it deserves a market PE. Something closer to 10-12x is probably more fair, and it's traded mostly in the 9-11x range in the post-2008 years. Wal-Mart and Target each trade at slightly richer levels, but honestly, they deserve it. Those companies are at least GDP stocks and I'm not convinced that Best Buy is. The latest trend in revenue certainly hasn't done anything to convince the planet otherwise.
And once again, here we are at fair value. The stock is trading in the mid 20's and earnings for next year should come in somewhere a little above $2/share. EPS growth is going to be slow, too, so unless you're in this stock for the really long haul or you are convinced that the analyst community and market is wrong and that Best Buy really is going to grow those earnings back to the $3+ range and the stock deserves a market multiple, there's not a whole lot here that's compelling. It gets a great big "meh," which ordinarily isn't worth pointing out but in situations like this, a common response is for investors to wonder if the dip warrants a buy.
In this case, I think it clearly doesn't. Don't buy this dip. And if you're long and got caught in the downdraft, be realistic about the hope you harbor that it'll get back to where it was. Stocks trading at fair value still contain plenty of downside.
There could easily be another 10-20% lower here. All the momentum is gone. The overall trend in revenue will stay lower as long as they keep closing stores. And as the latest data indicate, the long-term turnaround isn't going to produce short-term results. Not only is total revenue dropping, but same store sales and profitability are also suspect.
One of the greatest psychological sins we commit as investors is to anchor our expectations to improper and misleading data points. Yes, Best Buy traded north of $40/share. It's clear it had no business being there, though. Just as the median home shouldn't have been selling for four times the median income in 2005 and Citigroup should never have sported $230 of book value per share in early 2007. (Ha! "book" value)
In this business we get so hung up on the past. Past performance. The last year's earnings. Last month's prices. None of this really matters for Best Buy anymore. The business of tomorrow won't look like it did yesterday.
How to Play It
If you do want to play Best Buy or if you're one of those investors who bought the stock last year, ignored all the fundamental analysis, and rode the momentum for a little bit too long, there are still some things you can do. If you simply can't bring yourself to sell, at least get active with some enhancement strategies.
The good news is that the options on Best Buy arekiller right now. The January ATM calls are as of this writing giving you 2.13% for just the next three days. If you want to write something out in February, you can earn around 5%! That's an annualized return of around 57.9%.
Seriously, check out the results from our option calculator (subscribers only)
How much did you pay for Best Buy? $30? $35? Do this for a few months and you might be able to get a meaningful chunk of your losses back. If you're long, you may as well take advantage of the fear and uncertainty. Don't just sit there shell-shocked.
Especially given what we just discussed about what the valuation ought to be and what kind of future the stock has in store. A pragmatic, active strategy like this is a much better way to get your losses back than simply hanging onto the stock and hoping for the magic to return.
If that sort of thing sounds interesting to you, here's a little more information. We write about this kind of stuff every week. Full Disclosure: Best Buy isn't in any of the model portfolios we run right now, but really, it'd be a good candidate here given what the stock just went through.
Generally speaking, I prefer to own stocks that I feel are undervalued and work the options on them to lower my cost basis and/or enhance my returns. But honestly, there's not a whole lot here in the U.S. that's super attractive on a valuation basis. Sometimes fair value is the best you can ask for.
Look, the future for Best Buy is unclear. But that isn't so bad. You don't have to sit there clueless. You can understand the valuation realistically, adopt a proper strategy, and use the volatility to employ some short-term tactics.
Don't hope for the market you want. Take advantage of the market that is.
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.