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Best Buy is very likely undervalued [ClearOnMoney]
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Best Buy is very likely undervalued

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Investment

Best Buy is very likely undervalued

9 Oct 2012 by Jim Fickett.

Best Buy remains a dominant player, and its cash flow remains very strong. Today I took an initial position of 1% of the portfolio.

In the story that Amazon is killing Best Buy we have another great example of “truth by repetition”. The facts are that Best Buy's market share and revenue are stable; its online market share is actually growing; and its free cash flow has been and remains very healthy. So the default outlook should be that recent years provide a decent baseline for future free cash flow.

This would suggest future free cash flows of somewhere between $640 million (if one foresees some future shrinkage, and takes the long-term average free cash flow that includes years when the company was much smaller) and $810 million (the average of the five years 2009-2013, including the midpoint of current guidance). With a current market cap of $6,000 million, that range gives a free cash flow yield of 11% to 14%. That is very high, and suggests the stock is quite undervalued.

A widely quoted fact that supports a more negative view is that same-store sales have been dropping. However, if revenue and market share are stable, this means, by definition, that the sales lost at some stores are being picked up by other stores or the online business. Falling same-store sales are not good, but the company is not actually losing the business.

It is certainly true that, in the past, Best Buy has paid insufficient attention to its online business. They completely missed the importance of the iPod in its early years and, until just recently, one could barely find any mention of the web or the internet in the annual reports. But this is changing. In the last two years online revenues have grown 20% and 14%, and this year the company hired two new high level people who understand the internet – former Expedia president Scott Durchslag and former Starbucks CIO Stephen Gillett.

I have mentioned before that Best Buy does not have a very strong balance sheet. I think the strong cash flow largely mitigates this, provided that the strategy going forward does not require extremely large capital expenditures. This seems to be the case, with the main strategic points being to improve the website, improve personnel training, and slowly move towards smaller stores.

The weakest point in my case for Best Buy is that I assume market share and revenue can continue to be converted to income. But lately there has been pressure on margins. Here is a graph of Best Buy's operating income as a percent of revenue:

Obviously the company is currently feeling great pricing pressure. It is not clear how much of this is from online-only retailers (the CFO recently named some one-off pressures on margins), but probably Amazon is at least part of the story. On the one hand, Amazon is losing its biggest price advantage, in that more and more states are forcing it to collect sales tax. On the other hand, the former Best Buy CEO Brian Dunn said in 2011, “Taxing all online sites equally would be a major, but not complete, closure in the pricing difference.”

My case rests on the thesis that physical stores do, in fact, have some advantages, and that people will not mind paying, say, 2% more, in order to talk with a real person and then immediately buy. I think that is true, but it is always hard to know such things. So the biggest risk to this investment is not that Best Buy will soon disappear, but rather that profits and free cash flow could be lower if the company feels it has to match Amazon's prices.

Some other miscellaneous points

  • Best Buy has no legacy retirement benefit costs; i.e. it never had a defined benefit plan for employees.
  • One can find many complaints about poor customer service. An objective measure of customer satisfaction can be found in data from the American Customer Satisfaction Index. According to Best Buy's 2007 annual report, the company scored almost exactly at the national average.
  • I am not trying to guess whether Schulze will succeed in taking the company private. If he does, it will almost certainly be at a greater price than where I bought. If he does not, I am betting on a stable continuing business resulting in a higher stock price.
  • The current dividend yield is 3.8%. There is much talk in the annual reports about returning money to shareholders via stock buybacks; but in fact at least half the buybacks simply cover employee stock options.
  • Best Buy is trying out a new strategy of providing turnkey IT for small businesses, included equipment, setup and repairs, cloud services, etc. If done well, this seems like it could be a winner.

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