Best Buy (BBY, Financial) is quickly being rendered obsolete by online retailers like Amazon.com (AMZN, Financial). At least that’s what the headlines would have you believe. Best Buy’s recent quarterly results (same store sales declined 2.8%) and lowered guidance seem to lend credence to the “Best Buy is on its way out” line of thinking.
This negative sentiment has pushed down the share price of BBY and the stock now appears on GuruFocus’ Low P/S Screener. Some gurus also see value in Best Buy. David Einhorn has 4.62% of his fund in BBY and Bill Nygren has 1.94% of his in BBY. Other investors with smaller positions include John Hussman, David Dreman, Joel Greenblatt, Mark Hillman, and Leon Cooperman.
It’s easy to see why Best Buy looks like an attractive investment at first. The company has consistently generated positive EPS and free cash flow.
Gross margins and operating margins have been relatively stable for the past ten years. Operating margins have begun to decline lately but some of that is due to strategic choices by Best Buy (such as expanding the services offered by Geek Squad).
Best Buy has also posted respectable returns on assets and capital for a retailer, with the key phrase being “for a retailer.” Compared to all other businesses, BBY’s ROA and ROC are average or slightly below average.
While the past looks good there is no guarantee the future will be another 10 years of similar great performance. The company faces competition on almost all fronts. Just about every major retailer carries product lines that compete against Best Buy. Some of the stiffest competition comes from online retailers like Amazon.com which due to lower costs can undercut Best Buy on price. Additionally, the market share of online sales has been growing and most of this growth has gone to Amazon. In other hardlines such as TVs and appliances Best Buy faces competition from much larger retailers such as Walmart (WMT, Financial).
Best Buy has responded to these threats with what looks like two distinct strategies. The first strategy is to focus on services or product lines that would be difficult for an online retailer to replicate. This includes focusing on value added services like Geek Squad and retailing large item such as appliances. The second part of the strategy seems to be to take Amazon head on with the BestBuy.com website.
BestBuy.com
This quarter Best Buy announced that it was allowing third party resellers on to BestBuy.com in an effort to attract more traffic and customers. The new website will allow users to browse both third party items and BestBuy items on the same website and purchase both types of items using one checkout procedure. This arrangement is estimated to add about one third more SKUs to BestBuy’s online store.
Geek Squad
BBY is focused on expanding its Geek Squad services. The company will now begin offering (for a fee of course) comprehensive computer support on products for one to two years after the date of purchase. Geek Squad also offers a plethora of other services including TV installation, home theater set up, electronics repair, car stereo and GPS installation, and small and major appliance repairs. If I was an investor in BBY, Geek Squad, is the portion of the company I would be most enthused about as it is something that would be extremely difficult and perhaps impossible for an online retailer to replicate. As the service matures and expands it is also something that has the possibility of giving Best Buy somewhat of a moat.
Focusing on Appliances
Compared to computers and computer equipment and media, appliances are a category that has seen one of the lowest market share losses to online sales. Indeed, same store sales for appliances were up 12% this quarter and were positive for last year as well. This is one area where Best Buy should not face much competition from Amazon and other online retailers.
Magnolia Home Theater
Best Buy is also expanding its Magnolia Home Theater centers. Currently they are in 385 U.S. stores. This product line was the other rare bright spot with double digit comps this quarter. As with Geek Squad, advice in selecting high end audio equipment and help installing it is another point of differentiation over online only retailers.
Gaming
Best Buy remodeled their gaming area and also began accepting used game trade-ins for store credit for the past few quarters. Best Buy’s used game program is going up against a similar program at Walmart and the 800 lb used-game gorilla, GameStop. GameStop’s management has commented that it has not seen any affect on used game trade-ins at its stores that are near BestBuy stores that offer game trade-ins. Additionally, used game sales continue to remain strong at GameStop. Of course GameStop’s management might be a bit biased and I might be as well since we are long GameStop.
The reason for being pessimistic about Best Buy’s foray into used games is that managing a used game trade-in business is more difficult than you might think. It takes a sophisticated inventory management, pricing, and distribution system to redistribute inventory across all stores to ensure adequate levels of popular titles at each store. Pricing is another variable that is difficult to get right as prices must be managed to entice owner to trade-in games but still allow enough margin for the company to ensure a profit. Finally, companies entering the used game business on a large scale need adequate facilities to test and refurbish all trade-ins. Many retailers, including Best Buy and Walmart, have failed repeatedly to break in the used-game business. Until proven otherwise it might be safe for investors to assume the latest used game venture will end the same way the previous ones have.
Right Sizing Stores
Best Buy plans to reduce the square footage in some of its stores including a 10% to 15% reduction in 30 stores this year. The company plans to sub lease excess space or return it to landlords. This cost cutting should help improve margins but it could also be viewed as a harbinger that management believes sales in some of the company’s segments may have slowed permanently.
Summary
There are reasons to be optimistic about Best Buy but there are also plenty of reasons to be pessimistic. Best Buy certainly doesn’t face the same fate as recently defunct Circuit City since Best Buy has a much better balance sheet. The company has $2.2 billion in cash versus $3.6B in long term liabilities including $1.7 billion in long term debt. To be clear we are discussing business slowing down at Best Buy, not a catastrophic drop in sales. After all, BBY generated $1.5 billion in free cash flow over the past 12 months and management is projecting free cash flow of over $2 billion for the latest fiscal year. Taking into account a global economy that looks to be slowing and intense competition, there are more attractive candidates on GuruFocus’ screeners.
Disclosure: Strubel Investment Management and/or its clients are long GME
The Buffett-Munger screener is designed to find Buffett-type investments with extraordinary profitability, consistency, and future prospects. Our monthly Buffett-Munger Best Bargains Newsletter picks one stock from the screener. Our in-depth analysis shares with you why a younger Buffett and Munger would like this stock. If you are a premium member, you can download it here. If you are not, we invite you for a 7-day Free Trial.
This negative sentiment has pushed down the share price of BBY and the stock now appears on GuruFocus’ Low P/S Screener. Some gurus also see value in Best Buy. David Einhorn has 4.62% of his fund in BBY and Bill Nygren has 1.94% of his in BBY. Other investors with smaller positions include John Hussman, David Dreman, Joel Greenblatt, Mark Hillman, and Leon Cooperman.
It’s easy to see why Best Buy looks like an attractive investment at first. The company has consistently generated positive EPS and free cash flow.
Gross margins and operating margins have been relatively stable for the past ten years. Operating margins have begun to decline lately but some of that is due to strategic choices by Best Buy (such as expanding the services offered by Geek Squad).
Best Buy has also posted respectable returns on assets and capital for a retailer, with the key phrase being “for a retailer.” Compared to all other businesses, BBY’s ROA and ROC are average or slightly below average.
While the past looks good there is no guarantee the future will be another 10 years of similar great performance. The company faces competition on almost all fronts. Just about every major retailer carries product lines that compete against Best Buy. Some of the stiffest competition comes from online retailers like Amazon.com which due to lower costs can undercut Best Buy on price. Additionally, the market share of online sales has been growing and most of this growth has gone to Amazon. In other hardlines such as TVs and appliances Best Buy faces competition from much larger retailers such as Walmart (WMT, Financial).
Best Buy has responded to these threats with what looks like two distinct strategies. The first strategy is to focus on services or product lines that would be difficult for an online retailer to replicate. This includes focusing on value added services like Geek Squad and retailing large item such as appliances. The second part of the strategy seems to be to take Amazon head on with the BestBuy.com website.
BestBuy.com
This quarter Best Buy announced that it was allowing third party resellers on to BestBuy.com in an effort to attract more traffic and customers. The new website will allow users to browse both third party items and BestBuy items on the same website and purchase both types of items using one checkout procedure. This arrangement is estimated to add about one third more SKUs to BestBuy’s online store.
Geek Squad
BBY is focused on expanding its Geek Squad services. The company will now begin offering (for a fee of course) comprehensive computer support on products for one to two years after the date of purchase. Geek Squad also offers a plethora of other services including TV installation, home theater set up, electronics repair, car stereo and GPS installation, and small and major appliance repairs. If I was an investor in BBY, Geek Squad, is the portion of the company I would be most enthused about as it is something that would be extremely difficult and perhaps impossible for an online retailer to replicate. As the service matures and expands it is also something that has the possibility of giving Best Buy somewhat of a moat.
Focusing on Appliances
Compared to computers and computer equipment and media, appliances are a category that has seen one of the lowest market share losses to online sales. Indeed, same store sales for appliances were up 12% this quarter and were positive for last year as well. This is one area where Best Buy should not face much competition from Amazon and other online retailers.
Magnolia Home Theater
Best Buy is also expanding its Magnolia Home Theater centers. Currently they are in 385 U.S. stores. This product line was the other rare bright spot with double digit comps this quarter. As with Geek Squad, advice in selecting high end audio equipment and help installing it is another point of differentiation over online only retailers.
Gaming
Best Buy remodeled their gaming area and also began accepting used game trade-ins for store credit for the past few quarters. Best Buy’s used game program is going up against a similar program at Walmart and the 800 lb used-game gorilla, GameStop. GameStop’s management has commented that it has not seen any affect on used game trade-ins at its stores that are near BestBuy stores that offer game trade-ins. Additionally, used game sales continue to remain strong at GameStop. Of course GameStop’s management might be a bit biased and I might be as well since we are long GameStop.
The reason for being pessimistic about Best Buy’s foray into used games is that managing a used game trade-in business is more difficult than you might think. It takes a sophisticated inventory management, pricing, and distribution system to redistribute inventory across all stores to ensure adequate levels of popular titles at each store. Pricing is another variable that is difficult to get right as prices must be managed to entice owner to trade-in games but still allow enough margin for the company to ensure a profit. Finally, companies entering the used game business on a large scale need adequate facilities to test and refurbish all trade-ins. Many retailers, including Best Buy and Walmart, have failed repeatedly to break in the used-game business. Until proven otherwise it might be safe for investors to assume the latest used game venture will end the same way the previous ones have.
Right Sizing Stores
Best Buy plans to reduce the square footage in some of its stores including a 10% to 15% reduction in 30 stores this year. The company plans to sub lease excess space or return it to landlords. This cost cutting should help improve margins but it could also be viewed as a harbinger that management believes sales in some of the company’s segments may have slowed permanently.
Summary
There are reasons to be optimistic about Best Buy but there are also plenty of reasons to be pessimistic. Best Buy certainly doesn’t face the same fate as recently defunct Circuit City since Best Buy has a much better balance sheet. The company has $2.2 billion in cash versus $3.6B in long term liabilities including $1.7 billion in long term debt. To be clear we are discussing business slowing down at Best Buy, not a catastrophic drop in sales. After all, BBY generated $1.5 billion in free cash flow over the past 12 months and management is projecting free cash flow of over $2 billion for the latest fiscal year. Taking into account a global economy that looks to be slowing and intense competition, there are more attractive candidates on GuruFocus’ screeners.
Disclosure: Strubel Investment Management and/or its clients are long GME
The Buffett-Munger screener is designed to find Buffett-type investments with extraordinary profitability, consistency, and future prospects. Our monthly Buffett-Munger Best Bargains Newsletter picks one stock from the screener. Our in-depth analysis shares with you why a younger Buffett and Munger would like this stock. If you are a premium member, you can download it here. If you are not, we invite you for a 7-day Free Trial.
