Best Buy (BBY) Memo. Garrett Hynson CLAS (ECON) 2 nd Year

Transcription

1 Garrett Hynson CLAS (ECON) 2 nd Year Important Company Financial Data 2011 Revenue: $50.27 billion (up 1.16% YoY) 2011 Total Operating Expenses: $10.52 billion (up 6.03% YoY) 2011 Operating Income: $2.11 billion (down 5.41% YoY) 2011 Ending Total Cash Balance: $1.13 billion (down 41.28% YoY) 2011 Free Cash Flow from Operations: $1.19 billion (down 46.06% YoY) Same Store Sales Trailing 3/9 months: Up 0.3%/Down 1.4% Net New Stores Revenue Trailing 3/9 months: Up 1.3%/Up 1.6% P/E (compared to Forward and Industry): 7.5/5.7/23.5 P/B; P/S; P/CF: 1.3/0.2/2.6 Dividend Yield: 2.94% Short Float: 16.25% Market Cap: $7.6 billion Thesis / Key Points Online sales are crushing Best Buy s market share. Traditional retailers have struggled to adapt to competition from online retailers such as Amazon. Circuit City failed during the recession, and Best Buy is not far behind as it has failed to compete in the market with online retailers and others. The company has failed to successfully merge its online and retail business, and this is helping to kill it. Customers have reported inconsistencies with store inventories as seen online and then in the actual store. During the holidays, the company was unable to fill over 30,000 online orders, and offered the affected customers little in the way of an apology, failing to fully appreciate how much this could have affected them. Indeed, it let them know just three days before Christmas, a time when they would have had few if any alternatives. This pales in contrast to Amazon s reputably outstanding customer service, and will certainly not help Best Buy gain any traction among consumers. The failure in customer service is not just administrative it is pervasive all the way down to the store floor. Customers, and even some former employees, note the sales culture at Best Buy almost pushes the product on the customer to the point where it seems to some like the goal is more to not let the customer walk out empty-handed than to help them find what they came in looking for. VAR confirms this sales culture, and Larry Downes January Forbes article entitled Why Best Buy is Going out of Business Gradually highlights it as well. The fact that so many people can see these flaws, yet management refuses to change the culture, should be a huge red flag for investors. Management recognizes what s wrong which is a good thing but has done nothing to change it. Online shopping has been a big thing for years, and it has been apparent for some time that it is not simply a fad, but is here to stay. In his response to Downes article, Dunn agreed with some of Downes analysis, particularly certain problems that he pointed out. However, his response explaining what Best Buy was doing to change this was very vague, and came off sounding weak. The company has no excuse to just now be reacting to these flaws, when they have been visible for years. The lack of a strong leader will prevent Best Buy from implementing any effective plan until it is too late. CEO Brian Dunn just recently resigned, leaving the company with no leader. Analysts have labeled the CEO search committee weak, with Sanjay Kholsa, president for Kraft developing markets, as seemingly the only qualified candidate. The other members have seemingly little experience or knowledge of what would make a good CEO. However, who the next CEO is may be entirely irrelevant anyway the longer it takes to find a new CEO, the less it will matter who the new CEO is, because they will have less time to save a sinking ship. A new strategy will take time to be implemented, and time is ticking away quickly for Best Buy. The committee must make a swift decision and pick a strong candidate if it is to turn the company around. Current strategy is not working. The current strategy is unsuccessful. The company recently announced plans to shut the doors of 50 stores this year. This is exactly how Circuit City began its demise, closing stores to cut costs instead of shifting its strategy. The company needs to focus on making stores more appealing to customers and integrating them with its online business, as opposed to simply cutting costs. Best Buy also pays a dividend, something it cannot afford to do as it has been on the decline. While this does help make its stock more attractive to potential shareholders, the company should instead be dedicating these resources to figuring out how it can restructure itself to adapt to changing market conditions and compete in this environment. Misperception Extremely low valuation provides a good buying opportunity a low valuation is not the same as an undervaluation: there is a reason Best Buy s multiples are so low. People are expecting the company to fail, and this is why it is so lowly valued. Several analysts have indicated that Best Buy is a value trap, or a company destined to fail that value investors should not buy simply because they see it as cheap. Best Buy has the potential to be acquired by a private buyer after losing so much market capitalization. Any private buyer,

2 likely a private equity firm, would be taking on Best Buy in an attempt to save a sinking ship, and this is unlikely. With Circuit City out of the picture, Best Buy can gain market share in the consumer electronics market. Just because Circuit City is out of the picture, this does not mean that Best Buy will be able to take on its customers and market shares. Yes, it is the only remaining large electronics retail store, but much of this market has moved on to online retailers, such as Amazon, or to other wholesale or discount stores, such as Costco and Walmart. Best Buy has become more of a showcase for these electronics stores than anything, and customers now frequent its aisles just looking for information about goods that they will buy from another supplier later. This has squeezed Best Buy s margins, and crushed it as a company. VAR Unhappy employees. From speaking with workers at several Best Buy stores, it doesn t seem that anyone really enjoys their job. Employees see others quitting, and those still at the store complain of low wages, long hours, and how they are treated. Corporate culture is not appealing. Best Buy s culture almost forces the sale upon the customer, and both employees and customers I have spoken with have confirmed this. The business model is obsolete. Analysts continue to wonder how long Best Buy can sustain itself as an electronics retail store, and most agree that pressure from online retailers such as Amazon will force it to adapt or fold. Miserable Customer Experience. As visible with the cancelled online orders debacle this holiday, it is evident that Best Buy does not take its customers feelings into full consideration when making a decision. Customers complain of feeling pushed to make a purchase, particularly of something they did not originally intend to buy when they walked into the store. In addition, consumers have complained of constant store reorganizations making things difficult to find. As Best Buy cuts stores and reorganizes the remaining stores into the most efficient way possible, consistency will only be harder to come by, further frustrating its customers and making them even more dissatisfied with their experience. How It Plays Out As more and more traffic moves into the online space, Best Buy s revenue, profit, and margins will continue to shrink. It will need to close more stores, and barring a great hire to fill its void at CEO, the ship will continue to sink. Seeing this, Best Buy will continue to close more and more stores until it finally realizes what is already apparent to others: its business model is simply unsustainable. Then it will go the way of its former competitor Circuit City, and simply be forced to go out of business. Risks / What Signs Would Indicate We Are Wrong? The company hires a CEO who is able to implement an effective vision. This is probably the thing most likely to turn Best Buy around, and considering that Best Buy s CEO just resigned, the time to implement a new strategy and vision is now. However, the committee designated to pick a new CEO seems inadequate at best, and Best Buy needs someone outside the company to invigorate it and spur the change it so desperately needs. This committee must look outside the company, and if they fail to do so, it is likely the same corporate culture that has plagued Best Buy will continue to drag it down. Same-store sales increase. This seems highly unlikely, as Internet sales only continue to gain traction. New customers are growing up having known the Internet as their primary marketplace, and the trend towards Internet sales holding prominence does not appear to be lessening. Best Buy is able to gain market share even while facing strong competition from Internet retailers such as Amazon. Because of the trend towards Internet sales, this appears unlikely to occur through physical retail. However, should Best Buy successfully establish its own online marketplace (a more fully integrated marketplace that is combined with its physical presence in order to give it a competitive advantage), it could potentially steal market share back from the online giants such as Amazon. Investors decide to revalue the company at higher multiples. Considering Best Buy hit a 52-week low yesterday, from a valuation standpoint shorting the company may not look attractive. However, should sales and profits continue to decline, as is expected, the continued decline in share price will be proven appropriate. Signposts / Follow-Up Who the company brings in as CEO Change in company culture Same-store sales Valuation Innovation including opening a new online marketplace to compete with companies like Amazon Company Description BBY is the largest consumer electronics retailer in the United States. With approximately one-fifth of the $180 billion market for these goods, Best Buy is the market leader. Globally, it commands approximately a 7% market share of the $700 billion worldwide market. The company runs operations under the Five Star and Future Shop brands in China and Canada, as well as the Geek Squad, Magnolia, and Pacific Sales brands in the United States.

3 The diagram above shows Porter s Five Forces, a theory about the competitive forces that shape an industry. In Best Buy s case, these would be: Bargaining Power of Suppliers: As Best Buy loses market share, its suppliers will have greater pricing pressure as it will not be as large a purchaser as it once was, and will not have as much negotiation power. Bargaining Power of Customers: Customers are already exhibiting their increased power as they look to other places to purchase products. Many are shifting to online retailers such as Amazon, or even going to larger wholesalers or retail outlets such as Costco or Walmart to purchase TVs, video games, or other products. Apple s retail stores have hurt Best Buy in the computer segment as well. Threat of New Entrants: New entrants are already crushing Best Buy s position in the market. Even though Circuit City is no longer a competitive threat, Amazon and other online retailers have hurt Best Buy s market share. Others such as Costco or Walmart are encroaching as well, and even small-store retailers may be able to hurt Best Buy if they can offer better customer service. Best Buy has no clear competitive advantage. Threat of Substitute Products: There are many players in the retail electronics market. Online players as well as brickand-mortar stores pose a threat. Competitive Rivalry within an industry: Based on its bargaining power and threats from both new entrants and substitute products, Best Buy s competitive advantage has eroded. There is no reason to shop at Best Buy as opposed to buying from another retailer, either online or one that is brick-and-mortar, and this poses serious concerns for Best Buy both in the immediate future and down the road.

4 **Credit to Morningstar for a screenshot from Best Buy s most recent 10Q Share Repurchases Best Buy has made several share repurchases over the past year. This is concerning for several reasons: In a time when Best Buy must be conserving money, it has been hemorrhaging it on share repurchases. Even if these shares are being purchased at a discount, the company has no money to be doing this right now. It must use this money to innovate, and create a distinct, sustainable competitive advantage that will allow it to thrive in the face of many headwinds in this ever-changing market. More often than not, research has shown, company management poorly times share repurchases. Companies tend to buy high and sell low. In good times, when the stock is doing well, more share repurchases tend to occur, and they occur with less frequency the more poorly the company does, in bad times. Clearly, Best Buy is purchasing shares in bad times, but statistically this will still tend to be at a premium to where shares will trade later. This has proven true, as the repurchases in the graph above all occurred at higher price points than where the current shares are trading (21.70 as of closing on April 24, 2012), which is not a positive sign. Share repurchases can be done as a way to mask the decline in earnings by bolstering earnings per share. By repurchasing shares, Best Buy will have fewer shares outstanding. Thus, its earnings per share will continue have less shares by which to be split up, and it will artificially boost the earnings per share. While many people look at net income, earnings per share are also an important metric for analysts. By repurchasing shares, Best Buy could maintain the same level of net income, and increase its earnings per share, something the company could brag about to analysts, regardless of how its overall net income was affected at the time.

5 **Credit to Morningstar for a screenshot from Best Buy s most recent 10Q Finances in Decline Clearly, by the above income statement offered in Best Buy s most recent 10Q, we can see that earnings are in decline, along with several other concerning metrics (all for the three months ended YoY): Cost of goods sold increasing faster than revenue o Reduced gross margin from to 32% to 33.5% Selling, general, and administrative expenses increasing 0.7% granted, less than revenue s 1.75% increase A 53.8% decrease in operating earnings A 45.3% decrease in EBIT A 45.4% decrease in net earnings including non-controlling interests A 40.9% decrease in net earnings A 27.9% decrease in basic earnings per share