Best Buy - The Retail Store Defying Gravity (What Goes Up Must Come Down)

Summary

• Since Jan. 1, 2016, BBY stock price has more than doubled (as of Aug. 25, 2017).
• Best Buy has beaten the Street's expectations in past quarters -- will they do it again on Aug. 29?
• While the company has cut their expenses to a minimum and made shareholders happy, I see another RadioShack story going on.

What would you tell me if I offered you the opportunity to invest in a stock that has doubled in value since Jan. 1, 2016, (as of Aug. 25) and has doubled its dividend payouts over the past five years -- and that is trading at a P/E of 17 in this crazy market? This is the recent Best Buy (NYSE:BBY) fairy tale:

But do you really buy that? At a time when Amazon (AMZN) is making the world of retail shake, Best Buy defies gravity with stronger sales and earnings and beats analysts' expectation along the way. However, the more I think about it, the more I smell a burnt transistor in the storage room. I really think the BBY story will end up like RadioShack.

Understanding the Business

Best Buy is an electronic store. It sells a wide range of technology products from smartphones to TVs, gaming consoles, computers, etc. Best Buys operates 1,026 stores and 309 mobile standalone stores in the U.S. It has also an international presence, including 134 stores (+53 mobile) in Canada and 20 stores in Mexico. Best Buy is strong in North America due to its broad presence and brand name. However, it can't do much in terms of product diversification. What is the difference between the iPhone 7 you buy from Best Buy and the one you buy online from Amazon? Yeah … exactly.

Revenues

Don't be fooled by the "huge drop" of revenue from 2012 to 2014. This is because BBY decided to sell the rest of their international division and solely keep the North American stores (in Canada, the U.S., and Mexico). Since then, revenues have not been going anywhere. When the market gets super excited about 1.6% growth in sales when it expected a drop of 1.5%, you know something is wrong.

I understand this "performance" translates into a strong statement against the internet juggernaut, but we're talking about a 1.6% increase. What if it was just temporary and BBY sales fail to meet expectations next week? I'd guess BBY could lose 10% of its value in a heartbeat.

Earnings

Similar to what happened to BBY's revenue between 2012 and 2014, the EPS after the restructuring period is fairly stable. Management has concentrated its effort on cutting costs in its "Renew Blue" program. After cutting $1.35 billion (see the 2017 annual report, pg. 8) and making BBY a more lean and flexible beast, management believes there is still room for improvement. I hope so, as margins don't seem to have expanded much over the years.

I don't see how Best Buy can expand margins in such an environment. After the RadioShack collapse, mass merchants and online companies have grabbed most of that market share. Since then, Best Buy has been battling every quarter against behemoths like Costco (COST), Wal-Mart (WMT) and Amazon (AMZN).

Dividend Growth Perspective

Best Buy has successfully increased its dividend for the past 14 consecutive years, making it part of the Dividend Achievers Index. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least 10 consecutive years. At the time this article was written, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

While the dividend increase has been modest for several years, BBY has aggressively become generous with shareholders since 2012. The company doubled its dividend payment (from $0.17/share quarterly to $0.34), but also threw in two special dividends of $0.74 and $0.73 during the same period. When you look at BBY's dividend profile, it's hard to not fall in love:

Even better, both payout and cash payout ratios are well under control at 31% and 22%, respectively:

This is a great example of a possible mistake you can make when you look at the past, but forget you live in the present and you invest for the future. The past is that BBY has successfully restructured its business model and rewarded its shareholders. The present is BBY facing lots of competition on all fronts. And the future remains quite uncertain when you think about the lack of differentiation Best Buy offers compared to its competitors.

Potential Downsides

Well, I have three words to start with: techno goods + Amazon. Need I say more? As I previously mentioned, competition in this sector is coming from everywhere. The problem with Best Buy is that most of their stuff can be found at multiple locations (including online -- especially online), and there isn't much incentive to take my car and drive down to the store to buy the same thing online. Therefore, this situation screams for a price war where margins will hurt.

For now, Best Buy has been able to minimize this impact due to a few factors such as their high volume of clients in store. Many customers still want to see their TV before they buy it. I get that. I also understand the interest for the Geek Squad offering face-to-face service. However, I don't think this is enough to keep the "New Blue" on top of the food chain.

Plus, while Best Buy online sales increase, this is not exactly good news. More online sales mean fewer extra warranty sales. You know, the thing the salesman keeps referring to once you have a box in your hand? This doesn't happen too much online. I really think it's about time to get off the boat and start looking for other buying opportunities.

Valuation

For the last segment of this article, I will go through a valuation analysis for BBY. First, let's take a look at BBY's 10-year history:

As you can see, BBY isn't trading at a high valuation compared to the rest of the market. This might lead you to the conclusion that there's still time to jump on that train. But I'm telling you it will fall off the cliff soon. Let's look at the Dividend Discount Model:

Input Descriptions for 15-Cell Matrix	Inputs
Enter Recent Annual Dividend Payment:	$1.36
Enter Expected Dividend Growth Rate Years 1-10:	9.00%
Enter Expected Terminal Dividend Growth Rate:	6.00%
Enter Discount Rate:	10.00%
	Discount Rate (Horizontal)
Margin of Safety	9.00%	10.00%	11.00%
20% Premium	$73.98	$55.00	$43.63
10% Premium	$67.82	$50.42	$40.00
Intrinsic Value	$61.65	$45.83	$36.36
10% Discount	$55.49	$41.25	$32.73
20% Discount	$49.32	$36.67	$29.09

Click to enlarge

Please read the Dividend Discount Model limitations to fully understand my calculations.

As you can see, BBY could lose 25% of its value according to my valuation model. You could argue that I used a 10% discount rate, but I think that's only fair considering the current market situation. Plus, I've been more than generous in terms of dividend growth rates. At best, BBY is fairly valued (a discount rate of 9%), but I wouldn't take that bet.

Final Thought

I'm sorry, but I just don't buy it. In the 2017 annual report, management tells shareholders Best Buy will focus on becoming their customers' trusted adviser:

As we look ahead, our purpose is to help customers pursue their passions and enrich their lives with the help of technology. We want to play two roles for them: be their trusted adviser and solution provider; and be their source for technology services for their home.

Is it me or does this sound like RadioShack?

The company's knowledgeable sales associates and brand position, 'You've Got Questions, We've Got Answers,' support RadioShack's mission to demystify technology in every neighborhood in America.

If you want to know about the retail stock to buy now, I just wrote an article about it for my Marketplace service Dividend Growth Rocks. If you like my analysis, click on "Follow" at the top of the article near my name. That will allow my articles to display on your homepage as they are published.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.