Look To This Company Instead Of Best Buy For Better Returns

By Bill Edson - September 24, 2012 | Tickers: BBY, JCP, RSH | 0 Comments

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Is Best Buy (NYSE: BBY) a value play or a value trap? Ultimately, this depends on the company’s ability to reinvent itself. This will likely be a long and tough process, and can be compared to many other turn-around stories currently in progress, most notably that of J.C. Penney (NYSE: JCP).

Big Boxes, Big Problems

Best Buy’s shares have fallen 22% this year so far, marking this year to be the fourth in the past five that its market capitalization has dropped. Valuations are hitting low price-to-earning percent discounts the likes of which have not been seen since 1993. Huber Joly, Best Buy’s new CEO, hopes to remedy these losses in a big way by transitioning the store format from big box stores to small mobile device retailers in strip malls. While the idea to downsize and open locations focusing on cell phones, e-readers, and tablets. Though hardly a new strategy, Joly has singled out this plan as an important for boosting Best Buy’s profits.

Over the next three years, Joly plans to close big locations and reduce their size while opening up 800 mobile stores. Mobility Chief Shawn Score is particularly fond of strip malls for new store locations for two reasons: the rent is cheap (since many businesses have vacated rental spaces when the economy turned sour) and strip malls generate foot traffic organically. With less rent to pay and more locations to increase convenience and visibility, Best Buy is hoping that this move will limit the predicted 2.6% drop in 2012 revenue to $49.4 billion in expected revenues. Best Buy is searching for spots in strip malls that feature anchor stores like Target, Home Depot, or grocery chains.

Best Buy’s new store format puts them in what once was RadioShack’s (NYSE: RSH) niche. RadioShack has 4,400 company-run stores, and while Best Buy feels that RadioShack is dated, RadioShack believes that its longstanding experience in the mobile electronic market will withhold Best Buy’s attempt to compete on RadioShack’s turf.  Best Buy will also be up against Verizon (VZ) and AT&T (T) locations but may have an edge over these stores in being able to sell e-readers and tablets as well as phones, especially as employees are trained to draw customers’ attention to how these devices can interact with one another.

J.C Penney’s Rough Turn-Around

J.C. Penney is also redefining itself.  Former Apple (AAPL) executive and New CEO Ron Johnson began reshaping the company into a new kind of department store concept he calls a “specialty department store.” Johnson warned that his strategic repositioning of J.C. Penney will take four years.

CEO Ron Johnson has convinced investors that J.C. Penney is on the upswing and up. J.C. Penney’s management had announced this aim with “extraordinary confidence” that it could be attained and promised that they would not “commit to anything that we’re not confident we can hit.” Despite news of a $147 million loss in the second quarter and it lowest sales in over 20 years, Johnson’s frankness with the public about not falling short and revealing his strategy for how to improve the brand stopped shares from dropping. Much to my amazement, his assurances that everything is going according to plan and that this year was expected to be a rough one was enough to get investors on board despite the company’s underperformance compared with both what was projected and last year’s performance.

The company cited closing its outlets and a lack of marketing strategies change as reasons for why it did worse than predicted. Management is not questioning the firm’s bold strategy itself.

Four years is a long time to wait when only a year of this process has created a string of disappointments packaged with CEO verbiage.

Not everyone believes in the CEO’s vision. Retail analyst Howard Davidowitz predicted problems with J.C. Penney’s new leadership and direction. In an interview he stated

“J.C. Penney didn't need a revolution, it needed an evolution. You can't take an old line company that's been operating the same way a very long time and throw everything out the window and say 'now we've reinvented the company.'"

Davidowitz’s concerns were later validated in a 20% drop in sales in J.C. Penney. He remains critical of the new CEO, and has stated, "He's caused incalculable damage.” In particular, Mr. Davidowitz is critical of Mr. Johnson’s abandonment of promotions and couponing.  “The customers are everything. They don't know what the hell he's doing."

Valuation Realities: Risk Must Increase Required Return

Investors should recognize changes in strategy for what they are: risk. When a company rips up the business model and tries something new investors should demand a higher required rate of return. After all, the proven business model is no longer in play and management is essentially launching a new venture from within the firm. Investors should require venture capital-like payoffs for such leaps of faith.

Which turn-around firms are priced appropriately for the risk of reinventing their businesses? Consider the following financial metrics:

Investors are better served by buying shares of RadioShack since this company is trading at a discount to Best Buy on a price-to-sales and on a price-to-free cash flow basis. Since RadioShack already operates in the space Best Buy is looking to encroach upon, their growth trajectories may be closer than analysts think.

But, it should be noted that Best Buy looks to be better priced than J.C. Penney because it has cash outflows and a much lower price-to-sales ratio. If investors are hungry for growth, they could invest in Amazon.com since analysts expect it to have higher earnings growth. What’s more, it has positive earnings and cash outflows, which is more than can be said for J.C. Penney.

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