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Best Buy: The Drop in Profit in Q2 Does Not Signal Permanent Business Impairment

September 14, 2011 | About:
Throughout the economic downturn, the biggest electronics retailer in the U.S. had performed quite well because shoppers are very eager to look for new smart phones and notebook computers as long as they have been released and are on the shelves. However, yesterday, Best Buy (BBY) announced second quarter results. With a disappointing profit decline of 30%, the sales missed Wall Street estimates and the company’s executive lowered the forecast for new smart phones and notebooks as more customers are shopping at online retailers, discount stores and specialty chains.

On the conference call with investors for second quarter, Brian Dunn mentioned the company’s focus on the strategy to drive three key elements: financial strength and flexibility; the unique multi-channel approach to connect wherever and whenever people shop; and to optimize the scale to drive growth through new categories and new store formats, and to gain share in key categories.

For tfinancial strength, Best Buy has generated much more cash in the second quarter with more than $2 billion of cash on hand. The free cash flow was US$1.1 billion for the first half. And it is thinking about a share repurchase plan. The executive team has a target of buying back approximately $1.5 billion for fiscal year 2012. The company continues to see positive momentum from its investments in the two hottest consumer electronics products: tablets and mobile phones. The biggest driver in growth is in tablets, along with iPad sales.

The second strategic point is the multi-channel approach to serving customers’ needs. The executive of Best Buy is happy to see the continued double-digit revenue they have been experiencing, and they are moving into new digital capabilities. With the launch of Best Buy Marketplace, they are able to attract 800 million visits a year to Best Buy's e-commerce site. And the recipient of commission on each Marketplace sale would generate more incremental income to the bottom line. In addition, customers can choose the option of picking up their online order in stores. For the second quarter, in-store pickup accounted for over $40 million of domestic online sales volume.

Truly, the traditional retailers of electronics are moving more into online retailing, reducing the level of leases, but it prefers to keep both models. As the CEO has commented: "This world isn't moving to a place where it's digital all by itself or physical all by itself. Neither alone will be sufficient. What we firmly and fanatically believe is that where those things come together is in multi-channel so you can be where the customer needs you to be, wants you to be, when they need you there."

The third is to optimize the scale to drive growth. Brian thought the greatest differentiators are the service business. The new Geek Squad Tech Support can offer customers one or two years' comprehensive computer service via chat, store visit, phone, email, a vivid multi-channel sample.

The second quarter results are below original expectations, but the executive team has seen the business has fared comparatively well in the context of current macro and industry headwinds. The sales were flat comparing to last year. And the favorable impact of foreign currency and new store growth has been offset by a decline in comparable store sales of 2.8%. In this quarter, the product category worth noting is the e-readers, the category that delivered triple-digit comps again and lifted the domestic segment up.

With the lower sales situation in the second quarter, the executive team has taken action to reduce expenses while maintaining focus areas. The modest increase year on year in SG&A was because of new stores and an increase in advertising. However, excluding FX, total SG&A expense was essentially flat. For leases, almost 40% of total leases would be expired over the next five years, so the company has the opportunity to execute a portion of planned space reductions at the natural end of the lease, which is quite cost effective. Best Buy is actively pursuing options of both sublease and return space to landlords where it has opportunities. The management estimates that they would work with landlords on around 30 store locations, and they expect to reduce space over 50% of these locations to achieve total square foot reduction of 10% to 15% against the entire tranche of 30 stores.

It seems like it fell short on the short-term expectation, but the management has been doing everything it can to keep it focus on both the traditional distribution and digital distribution, creating more value for the shoppers. Looking back at its profitability and cash flow over the last 10 years, it is quite stable. It has 10 year of positive profitability, with average of 20% return on equity. And 9 out of 10 years it has had positive free cash flow. If we want to take the average of the 10 years, the FCF per share is around $2 a share. With the current price of $23 a share, it represents a free cash flow yield of 8.7%.

In conclusion, as the main item is electronics, it would face a lot of fierce competition from online retailers. It is mostly dependent on how the management plays out in the tough game of balancing the multi-channel approach for the shoppers to gain more and more customers, gain more revenue and grow the bottom line as well as free cash flow.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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