Is Big-Box Retail Back?

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Back in 2012, Best Buy (NYSE: BBY) saw its stock trade below $12 for the first time since the dot-com bubble burst; now the big-box retailer is back in favor, flirting with nearly $30. 

This miraculous turnaround has made Best Buy one of the best-performing stocks in the S&P 500 year-to-date, up nearly 150%. 

Question is; why was its stock down so much in the first place. Best Buy had long been the staple in the electronics retail industry, but the company fell out of favor when e-commerce company (NASDAQ: AMZN) burst on the scene. However, and this is where things get interesting, if you look at how the two have performed relative to each other, questions arise. 

Both Best Buy and Amazon have seen similar percentage declines when it comes to net income and and free cash flow generation over the past five years...

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…yet, when you look at stock price, it tells a very different story.

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A rebounding economy will lift these two companies even more, but what about the long-term sustainability of the company? It's hard not to get a little uneasy when looking at how fast Best Buy has returned to glory without any real evidence of a turnaround. 

But still struggling

Fiscal 2013 was another tough year for Best Buy. Analysts expect revenue to be down 4% in fiscal 2014, after a 2% decline in fiscal 2013. Best Buy saw same-store sales fall 3% last year, and operating margin narrowed 1.5 percentage points. What's more is that a key measure, free cash flow, was down to $680 million in fiscal 2013 compared to $2.3 billion from the last year. 

Grasping at straws?

Best Buy has been looking to find its place in the "new" normal that is the retail market. Part of this is its store-in-store concept that it's putting a lot of faith in. The idea is solid, in principal, allowing retailers to offer various brands under one roof. One of the biggest partnerships includes 1,400 Samsung store-in-stores. 

One of Best Buy's other big moves include closing 48 big-box stores in the U.S. during fiscal 2013, while opening 104 small Best Buy mobile stores -- resulting in a 3.5% net reduction in domestic square footage. Going forward, the company hopes to close 10 more big-box stores in fiscal 2014. Meanwhile, Best Buy is turning to China, planning to open upward of 250 Five Star stores, its wholly owned subsidiary, through fiscal 2016. 

Unlike Best Buy, Amazon is expected to grow revenue by over 20% in 2013, in part driven by market share gains from physical retailers and new hardware (i.e. Kindle Fire). Driving more sales includes its Amazon Prime offering. 

Amazon's business is capital-intensive and margins are low. Amazon spent nearly $4 billion in capital expenditures in 2012 and had an earnings-before-taxes margin of a mere 0.8%. 

Yet, one of the key strengths includes its balance sheet, with over $11.4 billion in cash and no long-term debt. The market opportunity remains impressive. Forrester Research believes the U.S. e-commerce market will rise by 10% annually until 2017 to $370 billion. 

However, what remains as one of the fundamental problems for Amazon is its ridiculously high valuation. Amazon trades with a price-to-book ratio of nearly 15 times, which is an over 100% premium to its peer group. 

Physical comp

GameStop (NYSE: GME), one of Best Buy's chief rivals in the consumer-electronics sector, is being faced with its own problems. This includes an over-reliance on the used gaming industry; however, Microsoft's reversing of its ban on sharing games for its Xbox One is a big positive for the company. Initially, GameStop's stock took a near 20% dive on the news, but it has since rebounded.

Revenue was down 7% in fiscal 2013 and is expected to be down another 0.5% in 2014. GameStop is the leading retailer of used games, with a diverse selection. This is, in part, what helps the company differentiate itself from the likes of Best Buy and other major consumer-electronics retailers. 

The other exciting thing about the used-game market is its superior margins. During fiscal 2013, gross margins for used games were nearly 50%, while the gross margin for hardware was 8% and 22% for software. 

Hedge fund rumble 

Going into 2Q, Best Buy had 36 hedge funds long the stock, a 13% increase from the previous quarter. This includes billionaire Ken Griffin's Citadel Investment Group with the largest position among major hedge funds, worth some $126 million (check out Citadel's high yielding picks).

Meanwhile, Amazon had a whopping 70 hedge funds long the stock. Billionaire Ken Fisher of Fisher Asset Management had the largest position, worth $640 million (see Fisher's small cap picks).

GameStop had only 26 hedge funds long the stock at the end of 1Q, with small-cap investor Royce & Associates having the largest position at $137 million (check out Royce's top small cap picks).

Bottom line

It's tough to admit having missed the tremendous rally in Best Buy, but I struggle to see the catalyst that will take the stock any higher. Analysts expect the big-box retailer to only grow EPS at an annualized 4% over the next five years, putting its PEG ratio at a relatively high 3.2. 

Amazon does not appear to offer investors a better opportunity. Even with analysts' expectations of 37% annualized EPS growth, its PEG ratio is a whooping 5.8.

It looks like GameStop could still be a worthwhile investment. With an expected 13% annualized five-year EPS growth rate, its PEG ratio comes in at slightly below 1.0. GameStop should benefit nicely from the upcoming release of next-generation Xbox and Play Station consoles, not to mention continued strength in its used- game business. 

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends The Motley Fool owns shares of and GameStop. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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