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Whatever anyone says, Best Buy (NYSE:BBY) still has a monopoly--on the fondling of all classes of electronics in one location. With Best Buy's 1,103 domestic stores and its 326 Best Buy Mobile stores, they have a sizable advantage.

With the drama of an ousted CEO, a parting founder, a lousy TV market, a poor video game market, and increased competitive pressure from Amazon (NASDAQ:AMZN) and other retailers, Best Buy shares are selling at a handsome discount: about 5 times free-cash-flow. That represents a return of 20%--if, and only if, Best Buy can maintain or improve its position.

Competitive Position

It is frequently repeated that Best Buy is Amazon's show room, implying that people look at products at Best Buy and purchase them on Amazon. But the relationship also works in the other direction, reading reviews on Amazon and purchasing in Best Buy. Therefore, such statements don't help us investors. That being said, Best Buy is working to end "show-rooming."

A lot has been said regarding Amazon's sales tax advantage (in some states) and the prevalence of price shopping with smart-phones in store. Both of those things may be true (for now), but people do not always buy goods at the lowest price. Many shoppers won't price shop and frequently price differences are immaterial. More importantly, Best Buy price-matches at some locations. Psychologically speaking, Best Buy's advantage rests on the fact that shoppers can be directed by sales staff, fondle a product, and then walk out the door with it without having to wait for its arrival by mail.

Apparently, there is also a misconception that Best Buy is losing market share. Mike Vitelli (President, United States - Enterprise EVP) said the following at the shareholder meeting Thursday morning in response to the question "why are you losing market share?":

We use NPD, a leading company that provides consumer and retail information; we use that, many of our competitors and suppliers use that, and they have told us, and Mike mentioned it earlier, that we have not lost share. We actually gained share last year. We have maintained our number one share in the leading industry categories of computing, of television and cameras; and gained, importantly, in very rapidly growing categories which are very important to our consumer: smart phones, tablets, e-readers, and a category we put some focus on, appliances. We have grown our market share in all those areas and maintained our leading position...We are focused on and we have gained share in the online industry. (Shareholder Meeting, June 21st, 2012; starting at 31:05)

Best Buy's advantage is its tangible stores, but the value they bring to the analysis is largely intangible. It is the ability of patrons to go into a store and see and feel the technology they wish to purchase.

Is convergence a problem?

Convergence is the idea that fewer gadgets will do more things, and therefore we will need fewer gadgets, to the detriment of Best Buy. Best Buy has long competed in one of the few industries where deflation is typical. Thus far Best Buy has adjusted itself to the changing times. For example, Best Buy started selling mobile phones when they became widespread. Best Buy is an electronics retailer and is not limited in what it specifically sells. In fact, we probably can't accurately predict what it will sell in the future.

Is their weak online presence a problem?

Best Buy's domestic online sales grew by 13% last year, bested only by their sales growth in China (about 15%). While I cannot answer this question myself, if they succeed in making their online sales more effective, in addition to leveraging their stores for pick-up, they could have a large advantage. Other than that, Amazon probably beats the pants off of them. For instance, Amazon's "electronics and general other merchandise" has grown at 60% year-over-year since 2009. The only problem for us analysts is what counts as "general other merchandise"? Hence, getting accurate data on Amazon's success in the electronics market has been difficult, although some data suggests that they have increased market share in some specific electronic markets, such as LCD TVs.

International Presence (25.8% of Revenue)

Best Buy's international sales have been growing at 3.9% since 2009, boosted by their Five Star retailers in China and offset by the European segment (the latter was the catalyst for their latest impairment charge). As noted recently by the Wall Street Journal, China's emerging middle class is entering the electronics market for the first time. This could benefit Best Buy via Five Star.

China's appliance subsidies expired at the end of 2011, which made China same-store comparable sales drop significantly (28%) in Q1 2013. However, Best Buy management expects this to improve as the year progresses. As a long term investor, the end of subsidies means a more sustainable consumer.

Apple (NASDAQ:AAPL) Stores

Apple stores are not a happy sight for a Best Buy retailer, they would much rather have a monopoly on the sale of Apple products. That being said, because many people use Apple products in addition to products of other brands, such as Microsoft's (NASDAQ:MSFT) Windows, Best Buy serves the customers of both groups. To me, this is a win. Some of these people will fall into status-quo bias and continue to use Best Buy more frequently than Apple simply because they go there for their other electronic gadgets. Besides, with Microsoft's Windows 8 and the prospect of a Windows tablet (in addition to new Xbox games this fall), Best Buy stands to gain.

That said, Apple electronics accounted for 19% of all electronics sold in the last holiday season, according to NPD Group. Such a market share helps the retail of both Best Buy and Apple stores, but helps Apple more. Further, the success of Apple stores has driven Microsoft to experiment with the concept itself. Such a move by Microsoft could be a more decisive blow to Best Buy than Apple alone.

Comparable Same Store Sales Declines and Strategy

Yes, this is the headline grabber: Best Buy same store sales down 1.7% (and 5.3% Q1 fiscal 2013 against Q1 fiscal 2012). Actually, it's worse because fiscal 2012 included a 53rd week. The same store sales declines are where we find our quantitative signal that Best Buy's strategy needs revision. Conversely, overall revenue was up 1.9%.

However, part of Best Buy's strategy is their new Mobile stores. To wit, some scuttlebutt research concluded that is "practically" where all their profits arise. According to their fiscal 2012 10-K, sales from their new stores, which are mostly Best Buy Mobiles, directly offset the loss in same-store comparable sales.

For those who do not know:

Revenue from U.S. Best Buy Mobile stand-alone stores is primarily derived from mobile phone hardware, subscription service commissions from mobile phone network operators and associated mobile phone accessories (Best Buy 10-K Fiscal 2012, p. 6).

And further:

In our Domestic segment, our current store development strategy is focused on increasing our retail points of presence, while decreasing our overall store square footage, for increased flexibility in a multi-channel environment. This includes our plans to remodel existing key stores in test markets with our new "Connected Store" format in fiscal 2013, as well as increasing the number of small-format Best Buy Mobile stand-alone stores. We announced plans to close approximately 50 large-format Best Buy branded stores in the U.S. in fiscal 2013 and explore options for downsizing other stores throughout our portfolio (Best Buy 10-K Fiscal 2012, p. 8; emphasis added).

They increased their Best Buy Mobile count by 128 stores in fiscal 2012 to 305. At the end of Q1, there were 326 Best Buy Mobiles.

Best Buy Mobile is accounted for under Best Buy's "Computer and Mobile Phones" category which had comparable same store sales growth of 6% and represented 40% of sales revenue in fiscal 2012, up from 37% in 2011. The increase was due to tablets and mobile phones, partially off-set by decreased notebook sales. These numbers suggest, superficially, that their new strategy is working.

Conclusion

Are Best Buy shares undervalued below $20 a share? If they maintain their free-cash-flow, yes. Do they have a margin of safety? Yes, I believe that there is a margin of safety at and below $20. If they were valued at only 10 times free-cash-flow they would be still be priced around $40. Around and under $20 leaves a good deal of room for error. Further:

  1. it appears they are executing their new strategy successfully;
  2. they have no "direct" electronics retail competitors besides Apple stores;
  3. Amazon and Wal-Mart will take some market share, sure, but I don't believe they can eliminate traditional electronics-only retail;
  4. their average capital expenditures are only slightly greater than half of adjusted net income and are typically less than depreciation--or rather, their free-cash-flow is nearly double their average capital expenditure; and
  5. with smaller stores come smaller capital expenditure.

The biggest question marks are: Will Best Buy remain favorable with suppliers? Can the Wal-Marts, Targets, and Costco's (NASDAQ:COST) take more market share without offering sales expertise and more varied product offerings? And, will Best Buy Mobile continue to be successful? How will the global economy develop in the near term?

Their competitors offer an experience different than the one at Best Buy, and further, the experience which is available at Best Buy, I believe, would be missed if it were removed from the American experience overnight. Their increase in sales in China is a bright spot for Best Buy. China has, after all, four times as many people as the domestic United States (and 20% of the LCD TV market last quarter). Even a small capture of this developing market will be a boon to a Best Buy shareholder.

Also, they have been repurchasing shares: about $1.2 billion and $1.5 billion, in fiscal 2011 and fiscal 2012 respectively. Their diluted share count has decreased from 427 million at the end of fiscal 2011 to 342 million on March 5, 2012, a decrease of 20%. In the first quarter they purchased $115 million dollars' worth of shares at $25 a share. Hopefully, they have been purchasing more while their share price is favorable. In theory, if they're able to keep up their present rate of free-cash-flow, they would be getting 20% return on their share repurchases. That would be an effective use of capital.

Hopefully share repurchases are moving forward while their shares languish.

Source: The Future Of Best Buy