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Best Buy got even cheaper last week [ClearOnMoney]
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Best Buy got even cheaper last week

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Investment

Best Buy got even cheaper last week

30 Oct 2012 by Jim Fickett.

Last week's announcement from Best Buy included some very encouraging strategic news. On the whole I remain optimistic that the company will bounce back. Since the future of Best Buy depends on convincing customers that it is worth paying a little more to take advantage of a network of physical stores, no one can predict sure success. I will increase my position a little and leave it at that.

Last week's announcement contained some very good news

Last week a press release from Best Buy caused rather a negative reaction from analysts and a fall in the stock price. Part of the press release is indeed bad news – a pre-announcement that for Q3 earnings will be down year over year and same-store sales will continue to decline:

The company is providing an update on its expected results for the fiscal third quarter ending November 3, 2012. Comparable store sales are expected to decline at a rate consistent with the range of results for the first two quarters of fiscal 2013 (-5.3% in the first quarter and -3.2% in the second quarter). Gross profit rate is expected to decline at a rate similar to that experienced in the fiscal second quarter of 2013, with a decline of more than 100 basis points compared to the prior-year period, due to the impact of product mix and product transitions in advance of several key new product launches. The company expects SG&A expense percentage growth to be in the low single digits over the prior-year period, due to investments related to the company's strategic focus on improved customer service (including increased training and higher compensation costs for sales associates). As a result, the company expects fiscal third quarter adjusted (non-GAAP) earnings per diluted share will be significantly below the prior-year period.

Although this is not happy news, it is not unexpected. The company is making changes, like closing stores, retraining employees, and strongly building up its web capabilities, and these changes cost money and take time. So things will not get better right away.

The other major part of the announcement, on strategy and personnel changes, also produced negative reactions from analysts but in fact it holds very positive news. The new CEO, Hubert Joly, is taking more direct control, moving those responsible for the current stagnation out of the way, promoting people who have gotten good results, and increasing the prominence of internet sales (newly reporting to Joly).

Effective January 1, 2013, Best Buy's operations in the U.S. will be structured around the following groups:

  • Two Channels - Online and Retail: While online continues to be overseen by Stephen Gillett, president of Digital and Marketing, Shawn Score is appointed to lead the U.S. retail channel.
  • Three Business Groups - Connectivity, Home and Services: Jude Buckley is promoted to head the Connectivity Business Group, succeeding Shawn Score, while Home and Services will continue to be led respectively by Mike Mohan and George Sherman.
  • Support functions, including Human Resources, Finance, Legal and Marketing, where there are no leadership changes.

In this phase of Best Buy's transformation, these groups will report directly to Joly. The current president of Best Buy's U.S. business, Mike Vitelli, will retire from the company at the end of the fiscal year. He will work closely with Joly to ensure a smooth transition. Executive Vice President of U.S. Operations Tim Sheehan will leave the company at the end of the month.

“Shawn Score and Jude Buckley have done a great job growing Best Buy Mobile and then leading the Connectivity Business Group. I look forward to working with them and the rest of our team as we re-invigorate and rejuvenate Best Buy,” said Joly. “Mike Vitelli and I will work closely together during the next few months to ensure a smooth transition. I am very grateful to him for everything he has done for the company and for his terrific support.”

So Joly is getting started on some important big changes right away, but is not going to make the changes effective until after the key holiday season. In the meantime, a promise to match Amazon prices evidences a strategy of holding on to market share now, and then working to compete more effectively at more realistic margins starting next year.

Critics are right that there is some risk in getting rid of Vitelli and Sheehan. These two know how to make the business run in its current form. However that is also exactly the reason to get rid of them. If Vitelli and Sheehan really appreciated the importance of the internet, Best Buy would not have given online sales such minimal attention over the last few years. And the only way to make big strategic shifts is to move the powerful people who have resisted the new direction out of the way.

A bio of Vitelli and a video interview with Sheehan are both long on generalities and short on ideas for producing satisfied customers. On the other hand, a five-part interview with Shawn Score, who will now be in charge of the physical stores in the US, discusses specific customer needs and specific Best Buy responses to meet those needs.

So all in all, I think the reaction to this press release was in the wrong direction – it contains more good news than bad.

Summary of the situation

At this point, I'd like to make a summary of the main points for and against Best Buy as a value play.

The big positives

1. The long-term track record is impressive

When evaluating a company, it is good to look not only at recent events, but at the long-term record. Best Buy has done extremely well, growing from nothing to become the single largest US player in consumer electronics. And even after investing strongly in growing the business, it has produced remarkably high free cash flows over time.

Is that changing? There is no evidence yet that it is. Since capital expenditures are so volatile, let's look at operating cash flow. This should not be confused with free cash flow, of course; the two differ, in the long run, by the average of capital expenditures. But if the business is really becoming unprofitable, as so many think, then we should see operating cash flows trending down.

The low value in Q2 could indeed be the beginning of the end, as many think. It is certainly cause for concern and vigilance. But it is not that different from other low points in the past, and so does not really indicate any serious downward trend just yet.

2. Current changes in strategy look smart

I am very impressed with Joly so far. It looks to me as if he is tackling exactly the right issues:

  • Improvement of the online “channel” is receiving top priority
  • Personnel changes at the top indicate a focus on the customer experience
  • He has highlighted the difference in performance between stores, probably indicating a willingness to change management at underperforming stores
  • Some of the big stores are being closed, and the successful small mobile device stores are expanding

The big negatives

1. Consumer electronics is a tough business to be in

Many people compare Best Buy to Amazon, Target, and Walmart, its three biggest competitors. But the comparison is not very helpful, as none of these three concentrates exclusively on consumer electronics. Perhaps a better comparison is to Dixons, a European retailer whose stores look very much like those of Best Buy.

Dixons reported a net loss in four of the past five years. This certainly means it is a tough business, and it might even mean that we should give up on Best Buy. Note, though, that the euro zone problems mean Europe's recovery from the great recession has been even rougher than that in the US. The euro zone problems are evident in Dixons performance – for the most recent quarter, same store sales were up 5% year-over-year overall, but were down 10% in Italy, Greece and Turkey. Incidentally, Dixons' turnaround plan looks very much like Best Buy's – closing excess stores, improving customer service, and putting a greater emphasis on “multi-channel” sales (buy on web and pick up in store; up 39% YOY).

2. Falling margins are scary

The fact that margins have fallen significantly in the last couple quarters certainly is not good for an investor's peace of mind. But it is to be expected in a situation where the company has to spend money, and take losses on previous bad decisions, in order to switch strategic direction.

It is extremely important for Best Buy to maintain its dominant market share. Think of the biggest challenge you would face if trying to build up a competitor from scratch. That challenge would be scale. A key reason that consumers are still attracted to Best Buy is that there is always a store nearby, and the selection available is very broad. That advantage must be maintained. So it makes perfect sense to put the first priority on holding onto customers, and let margins fall temporarily while improving the customer experience, and then to attempt to charge more fairly for what is provided.

3. Falling same-store sales are not a good thing

The bad news that is most often mentioned in the news is the falling same-store sales and, indeed, this is not a good thing. Many of the costs at any particular store are fixed, and so falling volume means reducing revenue while expenses fail to fall as much. This problem must be fixed. But the good news is that overall revenue and market share have not fallen significantly, and the problem is probably one of too many stores, and of some badly managed stores. That is fixable.

Myths

1. Best Buy is about to go under

Only a few very uninformed people are writing such things, but it contributes to the pessimistic mood. In fact free cash flow set a record in fiscal 2012, working capital (current assets minus current liabilities) at the end of fiscal 2012 was $1.4 billion, and free cash flow in fiscal 2013 is again expected to be healthy.

2. The costs for supporting retails stores is so much higher than the costs of an online business that Best Buy cannot possibly compete with Amazon

In fact the bulk of Amazon's advantage comes from not collecting sales tax, and this advantage is going away.

3. Showrooming is killing Best Buy

Although showrooming, in which people go to see the item at a retail location but then buy it online for less, might or might not really be a problem. But there is no evidence that it is a major one, and investors worry so much about it only because the idea seems plausible and the fear is often restated. As for evidence, Deloitte has shown that people who refer to their mobile devices while shopping in a physical store are actually more likely to buy. And in a recent Google survey of shoppers, half of respondents said their strategies include the opposite of showrooming – to research online and then go to the store to buy.

Conclusion

Soon after I began my career as a manager I was in a position to hire. As I prepared interview questions, a good friend looked over my list, which included many questions designed to probe knowledge, philosophical approach to the job, past relationships with colleagues, etc. His response shocked me. “Forget all that. Hire someone who has done the work you want done, and has done it well before. Then you know he/she can do it again.” It was good advice, and extends in a natural way to investing. Buy the shares of companies that have shown over the long haul that they can make money and grow a business. So I put a great deal of weight on Best Buy's long record of excellent free cash flow. Yes, they have some big challenges right now, but they have done very well in the past, and their strategic direction seems right.

The negatives most often mentioned in the news are myths, but there are real negatives, the most important being falling margins. On balance I think the evidence suggests that they have real competitive advantages, and can bring margins back up in a year or so. But they have to make some significant changes to show customers that they are really a top choice for shopping, and no one, certainly not I, can know for certain that they will carry this off.

On the whole it seems to me the burden of proof should be on those who say a successful business will be successful no longer, and I do think Best Buy will bounce back. So if the price tomorrow, when the markets reopen, remains in the neighborhood of Friday's closing, I will add to my position. But given the uncertainties, I will probably stop there.

Finally, on a lighter note

Previously on Best Buy