My valuation shows that Best Buy (NYSE:BBY) is worth $49/share. But, it really took it on the chin last week. After closing at $37.57 on January 15, it fell 29% the next day on 14 times its 3-month average daily volume. I attribute this beating to the company's failure to meet expectations reported during the last hour of trading on January 15 that same stores sales would be up 0.5%. The following morning, the company reported sales were down 0.9% and the stock was predictably crushed.
I think the market's overreaction provides an excellent opportunity to buy this well-run company at a 50% discount.
Best Buy's Profitability Is Higher
But before getting into the details of my valuation, let's briefly look at the progress the company has made since hiring Hubert Joly as its new CEO in September, 2012. Comparing the year ended 2/3/13 with the trailing 12 months, TTM, ended 11/2/13, the adjusted operating margin increased 41% and return on capital, ROC, increased 32%. Plus, Best Buy is back to earning more than its cost of capital, COC.
Adjusted Pre-Tax Operating Margin
Return on Capital
Cost of Capital
Yr. ending 2/2/13
TTM ending 11/2/13
To get a better idea of its operating income, I capitalized Best Buy's operating leases which increased its EBIT by $311 million for the year ended 2/2/13 and by $485 million for the TTM ended 11/2/13. Since goodwill impairment is a non-cash expense and not tax deductible, I added back the $822 million charge for both periods. COC includes the capitalized operating leases.
Best Buy's Game Plan
To assess Best Buy's potential, I first looked at Joly's stated game plan in November, 2012. The key points are listed below:
- Top priority-online retailing.
- Domestic online sales of 6% in 2011 could grow to 15%.
- Share of the $30B online electronics and appliance market could grow from 6.2% to 18% -- same as its share of the brick and mortar market.
- Best Buy had the largest share of total market as a whole-16% vs. Amazon's (NASDAQ:AMZN) 4% and Wal-Mart's (NYSE:WMT) 15%.
- Potential to increase ROC. Said peak was 16.8%.
- Tight rein on spending - Sales, General and Administrative (SG&A) expenses.
- Only 1.3% of online visits turned into sales vs. 40% of in-store visits (600 million visits annually). An increase of just one percentage point is worth $200 million in profit.
- Renew Blue
- Reverse declining same store sales.
- Reverse declining operating margins.
- Redesigned store formats and new product mix.
- Renew Blue
Based on Best Buy's business segments, geographical areas of operation, capital structure and using 2.82% as the risk-free rate, I estimated the initial COC at 9.24%.
I used its average effective tax rate of 35% for the first 5 years, gradually increasing it over the next 5 to the US marginal tax rate of 40%.
For the growth drivers, I estimated the compound annual growth or CAGR in sales, target pre-tax operating margin in year 10 and reinvestment rate.
I don't believe Best Buy can increase its share of the online market to 18% -- Amazon's was 21% in 2012. Instead I assumed its share would double to 12.4% and that online sales would be 15% of its domestic sales. This will require taking market share. But Joly mentioned during last week's conference call that Best Buy had gained share even though its overall industry had contracted 2%.
To estimate the size of the online market 5 years from now, I looked at the trend in Amazon's North American sales of electronics and general merchandise as reported in its SEC filings. Amazon's sales were up 74% in 2010, 57% in 2011, 34% in 2012 and 28.6% in the TTM. So, the CAGR is -29.2%. This lead to the following expectations for the size of the online market:
Assuming Best Buy doubled its online market share to 12.4% in FY 2019, its online domestic sales would be $8.4B and total domestic sales, $55.9B. If domestic sales remained 84% of total sales, total sales in FY 2019 would be $66.5B. With TTM sales of $48.6B, the expected CAGR is 6.2%.
Since Best Buy's sales are still leveling off, I assumed only 3% growth in FY 2015. I allowed sales to grow 6.2% for the next 4 years resulting in sales of $63.6B in FY 2019 instead of $66.5B. Then I gradually reduced the growth rate over the next 5 years to 2.82%, the long-term growth rate of the US economy which I set equal to the current 10-year bond rate.
During the TTM, Best Buy's SG&A was 20.6% of sales - lower than the 21.0% in FY 2013, but much higher than in fiscal years 2007 and 2008 when it was 18.8% and 18.5%, respectively.
Given Joly's intent to reduce SG&A, I assumed it would only be 19% of sales by year 10, FY 2024. Had SG&A been 19% for the TTM, Best Buy's adjusted pre-tax operating margin would have been 5.32%. I used 5.32% as my target because I think the current price-cutting environment will persist. For perspective, had SG&A been 19% during the past 8 years, Best Buy's average adjusted pre-tax operating margin would have been 5.69%. In fact, it would have exceeded 6% in FY 2011 and 2012. So, my target is not unreasonable.
Finally, to estimate the expected reinvestment required to grow the business, I looked at Best Buy's normalized sales to capital ratio based on the change in sales from FY 2007 to 2012 vs. the actual reinvestment in FY 2006 to 2011. It was 2.43. To estimate its sales to capital for its online business, I used Amazon's current figure of 11.6. So, for Best Buy's sales to capital ratio I used 3.8:
Sales to Capital = 15% x 11.6 + 85% x 2.43 = 3.8
Currently, Best Buy's reinvestment rate is negative because it is still closing stores and reducing working capital. However, to grow, it will have to invest. The 3% sales growth rate for FY 2015 implies reinvestment of $383 million in FY 2015, which is reasonable considering the company's recent history.
So, the growth driving assumptions are:
- Sales growth of 3% in FY 2015, sales growth of 6.2% for FY 2016-2019, then a gradual decline to 2.8% in FY 2024, with 2.8% growth thereafter.
- Target pre-tax operating margin of 5.32% in FY 2024.
- Sales to capital ratio of 3.8.
Based on my valuation, I expect sales to grow from $50.0B in FY 2015 (year 1) to $78.0B in FY 2024 (year 10). My sales projections are shown in the graph below. Sales in the terminal year are $80.2B. Realistic? Yes.
In November 2012, Joly stated that Best Buy's share of its total market was 16%. Sales for FY 2013 were $50.0B, so the market was $312B. Assuming the market was $312B last year and grew 2% a year starting in FY 2015 continuing through FY 2025, it would grow to $388B and Best Buy's share would have to be 20.7%, which is not unreasonable.
I expect growth in after-tax operating income to come largely from new investments, but efficiency growth will still be an important driver especially as the margin increases and sales growth declines.
New Investments Contribution
But, Can Best Buy Do It?
Yes. Best Buy has several things in its favor that it is just beginning to leverage.
First, it has over 1000 stores which it has just started using as fulfillment centers with its "Ship from Store" program. This enables it to provide next day or even same day delivery for less.
Second, though it matches Amazon's free shipping on orders over $25, there is no reason it can't copy Amazon Prime, offering free 2-day delivery for an annual fee. This would provide another source of revenue and its stores have the potential to reduce its fulfillment costs. Neither is reflected in my valuation.
It has data on over 50 million customers and is only now beginning to mine those data to provide target recommendations like Amazon coupled with coupons. The company expects to fully exploit this potential next holiday season.
Finally, it is reinvigorating its Geek Squad, which I expect is much higher margin than its product sales and is not included in my valuation.