Best Buy's Eroding Competitive Advantages

When I ask men to name their favorite store, the answer is almost always Home Depot, Lowes, or Best Buy. Companies that are so beloved usually have strong competitive advantages. The term “usually” is emphasized because it is not always the case—Borders was a beloved store by book readers and is now out of business.

Home Depot and Lowes have strong competitive advantages, while Best Buy’s are eroding in a remarkably similar way to Borders.

Home Depot and Lowes are often the largest home improvement stores in their city and carry the largest selection, which gives them the advantage of scale. Similarly, Best Buy has the advantage of being the largest brick and mortar source for electronics in most cities. Borders also had the advantage of being as big as or bigger than all of its competitor’s stores.

The other advantage Home Depot, Lowes, and Best Buy share is locality. If you have a Home Depot five minutes away, you are unlikely to drive a half hour away to another store. And if Best Buy is the closest place to pick up a new television, computer, or Ipad, they will likely get your business. However, Borders was also the nearest bookstore for many people before it went bankrupt.

In other words, scale and locality can be very weak competitive advantages.

Online Sales

The main difference between being a large home improvement retailer and a large electronics retailer is online sales. Most people are very unlikely to buy their wood, front doors, windows, paint, or washer/dryer online. And if people do search for hardware or home improvement products online, it is very likely they are going to Home Depot or Lowe’s websites.

Best Buy faces a much different competitive market online. You can buy a Hewlett-Packard computer through HP’s website, Amazon, or a number of other online sellers. You can also see what other customers think of the product through their reviews.

You no longer have to go to Best Buy to purchase DVDs because you can get them through dozens of online sellers or watch them on NetFlix. You can buy a blu-ray player or camera online at a discount. Televisions and appliances are the two things Best Buy sells that many people are less likely to purchase online. If Best Buy wants to be the number one seller of electronics and electronics related products, they need to focus on dominating online sales for their products.

I recently purchased an HP desktop from HP’s website. I double checked Best Buy to see if they sell it cheaper, but the prices were identical. In all honesty, I would have ordered it from Best Buy if they merely threw in a free $10 DVD of my choice. The DVD wouldn’t have cost much to Best Buy and they would have made hundreds off the profit of the computer. Throwing in a free DVD with expensive purchases is not a panacea to Best Buy’s online challenges—the point is that they should consider focusing on increasing online sales today even if it hurts margins in the short-term. If they develop a strong market share the profits will eventually follow. That, of course, has always been the strategy of Amazon and has made it remarkably successful. Best Buy is already very late to the game with video streaming and online music—huge growing markets that directly compete with DVD and CD sales at Best Buy.

Product Prices and Technology

Another contrast between home improvement retail and electronics retail is that the prices of electronics are more volatile. You can find very good desktops for your home for under $600 today. The prices of televisions fluctuate with new technologies and competition. Blu-ray players can now be bought for under $100. Low-end cameras and camcorders are becoming obsolete due to camera phones.

Despite the challenges of changing technology and prices, Best Buy has been successful in the past and could be in the future. Sometimes change is good because you weed out the weak sellers for new growth opportunities. Right now mobile phones and tablet computers are growing rapidly and can fuel sales.

Best Buy’s Competitors Killed Borders

Best Buy’s main competitor a few years ago was Circuit City. Circuit City went from being the largest electronics retailer to being bankrupt in a short period of time. When Circuit City went bankrupt analysts expected Best Buy to reap huge benefits—their number one competitor, who often had stores very close to Best Buy’s, was no longer going to take business from them. Common sense would say Best Buy would benefit. Best Buy, however, did not see a significant increase in business. In fact, they have been struggling to grow same-store sales and profits. They are also facing a fast-growing competitor in HH Gregg.

Similar to Circuit City, the bookstore chain Borders was the second largest book retailer in the country and went bankrupt. Borders and Circuit City were slow to adjust to the changing competitive landscape and couldn’t profitably compete. One of the biggest challenges Borders faced was that best-sellers, their fastest selling books, were being sold at huge discounts at places like Kmart, Wal-Mart, Target, Sam’s Club, Costco, and BJ’s (the same competitors Best Buy faces).

Borders also faced strong competition from Amazon and other online sellers of books. Borders, in fact, outsourced their online sales to Amazon for many years, which turned out to be a huge strategic mistake since it strengthened Amazon and prevented Borders from developing a strong online business. Many people blame e-books and the Kindle for killing Borders, but Borders was losing money before the Kindle was released. The Kindle just accelerated the inevitable.

Best Buy shares the same competitive struggles that Borders faced. Best Buy, in other words, has a very weak competitive advantage over their competition. This does not mean that Best Buy cannot remain profitable or even grow their profitability; however, it does mean that it will be very challenging for them to do so. As an investor in Best Buy you are placing a huge bet on management to implement a good strategy going forward. Borders bankruptcy is a testament to what happens when management makes a few missteps in strategy when faced with tough competition.

Growth Opportunities

Best Buy has growth opportunities, but they are challenging and not predictable with any degree of certainty. Growing internationally is one strategy management has expressed interest in, although they recently decided to leave China and the UK after a dismal few years of experimenting. However, Best Buy does have a presence in China through FiveStar stores and in the UK through The Carphone Warehouse. Best Buy Mobile is an area management has expressed interest in growing as well.

Management at Best Buy has decided to reduce the square footage of the average Best Buy stores, which may or may not be good news. On the one hand it is probably the right step; on the other hand it is an admission that same store sales are probably going to struggle.

Management has committed to repurchasing $5 billion worth of shares (about half of all shares outstanding at today’s price), which alone will increase EPS significantly even if Net Income remains flat. Best Buy currently sells at roughly 8 times this year’s expected EPS, which may or may not be cheap. It is cheap by historical standards, but Net Income was not flat in the past. If Best Buy can gives some sign that they are serious about becoming the dominant site for electronics and electronics related products, the stock would deserve a higher valuation.

The stock is depressed right now and management may be wisely repurchasing shares at these prices, but if the stock goes higher management needs to consider using their $1 billion in annual free cash flow to invest in their online business. If Netflix shares struggle, an acquisition for their streaming business would regularly bring millions of people to Best Buy’s website—giving them the online presence they need. That would likely create much more value for shareholder’s than share repurchases.

Best Buy is a beloved company. They have great products and excellent service. The question for investors is whether or not Best Buy management can beat the competition. They beat Circuit City, but they are playing in a whole different league today against the people that bankrupted Borders.

I know exactly what Home Depot and Lowes will be selling ten years from now. No one knows what the inside of a Best Buy will look like in ten years or what products they will be selling—and that, to an investor, is frightening. If Best Buy doesn’t gain a strong online business to complement their brick and mortar stores they will likely struggle.

Disclosure: I am long HPQ.

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