- Best Buy is going through one of the most challenging tests of its existence;
- A more detailed analysis tells us that the negative sentiment has been partially amplified by non recurrent items related with selling international assets at a loss;
- The company is on its way to complete a streamlining plan that, if successful, will significantly improve the current situation of the company;
- The normalized earnings suggest that the stock returns might be high.
Best buy (NYSE:BBY) is a multi-channel retailer of technology products. It operates via location based stores and through online distribution. Its main competitors are traditional store based retailers, other multi-channel retailers and internet based vendors.
The main competitive advantage possessed by Best Buy is the widespread store presence and the logistics that accompany it. At the same time, the same giant network of stores might be considered a weakness. The fixed costs of maintaining such a structure are huge when compared to the spartan costs of online retailers.
However, BBY does possess more competitive advantages. One example is the differentiated buying experience. Usually, when buying technology products, consumers tend to be unsure and afraid of not correctly assessing the use of the product they're about to buy. In this case, the buying experience in a store, with the advice of sales staff, is completely different from the adventurous lonely experience of buying online. It is my belief that there will always be consumers wanting to buy from specialized retail stores. But even for this strength there is a weakness, analysts fear that Best Buy's stores might become showrooms for internet retailers. Consumers go to the store, try the product and then order it from Amazon (NASDAQ:AMZN) or another online retailer.
No doubt that the online retailers are taking a dent on Best Buy's sales. At the same time that Amazon has been able to increase its sales during the last 3 years, BBY is selling less than it used to sell 3 years ago. With a huge structure in place, this means shrinking profit margins.
The previous diagnostic is what you can easily find in a couple of selected news about Best Buy's current situation. There is nothing fundamentally wrong with it; the only problem is that it is incomplete. The company is having problems in selling its products and that needs to be addressed, no doubt about it. However, the yearly losses that the company suffered in 2011 and 2012 also have another explanation. The lower sales (even after allowing for inventory write-downs) should have resulted in lower margins, not necessarily in two consecutive years of losses.
The main reason for the big losses lies on operating losses, goodwill impairments, restructuring charges and loss on the sale of assets like: large-format Best Buy stores in China and Turkey, Napster, MindSHIFT and Best Buy Europe (source: BBY 10K). Altogether, since 2011, these items totaled over 4 Billion in non-recurrent items.
Table 1 - Non-recurrent items (2013-2011)
These are mainly non-cash items. Obviously, this means the previous management made lousy choices in some of the investment decisions. However, this does not mean that Best Buy has gone from a successful business model to an economically unviable organization. The company did lose some grip to the market, but apart from lower margins and some non-recurrent items, BBY has everything in place to successfully recover.
Management's Turnaround Strategy
In 2012, Hubert Joly entered the company to take the CEO post. At the same time, Best Buy started the Renew Blue turnaround initiative (you can take a better look at the Renew Blue initiative here). Basically, the strategy is based on correcting the show rooming syndrome, through price competitiveness, and increase online sales through leveraging the brick and mortar stores. If the company presents a price as good as the price on the cheapest retailer, there is no reason for the customer to go buy that item elsewhere. On the other hand, if every store becomes a logistic warehouse for online sales, then it should be possible to reduce the delivery time and increase overall efficiency.
In my opinion, this strategy makes a lot of sense. It is based on some very simple principles and it is far from being rocket science. I also believe that Best Buy is using the negative moment to perform some accounting book's cleaning, which is further contributing to the negative market sentiment.
Price Drop Spells Opportunity
So far we have seen the current situation of the company, let us now look at the stock price.
Graph 1 - Stock Price Evolution 2010 to date (Source: Google Finance)
Since 2010, the company's stock price has sunk 40%. Clearly, the market has incorporated the negative developments into the stock price. Now, having seen what the company's management is doing, let's see how this can translate into a normalized income statement:
Table 2 - Normalized earnings after turnaround
I used the 2011 year as baseline for the normalized earnings. I believe this to be a conservative baseline, in the case of a successful turnaround. If the company is able to achieve these results, we can conservatively value it at 12 times earnings, around $48 per share, or an appreciation around 85% to the present price of $25.95.
The WCGW (What Can Go Wrong)
So far we have seen the overall situation, the management's strategy and the expected outcome if things go well. However, prudence demands us to understand the possible risks in this investment.
- Price competitiveness: Competing through price with companies which have a lower fixed cost base, might reveal troublesome. It might also contribute to a permanent shrinking of the profit margin;
- The inability to grow online sales will impede the dilution of the fixed costs with brick and mortar stores (i.e. inability to manage costs given the revenue stream);
- A permanent shift in the consumers' preferences towards online shopping might result in permanent loss of sales in the location based stores;
From the most likely to the least likely, in my opinion, these constitute the major threats to the Best Buy's turnaround.
I have stated the case in favor of Best Buy. I believe the company possesses a setup of resources and competences that will allow it to perform a successful turnaround. My view is that at the current price, the prospective stockholder might benefit dearly from it. However, there are some risks in the turnaround execution; it is your call to understand if the risk reward relation is worth it.