When it comes to most purchases, a lower price means a better deal. In the stock market, however, investors are often spooked by falling prices and may even sell their shares for no reason other than the stock price going down. This is not entirely irrational. The price of a stock reflects the common wisdom of a crowd and if a lot of people think they are witnessing some trend, they may be on to something. The tricky thing is to detect when the stock price is being affected by its own momentum rather than fundamentals of the underlying business, and it is trickier still to determine when the price trend changes course.
History and Outlook
I believe that Best Buy’s (BBY) stock has become a victim of its own price momentum and that patient investors will be rewarded for going against the grain. First a brief look at Best Buy’s history: Best Buy has increased its revenue every year for the last ten years. The company was profitable all those years, with earnings growing every year apart from 2003 and 2008. In fiscal year 2011, earnings per share fell slightly on a GAAP basis and rose on an adjusted basis.
There is no denying that Best Buy’s rapid growth is screeching to a halt. The company has already had the one time benefit of seeing its largest competitor, Circuit City, go into bankruptcy and is now faced with formidable competition from online retailers (most notably Amazon - AMZN) as well as larger merchants (e.g. Wal-Mart - WMT and Costco - COST).
Additionally, increased consumer preference for digital delivery of music and video content takes a chunk out of Best Buy’s business. Management is reacting to this changed reality by opening smaller Best Buy Mobile stores, increasing the emphasis on online sales and leveraging the advantages they have over the competitions, such as Geek Squad Services.
Taking everything into account, it seems that Best Buy’s days of conquering are over, but a collapse of the business does not appear to be imminent. Management is expecting revenue growth of 1-4% in the coming year and earnings per diluted share of $3.28 to $3.53, compared to $3.10 last year.
Valuation
The share price has fallen by over a third since last November and continues its relentless slide after the earnings announcement on March 24. At yesterday’s closing price (28.15), the shares are trading at a trailing P/E ratio of 9.1, a forward P/E of 7.6, based on average analyst estimates, and its enterprise value is a mere 3.65 times EBITDA. The company is active in returning capital to shareholders, having purchased 8% of previously outstanding shares of the company during fiscal 2011 and its dividends yielding a decent 2.1%.
Options Strategy
As compelling as the valuation may be, picking a bottom in the stock price is hard to do. An alternative to buying the shares outright is to sell put options. For instance, put options with a strike price of 28, expiring on May 20, most recently traded at 1.19 per share.
A seller of these options will acquire the shares at expiration if they are trading under 28 at that time. In this case, the effective purchase price would be 26.96 per share, 4.2% under the current price. If the shares stay above 28, the options will expire worthless and the option seller will pocket the 1.19 per share – not a bad return for a month and a half.
Disclosure: I am long BBY.
