With Best Buy (BBY) admitting that it lost market share in a few categories this quarter (TVs, mobile computing, gaming software) that more than made up for market share gains in other categories (wireless), there have been a slew of media and analyst reports discussing the demise of Big Blue, along with a host of analyst downgrades (almost always a bottoming sign!). The most common comment I have seen is that Best Buy is being beat by discounters and on line retailers that can undercut them on price. This will inevitably continue, apparently, because it is the natural order of retailers to succumb to Wal-Mart (WMT), Amazon (AMZN) and others.
I see some problems with this notion. First, it's not even remotely a new idea.
In the 10+ years I have been analyzing and trading Best Buy stock, this concern has been a constant refrain, usually to no avail. The reality is that Best Buy has tended to lose some share when the product upgrade cycle is weak, as it is now, and tends to gain it back (and then some, as evidenced by its long term share growth) when the cycle is strong. While new TV technologies such as 3D have seen slow adoption this year, that is not surprising given the major upgrade cycle TVs just went through and the fact that consumers have remained financially constrained.
However, this weak cycle has not just begun, but has been ongoing for several quarters, masked by market share gains Best Buy was still accruing from the exit of Circuit City. It will eventually end as well, probably with the recovery in consumer spending that (hopefully) will come next year.
Meanwhile, Best Buy is not likely to stand still. To some extent, I believe Best Buy's weaker results in 3Q were self-inflicted as it mis-read demand. If consumers were looking to buy cheaper TVs and were responding strongly to deep value marketing, there is no reason Best Buy couldn't have accommodated them. It appears that Best Buy went after a consumer that just wasn't there. Bundling offers work great in giving value at good margin to select customers, but if consumers were looking for something else (i.e., 32" TV at a low price), it really doesn't help to drive demand overall. Some of these issues are product-related and can be resolved immediately, such as a larger supply of iPads (AAPL) that is allowing Best Buy to sell them on line already in December.
Other areas such as promotions and discounts can be adjusted, such as going after more 32" TV business in December as the company said it would. This is not necessarily "bad margin" business either. Best Buy sell more TVs than anyone in the country. Is it possible they really don't get a price as good or better than anyone else as well? Increased promotional financing also looked to be an underused competitive weapon at Best Buy. What happened to 0% financing on anything over $500 or even $300? Best Buy mentioned they plan to be more aggressive here as well.
Overlooked in this report is the fact that Best Buy's gross margins will hit a 15-year (perhaps all time?) higher this year. Ironically, margin pressure concerns were what caused the stock's sell off earlier this year. While some of the margin gain BBY is seeing appears cyclical and more related to product mix, some of it (i.e.., gains from greater attachment of services) is likely structural and should remain even when the product cycle re-accelerates. Higher margins means sustainable higher cash flow and the all the financial stability and capital allocation opportunities that go with it.
Perhaps the biggest issue that remains longer term is what to do with the middle of the store, or packaged media, given the secular decline the industry is showing in this space. This, also, is not a new issue as the company has been struggling with it the last couple years. A small part of the solution is the used games business, which also helps attract more core gamers. The used games business is still in its infancy at Best Buy, but once the methodology is perfected, you can expect them to scale the changes rapidly. Another replacement for packaged media has to be more services and connections. These are at the heart of why customers come to Best Buy and are a key differentiator. These are also high-margin sales, which support continued margin growth even if it is with fewer sales dollars (initially at least).
What other strategy possibilities or environmental opportunities could there be for Best Buy's domestic business? Clearly, more than I could think of or write here. One idea that comes to mind is more product exclusives, such as the new Nexus smartphone. Best Buy is still by far the largest CE retailer in the industry and with Apple spreading its dominance in different product areas, it makes sense that Best Buy should more than ever be able to use its size as both a carrot and stick with manufacturers. Related to this, Best Buy is likely to continue its private label expansion where it can, allowing it to target under served areas of the market while capturing more margin. Another opportunity, albeit one somewhat out of their control, would be the slow shrink of industry wireless stores, both third party players that can't compete with BBY's and RSH's phone offers as well as fewer wireless carrier owned stores. The latter seems increasingly likely given the rising dominance of multi-branded wireless retailers as consumers show a preference for this type of shopping.
VALUATION: Trading way below takeout levels. Beyond all these arguments and hypothesis, valuation alone should tell investors BBY is being unduly punished by short term factors. BBY is trading at a P/E under 10.5x this year's consensus EPS forecast, which you would assume has little risk given the haircut BBY just took to its guidance. On next year's forecast, the P/E is only 9.5x. This is well below the average retailer currently at 14x and well below the company's 10-year CAGR in EPS at 15% (stock buyback alone should be 5%-7% accretive next year).
In early September, I wrote an article about Best Buy entitled The Case for a $20-Billion Takeover. Since then, the stock ran up to $45 and is now back down close to where it was. However, even with the haircut to earnings forecasts, the stock is still even cheaper than it was then, trading at only 4.3x 2010 EBITDA. While I don't recommend buying a stock solely on takeover potential, this article still seems quite appropriate and worth another look.
The takeover argument is even more relevant now that we have actually seen some private equity buyouts the last couple of months. Gymboree (GYMB) was recently bought at 6.8x its EBITDA and JCG is being sold for at least 8.6x. Arguably, the BBY global brand is far more valuable than either of these. At 6.8x-8.6x, the takeout price would be $57-$72 (up 65%-108%). So while a deal this size may be difficult for one PE firm to swallow, there is clearly enough room in the premium to find a level well worth it for both shareholders and the PE firms to be quite happy.
