Is This Best Buy's Last Chance?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
To be fair, I've been a staunch Best Buy (NYSE: BBY) supporter for a while now. I'll admit up front that I'm a fan of technology. I've spent many hours walking through the aisles, and countless thousands of dollars on items from the store. I've also argued multiple times in the past that Best Buy has several options to keep the company relevant and improve profitability. However, management seems to not have its eye on the ball, and maybe is looking forward to a buyout rather than a turnaround. If the company doesn't make some hard decisions soon, there may not be much left for shareholders.
Whether Best Buy realizes it or not, the company's main focus should be on the items that many customers ask for assistance with as this benefits their people centric model. Anyone who's been in a Best Buy knows that many times questions are asked specifically about computers, tablets, cell phones, and not much else. In theory, this should give Best Buy management an idea of where they need to place their focus going forward. With competitors breathing down the company's neck like Amazon.com (NASDAQ: AMZN), eBay (NASDAQ: EBAY), and even Wal-Mart (NYSE: WMT) and Target (NYSE: TGT), the company has to offer something that these competitors can't match. As I said before, the main thing that Best Buy offers but none of the above competitors can do quite as well is answering questions at the point-of-sale. You can certainly see that the company is struggling based on their last quarterly report. There are some positives that investors and management can take away, but the numbers don't lie and action is needed quickly.
When you see numbers like comparable sales down 4.3% and an earnings per-share loss of $0.04 versus a $0.47 profit per-share last year, there's no question Best Buy is having trouble with its competition. I have found personally that when looking for holiday gifts it's easier to go online and compare multiple selections than to walk into a Best Buy and try and find what I want. You would think that most of Best Buy's challenges are coming from online retailers like Amazon and eBay. However, Wal-Mart and Target have a different advantage in the sense that their selection of goods is much broader, and thus their stores are frequented tremendously more than Best Buy. Between customers using Best Buy as a show room and then buying online and customers choosing to buy on convenience when they are already at Wal-Mart or Target, Best Buy is being squeezed from both ends. That being said, Best Buy needs to play to its strengths and eliminate its weaknesses. If you look at the company's comparable sales by product line, it's fairly easy to see which items should stay and which ones should go.
Admittedly, there are only a few areas of clear strength in Best Buy's model. However, there's no doubt computing and mobile phone sales are a bright spot. In addition, though international comps on appliance sales were down, this has been an area of strength for the company for multiple quarters. There's no question the company's services (Geek Squad) have to be a core offering to differentiate Best Buy from other retailers. When it comes to the areas that Best Buy is struggling the most in, it's really no surprise that consumers are choosing to buy their entertainment and consumer-electronics items elsewhere. Amazon and eBay offer the advantage, in most cases, of paying no sales tax. When it comes to entertainment sales, these items have been moving toward digital sales consistently in the last few years. The traditional Best Buy store delegates a large amount of floor space to the sale of entertainment merchandise, and that is part of the problem. If the company makes hard choices to revamp the store model around the items that it sells the best, it would require smaller stores, less staff, less expenses, and a more nimble organization. Best Buy really has no choice, because on a financial basis the company is doing horribly.
For Best Buy to try to execute a turnaround plan requires that the company have sufficient capital to accomplish this feat. One issue standing in the company's way is their gross profit margin relative to their competition. After all, if Best Buy is unable to sell items at competitive prices, the company's cash flow will be challenged. Best Buy's gross profit margin was just 24% this quarter versus 25.6% last year. By comparison, Amazon carries a gross margin of about 25%, Wal-Mart's margin is a similar 25%, and Target carries an even higher margin at 32.67%. EBay operates an almost entirely different model, which makes a gross margin comparison not instructive. This lower gross margin and challenging comparable sales caused tremendous damage to Best Buy's cash flow and balance sheet.
The company's cash balance dropped by 85%, and adjusted operating cash flow decreased 32.39%. What really seems to make no sense is that the company generated about $300 million in adjusted free cash flow yet used $255 million on stock repurchases. While I would like to believe that management is convinced of future profitability, it doesn't make sense for a company with 85% less cash on the balance sheet and a huge decline in operating cash flow to use money to repurchase shares. One small piece of good news is that if the company had maintained its $300 million in adjusted free cash flow, this would've represented a just 18.33% free cash flow payout ratio of their dividend. Given the dividend yield exceeds 5.8%, this is good news, at least in the short term. Relative to its competition, the company is only a good value if investors believe that a turnaround will occur, and the dividend can be maintained.
If you look at the expected growth rate of each of Best Buy's competitors, each one is expected to post earnings-per-share growth of at least 9% over the next few years. Considering analysts are calling for negative 8% growth at Best Buy, even the company's seemingly cheap P/E ratio of just over five still doesn't look appealing. Investors looking for growth should likely consider eBay. The stock offers the best combination of growth (14%) and valuation (forward P/E 18). Investors looking for growth and income would likely be better served looking at Target and its 2.2% yield with just under 12% expected growth rate in the next few years. This leaves Amazon as a high priced and high risk stock, and Wal-Mart as a second choice behind Target. The problem is, Best Buy would seem at best to be the fifth best option among the companies we've looked at. Unless management is willing to make some hard choices, this earnings report may be just the beginning of the serious decline in Best Buy's finances. The company has one last chance to change their business model or I fear they will fade away.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Best Buy. Motley Fool newsletter services recommend Amazon.com, Best Buy, and eBay. 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!