Six months ago, I outlined my thesis for a pair trade: Long Best Buy (NYSE:BBY), short Amazon (NASDAQ:AMZN). The link to my article is below:
Below I describe why long investors in Amazon should tread carefully and refute various arguments put forth by Amazon bulls and Best Buy bears.
Argument #1: Best Buy is only a show room for Amazon and is losing massive market share.
While it is true Amazon is gaining tremendous market share, it is not true Best Buy is losing share proportionally to Amazon’s gains.
An effective way to monitor Best Buy and Amazon’s market share is to use retail sales data from the Department of Commerce as well as sales from Amazon’s electronics and other general merchandise segment. While this data is not exact, it is a very effective way to gauge market share trends.
What are the flaws? First, Best Buy’s fiscal year usually ends in late February/early March, although they just announced on the latest conference call fiscal year 2013 and future reporting periods will end one month earlier, thus using calendar year data from the Department of Commerce is not perfect. Secondly, there may be some areas in the Department of Commerce data that are not relevant to Best Buy. This was evident on the latest conference call, as one analyst mentioned the Department of Commerce data, while Best Buy executives hinted that they measure market share using different metrics and some of the Department of Commerce data may not applicable to their business.
Third, Amazon does not break down electronics and appliance sales specifically, reporting them together with other general merchandise. However, using information from an article written by Steve Smith and Alan Wolf on July 5, 2011, it can be estimated that approximately 72% of merchandise in this segment is from electronics, as TWICE’s Top 100 CE Retailers Report estimates Amazon had $7.9 billion in electronics sales in 2010, while the total reporting segment had revenue of $10.998 billion. Of course, this could be slightly higher or lower in the future depending on various factors, such as Amazon selling additional merchandise within this segment. Link to article below:
Lastly, there may be other, smaller lesser known websites, which are not part of this data, thus I may be slightly overestimating both Amazon and Best Buy's true market share. An example is Newegg.com.
Industry and Company Data Below:
|US Electronics and Appliance Store Sales 2005-2011 Bricks and Mortar (in millions) Source: Department of Commerce||2005||2006||2007||2008||2009||2010||2011|
|Electronics Sales Est.||1037||1454||2255||3182||4535||7900||12467|
|Total Segment Sales||1443||2024||3139||4430||6314||10998||17315|
|% Elec. Rev. from Segment||72%||72%||72%||72%||72%||72%||72%|
|Total E & A Market||102486||109280||113104||112051||102919||108371||113404|
|BBY Fiscal Year End||2006||2007||2008||2009||2010||2011||2012|
|Best Buy Domestic Sales||27380||31031||33328||35070||37314||37070||37615|
|Best Buy Total Share||26.7%||28.4%||29.5%||31.3%||36.3%||34.2%||33.2%|
While the numbers show Amazon’s impressive growth, they also show that Best Buy’s share losses are not as bad as some in the media are reflecting. Best Buy’s current share is higher than it was for much of the last decade. Best Buy’s huge market share jump in fiscal 2010 was most likely due to Circuit City’s demise. However, as Amazon began to make a presence, especially in the area of smart phones, tablets, and smaller laptops like notebooks, maintaining the huge share jump has proven to be unsustainable. But this does not mean Best Buy will lose share precipitously in the future. The most likely scenario is share reverting back to the high 20s over the next several years, a share reminiscent of the mid 2000s, an environment with more bricks and mortar competition. Only now the main competitor is online, not a bricks and mortar retailer.
Another issue which has hurt Best Buy sales has been the weak housing market. If electronics and appliance sales are broken down further, it is evident that demand for smaller items such as smart phones and tablets has grown over the past few years, but demand for larger durables such as televisions and appliances has struggled. Some of this surely has to do with the weak housing market. As can be seen from the data above, total electronics and appliance sales including Amazon are essentially flat since 2007. However, computer and software sales are up moderately. Data Below:
|(in Millions) Source: Dept of Commerce|
|Bricks and Mortar E & A Sales||110849||108869||98384||100471||100937||-2.31%|
|Computer and Software Sales||20546||20534||19618||22151||22536||2.34%|
|Ex Computer and Software||90303||88335||78766||78320||78401||-3.50%|
As the chart above shows, if computer and software sales are stripped out, it is obvious from the data that demand for larger durables such as televisions and electronics has been weak since the credit crisis. When the housing market was strong in the early to mid-2000s, demand for such items was much stronger as shown below:
|Bricks and Mortar E & A Sales||83897||86796||94524||101449||107826||6.47%|
|Computer and Software Sales||17311||17035||18142||19406||19777||3.39%|
|Ex Computer and Software||66586||69761||76382||82043||88049||7.23%|
Best Buy is likely to benefit when stronger demand for larger durables returns. While the firm is losing some sales to Amazon and lost some to a weak economy during the Great Recession, they are likely to do better in an environment with a CAGR of 7% versus an environment with a CAGR of -3.5%. Below is housing starts data:
|Average Annual Monthly Housing Starts Source: US Census Bureau and website below:|
Housing starts have not been this low any time within the last 50 years! When housing starts return to normal annual levels, around 1.4-1.5 million, part of completing and furnishing those additional houses will come from additional electronics and appliance sales. This is likely to take another two years given the excess inventory still needed to be cleared and the delayed foreclosure process. Below is the link to an excellent report on the housing market by JP Morgan:
Will Amazon continue to grow revenues? Absolutely. But with demand for larger durables such as electronics and appliances likely to grow as the housing market recovers, Best Buy should surely benefit. While many younger consumers will opt to purchase televisions and appliances online, many older, less technologically savvy consumers will opt for a one stop shop like Best Buy, which can provide appliances, electronics, installation, warranties, and a more convenient way to return and exchange. Below is an NPD study I linked in my previous article which shows many consumers are reluctant to purchase larger durables online:
Next I will address the concern that Best Buy is likely to go out of business.
Argument #2: Best Buy is headed for extinction within a few years. The end result will be just like Circuit City.
Below is a link to an interview with Michael Pachter, who believes Best Buy could be on life support within three to four years:
Based on Best Buy’s financial position and relatively consistent profitability, I believe these claims are baseless.
First, Best Buy is in decent financial shape with $1.339 billion in cash and investments as of 3/3/12 according to information from the latest press release, a manageable net debt position of $869 million, positive working capital of nearly $1.5 billion, and tangible book value in excess of $2.5 billion. The slight increase in debt is not due to the firm’s lack of profitability, as free cash flow is plentiful. Secondly, the company has been consistently profitable for a long time, as opposed to Circuit City, which in its last five full years of existence was mostly unprofitable. Below I compare Best Buy and Circuit City’s operating margins:
|Note: Best Buy fiscal year ends late Feb/early March, although now changing to late Jan/early Feb|
|Circuit City's fiscal year ended late March|
| Best Buy's number for 2012 is adjusted for non-cash goodwill impairment of $1.207 billion related to Best Buy Europe |
Source: SEC filings
As the chart shows, Best Buy has always been much more profitable than Circuit City. With the exception of 2006, which was inflated by the housing and credit bubbles, Circuit City struggled to turn a profit. The warning signs of their troubles existed far before 2008. And while Best Buy’s profit margins have contracted slightly since the housing/credit boom, I would argue they are only reverting back to normal levels. Before the peak of the housing/credit boom, during fiscal years 1999-2003, according to the company’s financial statements, Best Buy’s profit margin ranged from 3.5%-4.8%, lower than the artificially high levels above 5% in the mid-2000s.
Also important to the lifeblood of a firm is free cash flow. As the chart below shows, Best Buy has had consistent free cash flow for many years:
|Best Buy Co Inc (NYSE:BBY) Free Cash Flow|
|Operating cash flow||1361||1841||1695||1762||2025||1877||2206||1190||3293|
|Free cash flow||816||1339||1047||1029||1228||574||1591||446||2527|
|Source: Morningstar/SEC filings|
While $2.5 billion for fiscal 2012 overstates true free cash flow, due to working capital adjustments, true free cash flow was still significant, which I will define as net income + depreciation and amortization – capital expenditures +/- one-time items. For Best Buy, I would rather use net income than NOPAT so I take into account interest expense. In addition, the only major one-time adjustment for fiscal 2012 is goodwill impairment related to Best Buy Europe. It could also be argued that the non-cash restructuring charge of $288 million is also non-recurring, however due to the fact that Best Buy will be incurring restructuring charges for the next few years, I will consider this a recurring charge going forward:
|2012 Fiscal Year Best Buy True Free Cash Flow|
|Dep and Amort||945|
Based on today’s close, Best Buy’s enterprise value is slightly under $10 billion if net debt and minority interest are taken into account. Please note, minority interest should now be slightly lower according to the latest 10-Q and press release due to Best Buy’s buyout of Carphone Warehouse’s interest in Best Buy Europe, which was just reflected in goodwill impairment. True Free Cash Flow in excess of $1.4 billion represents a free cash flow yield of about 15% at the firm's current enterprise value.
According to the latest conference call and press release, management is committed to adding shareholder value through buybacks, dividends and cost cutting. Capex is likely to stay around $800 million as the company slightly decreases the following three things: big box store count, square footage and other operational expenses. They estimate $800 million in cost savings by fiscal 2015. Expansion will be focused on growing areas such as mobile connections, tablets and international opportunities, such as appliance demand in China through Five Star. More detail on this strategy can be read from my article linked above.
How did management allocate free cash flow last year? Primarily to add shareholder value through buybacks and dividends, as the firm paid dividends of approximately $228 million during fiscal 2012 and increased that dividend during the year, as the quarterly dividend is now up to $0.16 per share. Stock buybacks were $1.5 billion in fiscal 2012, helping to shrink the share count by nearly 14%! The company has plenty of authorization to buyback more shares as they authorized a $5 billion share repurchase program in June 2011, of which over $4 billion of authorization remains with no expiration date. Although there are approximately 30 million shares of anti-dilutive stock options excluded from diluted shares outstanding as of the latest 10-Q, dilution is not much of a concern, especially at lower stock prices, as management is committed to heavy share buybacks over the next few years, which will more than prevent dilution.
So what will Best Buy’s EPS picture look like in five years?
First I will start with revenue estimates. Given that the electronics and appliance market is likely to recover, especially when the housing market recovers, I will assume the total market including Amazon grows 3% the next five years, which is similar to the last decade, which includes a tremendous boom and bust. More information on the growth of this market can be found above or in my last article which is linked. If the market grows 3% the next five years, the domestic E & A market would be approximately $131.5 billion.
Given that Best Buy currently has 33% of this market, and only lost 1% share the last year, let us also assume the company keeps losing 1% market share the next five years and market share reverts back to levels in the mid 2000s. In this case, the firm would have approximately 28% share five years from now. Under this scenario, Best Buy domestic sales are still likely to be $37 billion five years from now. I view this as a realistic scenario. Do people believe once the housing market recovers and starts are double what they are now, that consumers will solely use Amazon to buy all their large appliances and electronics? Or is a mixed picture more likely with some consumers opting to use bricks and mortar retailers and others opting for online-only retailers.
If domestic revenue is likely to stay flat, what about foreign revenues? Foreign revenue has grown due to demand for mobile connections worldwide and appliances in China. Despite the tough environment in Europe and some would argue tougher environment than five to seven years ago in China, Best Buy still grew foreign revenues 3% year over year. Given their international expansion opportunities in China and mobile demand in Europe, moderate foreign growth seems realistic. Let us assume Best Buy’s foreign revenue grows at a 3% CAGR the next five years. Under this scenario, the firm would have $15 billion of foreign revenues, thus would have total revenues of $52 billion five years from now, which represents modest growth from today’s levels.
In addition, Best Buy should also improve or maintain revenues as they expand online sales, which are expected to grow 15% during fiscal 2013 according to the company’s latest press release, and service revenue, as service contracts relating to repairs and warranties play a big role in the purchase of mobile products, tablets, and larger durables such as televisions and electronics. The company expects revenue from the domestic services category to grow 10% in fiscal 2013. One advantage bricks and mortar retailers have over Amazon is customer service and in-store pick up, which offers more convenience for purchases, exchanges, returns and repairs.
More importantly, what will the firm’s profit margin look like? Despite a weak housing market, slow recovery from a major credit crisis, gloomy environment in Europe, and intense competition from Amazon, Best Buy has still been able to deliver operating margins of 4.5%. While this is below peak levels in the mid-2000s, it is more representative of a level seen before the housing bubble. I will assume the company’s profit margin continues to contract slightly and the firm is generating 3.8% profit margins five years down the road, which are slightly lower than fiscal 2009, the roughest year in many decades for most retailers. Thus in five years, the company is still likely to be earning $2 billion before interest expense and taxes.
I will also assume interest expense creeps up to $150 million, assuming interest rates rise over the next few years, and the tax rate is slightly lower at 35% due to more revenue from abroad in lower taxed jurisdictions. Under this scenario Best Buy would still earn approximately $1.2 billion in net income. While this is hardly exciting and an amount which is near or below today’s levels, earnings per share growth is likely to continue due to heavy share repurchases. Currently there are 347.5 million shares outstanding and roughly 30 million anti-dilutive options not included in diluted shares outstanding. The company is likely to exhaust its share repurchase program over the next few years, especially if the stock price remains depressed.
Let us assume they decrease share count by half as much as they have the past year, by 7% per year the next five years, which would represent the repurchase of approximately 105 million shares. This is easily attainable unless profits shrink dramatically or the stock price appreciates substantially. If this were to occur, in five years from now there would be approximately 240 million diluted shares outstanding. If we also assume the additional 30 million anti-dilutive stock options are now included in diluted shares outstanding, a worst case scenario, this would leave us with a share count of approximately 270 million. This translates into earnings per share of nearly $4.50. Applying a multiple of 12x earnings, below the typical retail multiple of 14-15x earnings, still yields a fair value of $54 per share. Assuming an average purchase price of $24 per share and that the dividend remains constant at $0.64 per share, this represents a total return the next five years of nearly 20% per annum. If the dividend continues to rise, which is definitely possible, the return would be that much greater.
While many find this situation crazy, Best Buy has been able to weather the storm of the recession, weak housing market and intense online competition quite well. Even if margins and market share contract over the next five years, the firm is still likely to be profitable and should be able to increase EPS due to cost cutting, international opportunities, a pick up in the domestic housing market and share buybacks.
Argument #3: Amazon is likely to improve margins as margins are only temporarily depressed due to rapid expansion. They also have a distinct cost advantage over bricks-and-mortar retailers.
Really? When will we see margin improvement? Below are Amazon’s revenue, gross, and operating margins from the last decade:
|Gross Margin %||25.2||23.9||23.1||24||22.9||22.6||22.3||22.6||22.3||22.4|
|Op. Margin %||1.6||5.1||6.4||5.1||3.6||4.4||4.4||4.6||4.1||1.8|
Over the last decade Amazon has grown revenues 12-fold yet gross margins are significantly lower than they were 7 to 10 years ago and operating margins have hardly improved. In my previous article, I estimated that Amazon needed to achieve 6% operating margins to justify a stock price near the most recent high of $250 per share, and if they were unable to improve margins, even with revenue growth abroad and from other areas such as AWS, they would need to gain control of nearly 100% of the domestic books and electronics markets within five years to justify a $250 stock price today, which is an impossible task!
Why are Amazon’s gross margins lower than they were in the early 2000s? A major factor is shipping costs. As the company has moved from selling lighter less expensive items such as books to heavier more expensive items such as electronics they have had to eat shipping costs to maintain competitive prices. Below are Amazon’s shipping costs as a percentage of revenue, which is included in its cost of sales:
|Percentage of Net Sales:|
|Outbound shipping costs||8.3%||7.9%||7.6%||7.2%||7.5%||8.3%|
|Net shipping revenue||-3.0%||-2.9%||-3.2%||-3.4%||-4.0%||-5.1%|
It is more than a coincidence that Amazon’s shipping costs have increased significantly since they began to make a presence in the electronics market. This has eaten into gross margins. Expect this to continue if Amazon wants pricing to remain competitive. The only other option is raising prices, which means losing market share.
While certain companies like Google, Intel and MasterCard have wide moats, Amazon does not. Google algorithms, Intel microprocessors and the MasterCard brand name/network have high barriers to entry and are very hard to replicate. While Amazon has established a large distribution network and strong brand name, they are essentially selling the same commodities as many other firms.
And while many Amazon bulls feel the firm has a cost edge over bricks-and-mortar retailers, the numbers show Amazon’s operating costs are as much or more than traditional bricks-and-mortar retailers, mainly due to suddenly increasing fulfillment and technology and content costs, which are necessary to supply, store, distribute, and track orders. As revenues grow, so do expenses to meet those revenues through building more data and fulfillment centers as well as the cost of additional technological infrastructure, much of which is related to AWS as mentioned in the most recent 10-K on page 28. Below I break down increasing fulfillment and technology and content costs, which have contributed to lower operating margins over the last year. For a broader description of fulfillment and technology costs, please read my previous article:
|As a Percentage of Net Sales:|
|Technology and Content Costs||6.2%||5.5%||5.4%||5.1%||5.1%||6.1%|
Although Amazon bulls think the cost increase is only temporary, Amazon says differently in the most recent 10-K on page 28 as relating to technology and content costs:
“Spending in technology and content significantly increased in 2011, and we expect this trend to continue over time as we invest in these areas by adding technology infrastructure and increasing payroll and related expenses”
If higher technology and content costs are expected to continue and fulfillment costs are rising as a percentage of revenue, isn’t any forecast of margin expansion really just speculation? What has the company said or done to lead you to believe that margin expansion will be achieved? It has not occurred over the last decade as revenues have grown tremendously and in the latest SEC filings and on the latest couple of conference calls, management has inferred costs will be higher for the foreseeable future.
But let us give Amazon the benefit out the doubt and assume costs subside somewhat over the next few years. If so, what might their earnings picture look like five years from now?
In my previous article, I projected Amazon to achieve revenues of over $140 billion by the end of calendar year 2016 based on various factors such as their share of the domestic books and electronics markets, foreign revenue opportunities, and growth of AWS. Although they slightly missed my revenue estimate for 2011, let us give them the benefit of the doubt and assume revenues compound at slightly more than a 25% CAGR and they achieve revenues of $150 billion by fiscal year 2016.
Gross margins have fallen because of higher shipping costs but I will assume the firm can achieve 23% gross margins as they did in 2006. Assuming higher gross margins is extremely generous due to intense competition on pricing and higher shipping costs. Under this scenario Amazon would generate a gross profit in five years of $34.5 billion.
Lets also assume they achieve some form of economies of scale and fulfillment and technology costs revert back to levels before 2011, thus I will assume the following costs as a percentage of revenues:
Fulfillment costs – 8.5%
Technology and content – 5.5%
Marketing – 3%
G & A – 1.25%
Other Costs – 0.25%
In this case operating margins would be 4.5% or $6.75 billion in dollar terms. Since there is some minor non-operating income such as interest income, let us assume earnings before taxes are $7 billion in five years. Due to growth of foreign revenues in lower taxed jurisdictions the tax rate is likely to be lower than the normal 35% domestic federal statutory rate. If a 25% tax rate is assumed, the company would earn approximately $5.25 billion in fiscal 2016. There has also been slight dilution over time; slightly over 1% per year due to stock options, etc. Thus I will also assume a 1% annual increase in share count over the next five years to 485 million diluted shares outstanding. A reasonable but slightly optimistic view of Amazon’s earnings in five years is as follows:
Net Income: $5.25 billion
Diluted Shares Outstanding: 485
Earnings per Share: $10.82
An acceptable long-term equity return is defined differently depending on the investor. To achieve a normal equity return over the next five years investing in Amazon of 10% per year, the stock would have to appreciate from its current price slightly below $200 per share to a price slightly above $310 per share. For an investor to justify a price of $310 five years from now, assumes the market grants Amazon a multiple of approximately 30x earnings. This is a risky proposition for a company that is likely to be much more mature five years down the road and that has struggled recently to achieve the 4.5% operating margin I assume due to the reasons outlined above.
The last issue I would like to touch on is Amazon’s free cash flow, or lack thereof.
At first glance Amazon’s free cash flow looks good if you define free cash flow as cash flow from operations – capital expenditures:
|Amazon Free Cash Flow ( in millions)||2006||2007||2008||2009||2010||2011|
|Cash Flow from operations||702||1405||1697||3293||3495||3903|
|Free cash flow||486||1181||1364||2920||2516||2092|
Although free cash flow has fallen since 2009, it has more than quadrupled since 2006. But if free cash flow is examined further, a major red flag is discovered in accounts payable.
Amazon’s payables period is more than twice its competitors and has increased dramatically over the last decade. Below I show how much the payables period for Amazon has grown and how much lower it is for other competitors:
|Historical Payables Period|
Amazon takes nearly twice as long to pay its suppliers than Best Buy and nearly 2.5 times as long as Wal-Mart. In addition, their payables period has increased dramatically over the last decade. This is bound to be exposed sooner or later. The main plausible explanation for this is the company’s lack of free cash flow. By extending the timing of its payments, Amazon is able to generate enough free cash flow to run their operations. But what would happen if the firm simply maintained a payables period of 66 days? What would their free cash flow look like in that case?
|Adj Avg AP||719||954||1157||1481||2060||2672||3405||4765||6690|
As the above chart shows, Amazon’s adjusted free cash flow for 2011 is negative! And keep in mind this is just a decrease in the payables period to 66 from 94. At this level Amazon would still be paying suppliers much later than competitors Wal-Mart and Best Buy. Imagine how much better Best Buy’s FCF would look if they decided to extend their payables period from 50 to 66 days? Imagine if they extended to 94 days? If working capital is ignored and free cash flow is defined simply as net income + depreciation and amortization – capital expenditures +/- significant one-time items, Amazon still has slightly negative free cash flow for 2011. Even if their peak free cash flow yield is used from 2009, this still represents a massively high multiple of enterprise value to free cash flow of approximately 38.5!
While this thesis required patience, I believe there is ample evidence that suggests Amazon is pricey at these levels and Best Buy has a huge margin of safety having already priced in a very bearish scenario. I welcome any comments or arguments refuting my thesis.