Best Buy Co., Inc.
Business Model Diligence
Was it really just a few years ago that financial analysts were writing Best Buy's (BBY) obituary?
Forbes was certain that that company would be out of business by now.
The Motley Fool won't back down, just a few weeks ago still pumping Amazon as Best Buy's executioner.
The bear case seems simple and has held sway since that fateful time in late 2012 when Best Buy shares dipped almost to $10. Best Buy has an untenable cost structure with its nearly 1,400 big box retail stores, all of which must be stocked, staffed, and paid lease on. This hampers the company when competing in the very low-margin, price-sensitive industry of electronics, leaving it open to price competition with online sellers. Oh sure, Best Buy makes a swell place to drop in on the weekends, play with the latest electronics, get the staff to answer some questions... and then go home and order the item from Amazon (a phenomenon known as "showrooming").
In fact, that may well have been the case 4 years ago.
But the "language of business" - the financial and operating metrics - are telling a far different story about Best Buy. And it's a story the market has not bought into yet. Best Buy's valuation is extremely cheap against both earnings and cash flows, and the firm has a defensible position in an important product category. I don't think the company can just survive - I think it can continue to thrive, and eventually the market should recognize this and reward it with a better valuation, driving gains for shareholders. It looks like an attractive option from the Deep Value Spell.
Let's get this out of the way first: Best Buy is NOT a revenue growth story.
I know that revenue growth is all that matters to a lot - possibly a majority - of stock analysts out there. And it is an important point for long-term investing.
But we're not long term investing here. We're looking for undervalued stocks for a 1-2 year holding.
And Best Buy has been strengthening its business for several years now. Through CEO Hubert Joly's Renew Blue initiative, Best Buy has focused on a few key initiatives:
1) Improve the Online Experience: Electronics have been the largest online sales category (surpassed only last year by clothing). Best Buy's online experience had long lagged competitors, and improving it was identified as a key initiative. Best Buy added much improved search tools, extensive information and research material, and - critically - integrated their store inventories with their online offering, so you can easily buy online and pickup in-store on the same day. The result? Best Buy has increased their online sales by mid-teens percentage points each year since 2014, with online sales growth exceeding 23% in each of the last 4 quarters. Online sales now make up 15% of revenue, up from under 9% in 2014.
2) Improving the In-Store Experience: For years, Best Buy was plagued with high employee turnover, which led to under-informed or disinterested employees and frustrated customers, as well as complaints of understocked stores and uncompetitive prices. Renew Blue attacked each of these in turn, leading to improved employee retention, a focus on the most popular products in each category, and - very importantly - a price matching guarantee that really eliminated the motivation for "showrooming". The result? While modest, same-store sales reversed their declines and are now showing slight positive momentum in a horrid retail environment. More importantly, Best Buy's net promoter score (a much-used corporate measure of customer satisfaction) has soared, rising over 400 basis points year-over-year last quarter.
3) Improve the Cost Structure: Best Buy was never going to be able to compete with Amazon and its ilk with sub-3% operating margins. Joly has implemented an number of initiatives here. Store margin has been enhanced by allocating space to growing and more profitable categories (and reducing or removing legacy stuff like DVDs and CDs). Higher margins have been accomplished by promoting private label products, particularly within its Pacific Kitchen appliances and Magnolia home theater sub-stores. SG&A costs have been streamlined by careful organization. Perhaps most importantly, under-performing and overlapping locations have been closed down, with footprint declining from around 1,500 in 2014 to 1,400 today.
The results of Renew Blue have been undeniable. While revenue is actually slightly down from 2014, Best Buy's operating margin has increased from 3.2% to 4.5%, leading to a 40% increase in operating earnings. Free cash flow generation has soared, up from $547 million in 2014 to over $1.6 billion in the trailing twelve months.
These financial results have put Best Buy in a very strong financial position. The company has more than 2x as much cash as debt on the balance sheet, and debt-to-equity is very comfortable at just 32%. What's more, shareholders have benefited from Best Buy's cash influx. Share count has declined almost 8% as the company embarked on a $1 billion share buyback program. The regular dividend has been increased from $0.68 in 2014 to $1.12 today - a 65% increase. On top of that, Best Buy paid a special $0.45/share dividend last year. Along with the stock's 35% increase, Best Buy shareholders certainly aren't feeling like this is a company about to be driven out of business.
Can It Continue?
A lot of analysts out there continue to doubt Best Buy, and it is a fair question for perspective share buyers today: can the company's momentum continue?
Best Buy discontinued holiday sales reporting last year, so we won't know holiday results until the next earnings call. But I see plenty of reasons for optimism that the company can continue its strong run:
1) It's the only major electronics retailer left. Circuit City is gone. Sears (SHLD) is falling apart and scaling back its electronics offerings. hhgregg (HGG) and Conn's (CONN) are both regional and having some of Best Buy's earlier struggles. Walmart (WMT) and Target (TGT) are major competitors but - other than in televisions and gaming - play to the low-end and have a poor shopping experience. Best Buy's selection is better than anyone's, particularly for appliances and higher-end electronics. It remains a go-to destination in a category where most shoppers like to examine the product "for real" before spending hundreds or thousands of dollars.
2) Price matching removes a reason not to buy. Personally, I think Best Buy's price matching reverses the showrooming trend. Now, I always shop online first for the lowest price, and then go to Best Buy to look at the item. If I like it, I know I can get my price and walk out the same day. I've used this to buy a washer recently for $200 off the tag price. It's a no-brainer. And in any case, nowadays Best Buy simply offers the same or cheaper prices than Amazon and even - gasp! - Walmart, without price matching. Don't believe me? Try some comparisons yourself - you'll be shocked.
3) Big new consumer electronics categories are gaining traction. Not since smartphones first exploded on the scene has there been so much product innovation in electronics. New categories including wearables, smart home devices, drones, virtual assistants, virtual reality, and even low-cost 4K televisions should continue driving category growth, which will benefit Best Buy, especially as uneducated customers wander in to try and learn about these new toys.
These are reason enough for me to have good confidence that Best Buy's revenues are not going to fall apart, and could even begin growing again.
Given that the stock is a member of the Deep Value Spell, we know it is quantitatively very cheap vs. the rest of the market. Indeed, Best Buy's earnings yield of 13.9% and its free cash flow yield of 12.9% put the stock in the 95th and 93rd cheapest percentiles, respectively, of all profitable and cash flow positive companies in the stock market. If you are more of a traditionalist, the stock's P/E ratio is 13.5 (vs. a market multiple of about 26), its price-to-free-cash-flow multiple is 8.7, and it's price-to-sales is just 0.36.
Even the most ardent short would have trouble arguing that Best Buy is an expensively valued stock!
Of course, as we've discussed, when putting together a valuation model, it is best to be quite conservative with growth estimates, as Best Buy is relying on methods other than revenue growth for earnings growth - not a long-term success strategy. Certainly, I think margin improvements and share buybacks are going to stick through 2017, creating very good year-over-year comparables and around 20% earnings per share growth (on basically flat revenue). Longer-term, though, I see Best Buy as a modest 0-3% earnings growth stock, driven mostly by share buybacks. The 2.5% dividend yield is well supported at about 30% of free cash flow and has room to grow.
Putting it all together with a high discount rate of 11%, I get a fair value in the high $50's for the stock, which represents a nice upside from current trading prices in the low $40's.
Risks and Conclusion
The risks are quite easy to understand and mostly covered already. Best Buy is not really growing revenue, and there is a limit to how much earnings growth can be squeezed out of margin improvements and share buybacks. Some of its competitors like hhgregg and Conn's are following Best Buy's turnaround playbook, and should they start improving, the competitive landscape becomes tougher. And of course there is always the elephant in the room, Amazon, who continues to gain market share in electronics retailing and is even becoming quite proficient in developing electronics of their own... although those devices are sold in Best Buy too! Finally, throughout a retailer's history, customer service gains are easily lost as management loses focus on it... Best Buy must continue to be diligent in this regard.
Overall, as deep value stocks go, Best Buy looks like an interesting one! Come join our low cost service to see all of the most attractive Deep Value stocks in the market today!
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