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Holding on to Best Buy

20 Mar 2013 by Jim Fickett.

I bought Best Buy at an average price of about $16/share. Today the stock closed at about $23. It is tempting to sell, but I think the stock is still very likely undervalued, and I will hold.

I first bought stock in Best Buy (BBY) on 9 Oct 2012, at $17.84 (Best Buy is very likely undervalued), and then again on 30 Oct 2012, at $15.21 (Best Buy got even cheaper last week). Today BBY closed at $23.07, giving me a paper gain of almost 40%. It is certainly tempting to realize that gain, but I will make two arguments that the stock remains undervalued.

First look at the long-term history of free cash flow, updated to reflect fiscal 2013:

Free cash flow is highly variable, and we need to take a long-term average to get some idea of a sustainable rate. The company grew pretty steadily over the period shown, and early dates are not representative because revenues were so much lower. It was nine years ago that the company first reached revenues one half of today's, so at least on the same scale. The average free cash flow over the last nine years was about $830 million, which at today's market cap of $7,800 million gives a price/fcf of about 9, which is cheap, or, equivalently, a free cash flow yield of 10.6%, which is impressively high.

Of course one has to ask whether the company can maintain its long-term average free cash flow. Both revenue and market share have been fairly steady over the last few years, so there is no reason to expect the company to shrink. It is possible that the bricks and mortar business will shrink, but Best Buy has hired new leadership that understands on-line sales, which are growing rapidly.

The big question is margins. Could it be that competition in the on-line world will drive down margins and reduce profits? Here is the history of free cash flow as a percentage of revenue:

Again, this number is highly variable, but looking at the variable numbers in relation to the long-term average rate (2.15%), there is no evidence that the rate is in a declining trend. The company is undergoing big changes right now, and no one can predict with any certainty how it will all turn out. But Best Buy has a long history of adapting to a changing world and producing healthy profits. It seems quite likely that their overwhelming advantage of scale over most competitors, together with a smart strategy of undoing recent mistakes (too many stores, not enough work on the web site) will pull the company through again. If so, then 2.15% of current revenues, which works out to $1067 million, might be a reasonable guide to free cash flow going forward. That gives a price/fcf of only about 7.

Of course if you think Amazon is going to kill all physical stores, none of this analysis matters. I've given my arguments before (see links in the posts already mentioned); I doubt very much that Amazon is going to significantly reduce Best Buy's market share. So I think Best Buy is a strong business and that future free cash flows will be generous to those buying at the current price.

Incidentally, at the current price the dividend yield is 3.1%.