In this three-part series (part I, part II), I have been making the argument that if we can get comfortable with Best Buy's (BBY) competitive position and future prospects, the current valuation (an 18% normalized free cash flow yield) presents itself as an extraordinary investment opportunity. I will now discuss what some commentators regard as the greatest danger to Best Buy: Amazon.com (AMZN).
The Amazon Threat
Online retailers-of which Amazon.com is by far the most important one-have indisputably gained market share in the retailing of various products sold by Best Buy. Most alarmingly for Best Buy, Amazon has grown in this area at a breakneck pace, with no sign of abating.
Amazon reports its revenues in two product categories, "Media" and "Electronics and other general merchandise." The latter category includes not just electronics, but things like diapers, pet food, shoes - everything non-media sold by Amazon. However, I infer from statements by the Consumer Electronics Association that about 2/3 of the category is electronics. All figures below are in millions of dollars and relate to Amazon's U.S.-sales only.
|Est. Amazon electronics sales||944||1,249||1,715||2,599||3,659||5,148||7,923||44.7%|
|Total U.S. electronics sales (including appliances)||95,468||102,698||109,541||113,448||112,528||103,532||110,894||1.5%|
|Amazon market share||1.0%||1.2%||1.6%||2.3%||3.3%||5.0%||7.1%|
|Source: Company filings, Department of Commerce|
To state the obvious, we know with certainty that over the long run, Amazon's market share in electronics overall will be greater than 0%, but less than 100%. We also know that notwithstanding Amazon's impressive trajectory in recent years, a component (Amazon) cannot forever outpace the aggregate (the electronics industry). The question, then, is at what level of market share Amazon's growth will plateau to the industry's long-term growth rate (say, 2.5%), and when the leveling off will occur.
In order to put the question into perspective, however, it is worth sensitizing Best Buy's future value against a range of potential outcomes. Doing so demonstrates that the threat from Amazon is more than priced into the stock at $24/share, and that the truly dangerous outcomes from Best Buy's perspective (market share above 30%, within just a few years) would require growth rates at Amazon that defy common sense. In short, in order for Best Buy to be worth less than $25, Amazon would need to grow its electronics business at 60%/year for the next 4 years, or 27%/year for the next 8 years. I would gladly take the other side of that bet.
Why Amazon Will Not Dominate the Electronics Market as It Has in Books
With the above analysis as a backdrop, I would bet against Amazon maintaining more than 20% market share in electronics over the long run, for the following reasons:
- Electronics are inherently less conducive to online commerce than are books (in some ways the archetype of online commerce disrupting traditional retail);
- Amazon's market share in books has stabilized around 30%;
- Moreover, Best Buy has been considerably more successful at executing its online business than Amazon's bookselling rivals ever were;
- Therefore, I expect Amazon's market share in electronics to ultimately stabilize at a significantly lower level than its market share in books.
I will provide some motivations for buying into this view.
First, it should be uncontroversial that not all retail categories are equally vulnerable to online competition. In general, whether the Internet puts the bricks-and-mortar retailer out of business should be a function of how much consumers value-and are willing to pay for-the respective experiential and economic characteristics of each channel, in a given product category.
In the case of bookselling, for example, the convenience and breadth of assortment available online has, if not destroyed the bricks-and-mortar model altogether, certainly made it less profitable. On the other hand, online retailing of most clothing has yet to take off on a comparably widespread scale, and perhaps never will, given the importance to consumers of physical contact with clothing before purchase.
Directionally speaking, electronics sales should migrate to the Internet to a lesser extent than has taken place in books, if the relative merits of shopping in stores versus online are greater in the case of electronics than in the case of books. The contrast shows up in the numbers: even though Amazon has been active in the electronics market since 1999, the story of Best Buy in the last decade looks very different from the story of booksellers.
|Same-store sales (indexed to 2000)|
|U.S. retail sales (bricks and mortar)*||100||103||106||111||119||127||135||140||143||134||121||1.9%|
|Barnes & Noble (BKS)||100||103||106||109||113||116||116||118||111||106||107||0.7%|
|Source: Company filings, Department of Commerce|
Admittedly, the electronics and appliances market that Best Buy serves is much larger (by a factor of seven) than is the book market. But, in a sense, that enormous scale only reinforces my point: it makes it less likely that Amazon will achieve a market share of the same magnitude that it has in books.
Why are books so much more conducive to online commerce than are electronics? In my view, online bookselling has several important things going for it that cannot be said of electronics.
Purchasing behavior. Books are generally a casual purchase - small-ticket items that put relatively little value at risk to the customer. A book will not malfunction and need to be returned. A book is something that the mailman can leave on one's doorstep without much concern. A book is, in these respects, more amenable to an online purchase than, say, a television. (According to figures cited by the Wall Street Journal, Amazon's share of the LCD TV market in 2010 was under 4%.) An electronics device is something the customer is more likely to want to examine physically before purchase than a book.
Customer service. In a typical bookstore, the role of sales personnel is generally limited to helping customers locate a title, the need for which obviously vanishes once the transaction goes online. In this respect, the value proposition of a store like Best Buy - where sales personnel provide guidance on how to serve the customer's needs and can even provide technical support services after the purchase - is more compelling than that of a store like Barnes & Noble.
Seasonality. As noted earlier, electronics are somewhat seasonal, but not to the extent that are toys-or books. Seasonality implies that a large proportion of total purchases are gifts. It is telling that Amazon's market share in books consistently spikes in the fourth quarter, suggesting that consumers' preference for Amazon over bricks-and-mortar booksellers is greatest when they are purchasing gifts. It is easy to imagine why this might be: for example, purchasing a book on Amazon makes shipping it to the ultimate recipient very easy.
In any case, clearly one of the drivers of Amazon's market share in books is related to the seasonality of the category. Consumer electronics is less seasonal a category, depriving Amazon in electronics of some of the relative strength it possesses in books.
Does a Weak Consumer Environment Make Best Buy a Bad Investment?
Before wrapping up, I will spend a moment discussing a final concern that may be giving Best Buy's stock a whiff of undesirability among market participants: the impact of a weak consumer environment on Best Buy's earnings.
Throughout the economic downturn, Best Buy has never had a year of declining sales. Still, same-store sales experienced small declines in 2008 and 2010 (-1.3% and -1.8%, respectively); and in both cases, the announcement precipitated huge declines in Best Buy's stock price. In my view, while such announcements possess some measure of materiality, the Wall Street fixation on same-store sales is one of the more egregious expressions of the short-term thinking that creates value opportunities.
Indeed, the market's swift negative reaction to Best Buy's declining same-store sales in the past two quarters, which specifically reflected weak TV sales, simply exaggerates the importance of TV sales to Best Buy's earnings. By my estimate, TVs represent about 18% of sales; more importantly, they surely contribute less than 18% of gross profit dollars, because gross margins on TVs are likely lower than Best Buy's average. Supposing that TV sales decline at an annual rate of, say, 20% (to pick a draconian number), then Best Buy faces an annual loss of less than 4% of its gross profit dollars (-20% x 18%) - a number that will get smaller as TV sales become a smaller contributor to sales.
Put into proper perspective, the issue of TV sales over the long run barely breaches what one might call the "materiality threshold." The trend that has characterized the consumer electronics retailing business for decades has been that as gross profit dollars associated with one product or technology decline, they are more than made up for by gross profit dollars associated with a new product or technology. Much has been made of the fact that it is not, at present, completely clear which new product(s) will drive incremental gross profit dollars going forward. Analysts have been disappointed in the performance of tablets and 3-D televisions, for example, which clearly creates some short-term uncertainty. Short-term uncertainty, however, is not evidence of an industry in secular decline.
Best Buy's business model clearly supports a free cash flow run rate of about $1.6 billion. This number could be off by $100-$200 million, plus or minus, but the margin of error is well within the bounds of Best Buy's current discount to fair value in the market. We also know with a strong degree of certainty how Best Buy has deployed its free cash flow in the past; and all of the company's recent actions and statements suggest that the pattern of shareholder-friendly capital allocation will continue.
Moreover, while the focus of this discussion has been on negating the bear case against Best Buy, there are additional potential sources of upside that I have not even discussed. Best Buy plans to double its Five Star stores in China, which could generate an additional $2 billion of revenues. BestBuy.com does $2.5 billion in sales, and has been growing at over 30% per year for the past four years. Best Buy enjoys a dominant, entrenched position in a growing market. RadioShack (RSH), with sales of nearly $5 billion, is in many ways a disaster, and Best Buy Mobile stores (whose number is growing rapidly) compete directly with RadioShack. These are all directionally positive things for Best Buy.
If one can get comfortable rejecting the idea that Best Buy is a troubled company facing secular degradation of its earning power, the value opportunity should be clear: companies that are not troubled do not stay priced at 18% free cash flow yields forever.
In closing, I would certainly buy Best Buy at current prices, with a view to selling at $45.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (I'm in something of a liquidity crisis at the moment.) P.S.: Hire me.