Back in June, I wrote an article laying out the case for why I felt Staples (SPLS) current situation was quite different than what Borders experienced in 2010. Since that time, some readers have asked for a similar comparison to the leading retailer of consumer electronics, Best Buy (BBY). At the time, I mentioned a few key categories that were worth addressing (particularly technological impact, management, and leverage); let’s address these topics one by one:
In the internet age, Best Buy has become the poster boy as Amazon’s (AMZN) showroom; as I noted in a recent article analyzing Q2 2012 ecommerce sales, Best Buy competes in multiple categories that topped the list for ecommerce sales growth in the past three months, particularly Digital Content & Subscriptions, Consumer Electronics (ex PC Peripherals), and Computers/Peripherals/PDA’s (three of the top five categories in terms of YOY growth through Q2). I also noted the following:
“Comscore presents some data that is highly useful for teasing out Amazon’s domination of certain categories; in their slide deck discussing ecommerce results in Q2, they have a chart that shows category share as a percentage of Amazon’s overall sales in comparison to that category’s share of the overall retail e-commerce market – for example, they estimate that AMZN’s Computers, Peripherals, & PDA share is in line with the index, or that the category (for Amazon) is comparable to the categories share of overall retail ecommerce (on a scale of 1-5, it’s in the middle at three; one would indicate under representation at Amazon, while a five would indicate that Amazon is particularly strong in that category).
Looking at the data, three categories fall in the upper end of the spectrum (Amazon is dominant): these are Consumer Electronics (ex PC Peripherals), Books & Magazines, and Toys & Hobbies, with the most noteworthy brick and mortar companies in those categories being Barnes & Noble (BKS) and Best Buy.”
When we think about the categories in question, it’s not too difficult to figure out why. First off, Best Buy is essentially Borders by another name when it comes to the sale of CD’s and DVD’s (video games will join this list in the coming years); unfortunately, just like with eBooks, both of these categories (in terms of physical products) have been pummeled by technological development (in February 2010, Apple’s iTunes Store surpassed 10 billion songs sold).
In addition, Best Buy has been the victim of unequal taxation. As the company noted at their most recent Analyst Day, only five states had e-commerce taxation laws enacted through 2011, leaving the company materially disadvantaged in comparison to their most prominent opponent. At the same time, the drop-off in CD’s/DVD’s has skewed Best Buy’s business towards higher ticket items like computers, TV’s, camera’s, and appliances; for the average consumer, the value proposition is presented as such: I can buy a $500 Samsung TV at Best Buy, pay $30-40 in sales tax, and then deal with lugging the thing home, or I can buy the same TV on Amazon (the perception will be at a lower price), skip out on the sales tax, and avoid the hassle of having to carry the TV home from Best Buy (it wouldn’t fit in my car). This example is simplified, and misses on some important points (for example, the services Geek Squad can offer with mounting, for example); with that said, I think its representative of how the average consumer views BBY (as Best Buy’s own research shows, the biggest factor in non-conversions is often price related).
I’ll be the first to admit that Staples and the office supply industry is facing structural headwinds in certain product categories; I think Best Buy’s facing headwinds that have emerged with much more fervor, and will only increase with the passage of time. In addition, and as I will continue to point out (though it doesn’t seem to be sticking in), Staples has a delivery business that is in no way comparable to anything Best Buy offers their customers; one cannot simply overlook a business that accounts for 40% of a company’s sales and 50% of its operating income.
As I noted in the Borders article, Staples is set in terms of management:
“The concern about new management is relevant in the office supply business, just not to Staples; while both Office Depot (ODP) and Office Max (OMX) have brought on new CEO’s in the past 24 months, Ron Sargent, the CEO of Staples, has been the company's chief executive since 2002. In the past ten years, he has taken the company from a three way tie in both Retail and Delivery to a demanding lead over ODP and OMX in both segments (50-60% market share); to put it succinctly, this management team has a track record and it’s quite impressive.”
Best Buy is on the same wavelength with ODP & OMX: the company recently announced the hiring of Hubert Joly, the former CEO of privately-held hospitality and travel company Carlson (brands include Radisson, Country Inn & Suites, etc). Mr. Joly said the following about taking the job at Best Buy: "I like challenges… Given the turmoil [at the company], it's easy to focus on its problems. But I'm impressed with its assets. We have the opportunity to write what could be an exciting new chapter here at Best Buy."
Upon his hiring, Michael Pachter, a well known analyst from Wedbush Securities, said the following: "We find Mr. Joly's résumé unimpressive… He lacks sufficient experience to engineer a turnaround at Best Buy." Time will tell whether Mr. Joly is the right man for the job; personally, I’m much more comfortable with Mr. Sargent’s track record at Staples than I would be with a newcomer stepping to the plate (others may disagree and think fresh blood is needed in these types of situations).
As we saw with Borders, this is the straw that broke the camel’s back:
“In fiscal year 2010, Borders reported its fourth consecutive annual loss of more than $100 million, with just $158 million in stockholders’ equity remaining on the balance sheet; sales had declined 21% (cumulatively) over the previous two years, and the company was subject to $2.6 billion of contractual obligations, with $2.3 billion tied to operating lease obligations.
Let’s compare this to Staples: sales have increased nearly 30% since fiscal year 2007 (despite a global recession), which has drove consistent free cash flow generation in excess of $1 billion annually. Contractually, the company has outstanding operating lease obligations of $4.6 billion, or two times the amount of Borders, despite having 4x the number of stores in their portfolio. In addition, roughly 25% of all leases are coming up for renewal in the next three years, leaving management with the option to close, remodel/resize, or renew leases at lower rents.”
Best Buy’s results look much more like Staples than Borders: in the past three years, free cash flow (after backing out acquisition of businesses) has averaged $1.46 billion; through Q2 of this year, the company’s estimated FCF is trailing just below the three year average ($1.25 - $1.5B). Looking at the balance sheet, the company ended the most recent quarter with $680 million in cash & equivalents, compared to $1.17 billion in long term debt (the current ratio is has moved lower over the past twelve months, and now stands at just 1.08x, compared to 1.56x for SPLS).
In terms of operating leases, Best Buy reported the following at the end of fiscal 2012: $7.5 billion in total operating lease obligations, with $4.1 billion of the total due beyond 2015 (and $2.3 billion, which is included in the 2015 amount, due beyond 2017); as I noted above, this compares to $4.6 billion in outstanding operating leases for Staples, or roughly 60% higher.
Best Buy’s obligations largely come from a retail portfolio expansion over the past decade:
By comparison, Staples has increased their U.S. retail store portfolio by roughly 50% over the same period that BBY's increased more than three fold. Over this time period, the size of the stores has decreased: from an average store size of 45,000 square feet in FY 2000, the company’s average store now comes in around 38,500 square feet. To put that in perspective, the office supply chains used to emphasize store sizes of 25,000 square feet – and now are targeting models of 5,000 – 8,000 square feet and 12,000 – 15,000 square feet. As I noted above, I seriously question whether Best Buy will find the products to sell that can justify the larger (and higher rental expense) units they have pursued to date; while they are looking to move to a smaller box format, one wonders if they are moving quick enough: the company’s target is to reduce U.S. square footage of big box stores by 10% over the next 3-5 years. By my estimates, the office supply industry will reduce their store count in the low-mid teens over the next five years, and reduce their square footage at an even faster rate.
I haven’t followed Best Buy closely enough to make an educated guess one way or the other, but I think (from the perspective of a consumer) that their brick-and-mortar portfolio is particularly susceptible to secular changes in media consumption and the current ecommerce tax situation, both of which are taking their toll with few signs of abatement on the horizon (to be fair, BBY still holds strong among the retailers, as outlined by NPD). With a new CEO, it will be interesting to see the direction the company takes in the coming quarters; from my view, all I can say is that I would much rather be facing Staples’ headwinds than Best Buy’s.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.