Electronics retailer Best Buy (BBY) experienced a significant decline in earnings quality for Q3 2011.
Financial Statements: The most striking observation of our analysis is the deterioration in Q-to-Q line-item changes and weak quarterly comparison to median average changes over our seven period study.
Below we have listed some of relationships which caught our attention. Note: numbers in paranthes are references to data in our report which can be viewed here.
Accounts Receivable: Q3 receivables spiked 64% versus a 4.9% rise in sales. During the similar period last year, receivables grew 48% compared to a 9.1% rise in sales. Considering the competitive nature of consumer retail electronics, seasonal spikes in receivables are not unusual.
However, retailers are getting savvier to collection cycles as it is the final step to cash. Thus, we were surprised to see days-sales-outstanding (number of days to collect on a receivable) get stretched by 30% (approx. 2 days) in the latest period as compared to last year. Two days might seem trifle, but for every day not paid, earnings yield suffers.
Inventory: BBY Q3 ended Nov. 27. Inventory builds heading into holiday sales are typical. In the latest quarter, inventory levels grew 58.6%, almost identical to last year. But, as a % of sales, recent Q3 levels were a lofty 84.6%, compared to 74.7% the prior year.
Accounts Payable: This is what concerns us the most. Recent quarter payables grew 60.5% versus 54.8% the prior year. But, sales last year were 1% higher than sales in the recent period.
Cash-flow: Our dual cash-flow indicators suggest that BBY's operating cash levels are settling into a bearish trend. Although the overall confirmed trend remains modestly bullish, recent downtrend is most severe of the seven periods reviewed.
Negative dual cash-flow ratios are the first sign of weakening earnings quality. More importantly, it indicates a diminished contribution from actual operating cash flow to support an earnings report.
Accruals: Surprisingly, BBY's accrual picture is the most positive aspect in this report. Despite the weak operating environment, we give BBY good marks for not pulling a lot of non-cash levers to make their numbers.
For example: Excessive reliance on non-cash adjustments combined with deteriorating operating cash flows...would have us eyeing the exit signs.
Revenue Metrics & Capital Productivity: On the margin side of the equation, operating expenses were the biggest headwind in the recent period. As for capital productivity per-dollar-of-sales, inventory and receivables put a 45% dent in asset returns, approximately 34 cents of each dollar in sales.
Conclusion: We encourage investors to avoid building a case for or against a stock based solely on one or two peculiar aspects of a financial statement. Rather, view the "picture" in its entirety and evaluate the sum of its parts.
To be sure, a little smoke can become a big fire. However, knowing where the dots are connected and the strength of their relationships to each other, investors will have plenty of solid clues to make profitable investment decisions.
BBY is a well managed company competing in a challenging retail environment. They face price competition from WalMart (WMT) and a consumer who would love to buy a big screen TV, but either can't afford it or bought it at WMT.
The point here is when you connect all the dots to the BBY story, it tells you this:
- Slowing sales momentum
- Challenges to asset returns
- Inability to recycle capital efficiently
- Potential for declining earnings yields
- Erosion of capital reserves
- Competitive environment
Shares are currently trading about 18% above our fair value estimate of $30.
Any pullback to this area or below would likely provide a good entry point for value buyers. Traders may find opportunities in the low to mid-30's.
With Circuit City out of the picture, Wal-Mart (WMT) is the main threat to BBY profits and margins. Consumers are definitely focused on value, but they also realize convenience and access to decent customer service can sometimes be a reasonable alternative to traveling further just to save a few bucks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
