Last week I posted a comparative valuation of two unnamed companies. It wasn't hard for you to guess which the companies were, which reminds me that I will have to come up with harder cases if this is to remain a blind valuation exercise.
The comment of Seanickson (and I thank him for not revealing the names of the companies) nicely summarizes the idea of this case. Looking at the numbers, Company B is clearly the better of the two. Yet, going beyond the numbers, a look at the bigger picture would change, maybe even reverse, the decision to invest in Company B.
Time to pull the curtains up:
- Company A is Circuit City
- Company B is Best Buy (NYSE:BBY)
At its core, retailing is all about:
- Setting up a sales floor
- Sourcing goods cheaply
- Selling a decent volume at a decent margin to cover your large fixed costs.
A company can't adjust its operating structure quickly to accommodate changes in the business environment. Whether you own or lease the stores, changing their number is neither cheap nor easy. Often it is harder to reduce them than to increase them. Thus, a bloated, competitively handicapped retailer's most probable exit is bankruptcy. That's the road down which Company A went.
You have figured out from the summary data that Company A's gross margin stayed more or less constant around 24%. At the start of the observed period Circuity City was at the top of its game (No. 1 electronics retailer) and its valuation (over $13 billion in 2001). During the same period, Best Buy was quickly catching up. Company B's gross margin improved, first faster then slower, from 16% to 25%. It was clearly giving Circuit City a run for its money.
Although Best Buy only managed to reach, and never exceed by much, the level of Circuit City's gross margins. This is where volume comes into play. With the same margins but much faster growing sales volume, Best Buy soon took the No. 1 place in electronics retail. Coincidentally, at the start of the period studied both companies had very similar sales — in the $8 to 9 billion range. Nine years later, Circuit City crept up to a little over $12 billion, while Best Buy soared to a whopping $36 billion. In compound growth terms, that's 3% versus 16% annually. Losing market share at this rate is no way to stay in business.
Of course, super-fast growth does not guarantee good results. For retailers, it is very important how well they control operating expenses. Operating margins are thin by default for this industry, so shaving a couple of points can make a big difference. That's what Best Buy did. It managed to increase the 2 cents it kept from operations at the start of the period to over 5 cents. At the same time Circuit City's 3 cents slipped through its fingers until there was nothing left.
A quick DuPont breakup shows that Best Buy had larger profit margins, more turns and better use of leverage, resulting in incomparably better returns on equity.
The numbers are pretty clear.
Beyond the Numbers
Researching the qualitative side would have demonstrated that Circuit City's management became complacent, lost focus, fired its best sales people and didn't mange the real estate well. All these red flags were raised when credit finally became tight, suppliers started asking for money up front and Circuit City was not in shape to survive.
Best Buy survived. Not only that — it benefited from ousting its biggest competitor. What more can a business ask for?
The big picture matters. Selling electronics is not, in itself, a bad business. Surely, people will keep buying electronics in the future. Probably more than ever. But the changing economics of the business and the changes in consumer spending will affect how this shopping happens. With a ubiquitous retailer like Amazon — running super-efficient operations and passing the savings on to increasingly price-conscious buyers — there will be little, if any, place for big-box electronic retailers, doing business the old-fashioned way.
While the numbers describe a stable business, generating very good return on equity, the bigger picture suggests that this business is going extinct due to the disruption to its industry. It is interesting that it happened now and not earlier. Amazon (NASDAQ:AMZN) has been around while both Circuit City and then Best Buy thrived. I think it was a combination of Amazon picking up scale and people becoming more comfortable with online shopping and much more price-conscious due to the ongoing hard times. The advent of mobile apps for instant price comparison also play a vital role.
In any case, the result was this:
BestBuy gained more than 300% over the observed period while Circuit City lost 75%.
Yet, the future wasn't bright. After becoming number one and losing its main competitor, Best Buy still went on to lose 60% of its market cap.
I think this case illustrates well why it is so important to try to imagine where the business you are analyzing could be 10 years from now. Not the precise forecasts used in DCF valuations, but more an indication that you have a good grasp on the business. If the future has too many unknowns, the company is probably for the too tough pile.
I would like to thank all the people who took part in this little exercise. It wasn't too difficult but I hope you found it as useful as I did.
I intend to keep posting — here and on my blog at StudentOfValue.com — such cases whenever I have a more interesting one to share. You can follow me on Twitter, also.