After being one of the best stocks in the S&P 500 in 2013, Best Buy (NYSE:BBY) has had a pretty miserable 2014 with shares dropping from $40 to $25. Results from the Holidays raised concerns that Amazon (NASDAQ:AMZN) continues to take share from Best Buy, forcing the company to aggressively discount items. It hasn't helped that discount retailers like Wal-Mart (NYSE:WMT) have also pushed into this already crowded space. However on Thursday morning, Best Buy reported its quarterly results, and while they were far from perfect, this quarter shows that Best Buy isn't dead yet. In fact, the company may be able to carve a niche in an increasingly challenging brick and mortar environment.
In the company's fiscal first quarter, Best Buy earned $0.33 on $9.03 billion in sales while the market was looking for $0.20 on $9.2 billion (all financial and operating data available here). Revenue was down 3.4% year over year, which isn't great but better than the decline in some previous quarters. Shares were trading 5% higher as investors digested these results. Overall, same store sales fell by 1.3% domestically. International has been a mess with comps dropping 5.8%. Best Buy is restructuring this unit and can hopefully stabilize it by the end of the year. Right now, I expect international to be a drag for the rest of the fiscal year. On the bright side, Best Buy's push into online retail has worked out well. While the company is still reliant on traditional stores, its website is providing some incremental revenue and online sales jumped 29.2% year over year.
The fact is that being a brick and mortar retailer is a lot tougher with competition from online retailers and the price transparency of the internet. Best Buy's store sales are not going to return to pre-crisis levels. The key is to maintain profitability at a lower revenue rate by cutting costs and running a highly efficient operation. On this front, Best Buy has made substantial progress. Even though revenue fell year over year, operating income margins grew to 2.3% from 2.0%. With further cost cutting and the closure of underperforming stores, I still think that 3% is a reasonable target, which would significantly increase profits even with revenue struggling.
Best Buy's cost cutting has been focused on SG&A, which fell from $1.98 billion to $1.82 billion. As a percentage of revenue, SG&A fell to 20.1% from 21.2%. This cost cutting plan, known as "Renew Blue" has significantly boosted profitability and margins. Now, it was disheartening to see another decline in gross margins to 22.4% from 23.1%. Gross margins are indicative of a company's pricing power, and Best Buy continues to have less than it once did. To avoid being Amazon's showroom, Best Buy has to meet the best price, which is negative for margins.
Further gross margin erosion is the biggest risk to the Best Buy story, and a decline below 20% would be truly catastrophic. Cuts to SG&A have been offsetting the shrinking gross margin, but that is not a tenable long term strategy. Best Buy management expects mild same-store declines in the next two quarters, which makes the holiday quarter even more important. Investors need to focus on gross margins and see if it can stabilize in the coming quarters. If it does, Best Buy could have significant upside, otherwise there may be appreciable downside.
Therefore, Best Buy has cut costs to improve operating margins even at a lower revenue level. On the other hand, shrinking gross margins show how little pricing power Best Buy has. Basically, Best Buy is strong enough to survive, but it isn't thriving. Cost cuts and a push online are making its business model tenable, but pricing and lackluster demand are still a challenge. With cost cutting, I believe Best Buy can still generate operating income of $2.50-$3.00 this year. At 10x earnings, Best Buy is factoring in the downside risk, and it is better to buy than short Best Buy at current levels.
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.