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Best Buy's Best Days Are Ahead

|Includes:AMZN, Best Buy Co. (BBY), WMT

Where to start?

Best Buy is going out of business, not one person shops in physical stores anymore, prices are uncompetitive, electronics are over, our Amazon overlords will dictate how we shop in the future...

A Starting Point

Best Buy had very good earnings in its most recent fiscal year. Adjusting for non-cash charges of goodwill, Best Buy made $3.64 per share. The reason I'm using non-GAAP numbers in this case is due to the non-cash nature of the 'losses'. Basically, the 'losses' consisted solely of changing one number to a lower number---- no cash was lost, no debts created. Just a number change, for accounting purposes.

Combined with a balance sheet with no net debt, Best Buy is in a very strong financial position.

Best Buy has forecast $2.85-3.25 in earnings for 2013 after taking into account restructuring costs related to the closure of stores. (In this case, the 'losses' are real, so need to be reflected in investors' minds.)

Founder and Chairman Richard Schulze, a 20% owner of BBY, is a huge benefit to the company. Having built the company and retained a huge interest in BBY, he's not going to let the company fall by the wayside.

Recent Past

Best Buy used to sell a ton of CD's and DVD's. Then came iTunes and Netflix, who took most of that market in the early and mid-2000's. That segment is not coming back. Digital is here to stay. Best Buy lost that market midway through the last decade--- it can't lose it again. The 2012 performance is a fair metric of what the future will look like.

Best Buy used to sell a ton of $2,000 flat-panel televisions. The average cost of a flat panel is about a third of what it was just a handful of years ago. So, Best Buy has to sell three $650 televisions to come up with the revenue and earnings of one $2,000 tv. The vast majority of the 'average sales price decline' is over. Even if the $650 television drops to $500, BBY only loses $150 of revenue--- not the $1,350 it lost in the prior years. The 2012 performance is a fair metric of what the future looks like, though softness in the television market is likely to persist.

(LCD tv makers are merging at a fast clip, to stem losses from unprofitable LCD television businesses. This may stop the LCD price decline but investors should not rely on it.)

Amazon, The Internet and Showrooming

There is so much information (and misinformation) about Amazon versus Best Buy that its difficult to know where to start. How about some facts:

BBY had $2,527 million in free cash flow in 2012; Amazon had $2,092 million in free cash flow in 2012.

BBY's recent market capitalization: $8 Billion; AMZN's recent market capitalization: $87 Billion.

Best Buy actually does have a website (www.bestbuy.com). Best Buy has a large online business (it is an internet retailer!).

Amazon gets a huge price advantage by avoiding charging sales taxes. In 2011, Amazon had to charge sales tax in states with a combined population of 34 million people. By the end of 2012, that number will jump to 117 million people! Most of that is CA, but Indiana and a number of other states will enforce sales tax laws. Average state tax rate of 6.5%, which will crush AMZN's price advantage.

Amazon does not have an inherent price advantage. Unlike Walmart versus Target, Amazon does not get products at a discount price to Best Buy. At all times, Best Buy has the option to match prices. So, there's no structural pricing advantage at Amazon. If, or when, the state tax issue has been addressed nationwide, Amazon will lose any structural advantage versus Best Buy.

FedEx and UPS have announced price increases between 7-8% for shipping packages. Those higher prices will either affect online prices or pinch online retailers' earnings.

Showrooming is a concept that affects few people. Most people are not dissuaded from paying $10 more and having a product in-hand to play with, rather than buying online and waiting 2-4 days to play with it. Some people do this; some people 'extreme coupon'; but somehow, media/bloggers/investors have convinced others that this fringe behavior is mainstream. Personal showrooming stories are interesting, but only the cheapest of the cheap waste a couple days waiting for a ten dollar savings (or less!).

BBY has not allocated capital the best in the past. Have you seen those electronics vending machines in airports that have thousands of dollars of inventory not to mention the huge cost for the machines? Management overestimated the value of convenience there and hopefully has learned from its mistakes.

The Future

With a subheading like this, I must have something really great up my sleeve. Well, to burst that bubble, I don't.

Best Buy is investing in Mobile (cell phones), with the idea that cell phones have a strong future in people's lives. That's a fair assumption, in my mind.

Best Buy is clearing out extra floor space from the CD/DVD days by moving into smaller stores and closing larger stores. It's expensive to close store and open new ones. Management had better be confident about this switch, since it's so expensive.

Best Buy is focusing on a combined internet/bricks and mortar strategy, where people can buy products online and pick up in-store same day. Customers can also return any product to Best Buy stores. After a lot of thought on this issue, I think that any retailer (AMZN included) will ultimately have a two-pronged strategy like this. Think internet retailer, without return hassles and the benefit of getting something same day. Reportedly Amazon has already tried this via partnership with 7-Eleven.

Best Buy will get some benefit from Amazon charging sales taxes in the new areas. Probably not a huge boost, but some benefit.

Electronics prices will continue to fall. This is likely, but the rate of price decline is likely to flatten. As a result, small volume gains will offset price declines, unlike the $2,000 tv and three $650 tv's example. Best Buy will benefit from any price stability.

New game consoles (Xbox and Playstation) are coming out in calendar year 2014. New gaming technology tends to benefit BBY significantly, as BBY sells consoles, games and accessories. With two major hardware releases in the same year, Best Buy will get a boost from increased traffic and sales. Too difficult to suggest a number on the benefit here, but clearly some benefit.

Value

Finally, here's the main question for investors--- what's it worth? Assuming $3/share is a fair future value for earnings and no net debt, BBY has an intrinsic value in the $40-45 range currently. The largest threat to BBY is really the current negative press related to its operations, most of which is inaccurate or misinterpreted (see above).

If an investor (activist or private equity) came in to maximize free cash flow, BBY could generate $4/share or more in annual free cash flow. In that scenario, the intrinsic value rises past $50 per share.

Regardless of anything else, Richard Schulze's presence as founder/chairman and 20% equity-owner should make shareholders happy. He's been silently behind the scenes, but I'm confident he'll ensure that BBY is primed for the future.

Disclosure: I am long BBY.

Stocks: BBY, AMZN, WMT