Best Buy Co. Inc. (NYSE: BBY). Best Buy’s online capabilities and curbside service are helping the company through the COVID-19 crisis. We see this as a validation of the company’s investments in its e-commerce infrastructure and management’s ability to adapt.
We expect a smooth management succession. Former CFO Corie Barry has become the new chief executive. Ms. Barry and former CEO Hubert Joly, who retired from the board at the calendar 2020 meeting of shareholders, have been instrumental in growing Best Buy’s online sales channel and laying the foundation for future e-commerce growth. We believe that Ms. Barry, who led the Renew Blue turnaround program, will continue to position the business for the future, and drive operating improvements by finding innovative ways to sell technology products for the home.
Management has taken a methodical approach to rescuing the company by reducing costs, divesting unproductive businesses, creating in-store ‘shops’ for Apple and other key vendors, matching Amazon prices to stay competitive, and adopting more effective marketing and operating practices. However, we believe that BBY faces three major challenges apart from COVID-19: intense competition from online and big-box retailers; product innovation that is consolidating music, video, computing, communications, gaming, and photography products into a small number of devices, like smartphones and tablets, which often carry low margins; and a slowdown in the smartphone market.
An offset is that the company is moving aggressively to be a destination for products in the ‘Smart Home,’ including senior (and baby) monitoring systems; fitness equipment that networks with outside classes or other athletes; and modules to control lights, thermostats and enabled appliances from a remote location. We believe this is a large opportunity that is addressable for BBY, but it will take considerable patience and selling skill.
On November 24, BBY reported fiscal 3Q21 adjusted EPS of $2.06, up 82% from a year earlier.
The GAAP number includes $0.14 of inventory markdowns and $0.38 of restructuring charges relate to the decision to exit operations in Mexico. BBY had GAAP earnings of $1.10 in the prior year.
The Chief Executive Corie Barry expects the pandemic fueled shift to digital shopping to be permanent. The company did not provide formal guidance, but 4Q sales got off to a strong start helped by the launch of new gaming consoles from Sony and Microsoft. BBY expects 4Q sales to grow on a year-over-year basis, but not at the rate we saw in 3Q.
Enterprise comps were up 23% compared with the consensus call for a 13.6% increase. Sales of computers, and appliances were strong as customers focused on working and cooking at home. The company also saw some strength in Home Theatre. The company gained new customers and saw a return of many customers who had not shopped with them in a while. Third-quarter sales benefited from a shift in Best Buy’s own promotions to counter Amazon’s prime day as well as an earlier start to holiday promotions. This helped Domestic comparable sales to rise 33% in October.
Domestic online sales were up 174% in the quarter, reaching 35% of domestic revenue, up from 15.5%. Brick and mortar sales were down about 8% in the quarter.
The gross margin rate was 10 basis points lower than we expected at 23.9%, reflecting higher supply chain costs from outsized growth in online sales and lower profit sharing revenue from the credit card program, offset by a more favorable promotional environment. The SG&A rate was 30 basis points lower than we modeled and 30 basis points below consensus. That takes us to adjusted operating income of $728 million, or 6.1% of sales, which was about $200 million higher than we modeled.
The 10-Q, which was filed a few days later said that BBY had resumed repurchases.
EARNINGS & GROWTH ANALYSIS
While the company was prudent in suggesting that the tremendous strength in 3Q would probably ease, it is seeing strong demand in 4Q led by new gaming systems. The strength of the current numbers may reflect a pull forward of some sales from later in the quarter. Sales could be constrained by inventory shortages in some categories. BBY expects gross margin pressure in 4Q from higher supply chain costs and from holiday surcharges from shipping companies. The company expects SG&A dollars to increase in the mid-to-high single digits from incentive compensation and higher variable cost on expected demand growth.
While this is admittedly the kind of fine tuning we try to avoid, we had published our bias for reducing our estimate. Earning $8.00 per share in FY25 seemed like a long shot at the beginning of the summer of calendar 2020. It now seems plausible that the company could hit $9.00. We will be revisiting this after the 4Q21 earnings report. The company’s guidance is for a 5% operating margin in FY25. While we expect continued margin pressure in the company’s current core products, BBY can potentially offset some of the gross margin pressure if it can generate a higher mix of services. We are confident that management can intelligently reduce costs. We expect BBY to generate a lot of cash and we may be conservative in our estimate of share repurchases (which have resumed in fiscal 4Q21). Over the next few years the amount of buyback activity will depend on capex needs, the amount of the dividend, and the share price at which it is able to repurchase shares when it reinstates the plan.
Our financial strength assessment for BBY is Medium. On October 31, the company had about $5.1 billion of cash, even after the 2Q repayment of $1.25 billion that it borrowed to max out the revolver in 1Q. BBY has done an excellent job bolstering its finances.
Real estate is not a major asset compared with what we see at some other big-box retailers, such as Target, Home Depot, and Costco. Excluding leases, outstanding debt was about $1.9 billion, or 32% of capital in 1Q21.
S&P recently raised its rating for Best Buy’s debt to BBB, which is now investment grade. The outlook from S&P is Stable. Moody’s has a long-term Baa1 rating, and the outlook is stable.
Net income was higher, accounts payable were higher, and inventory was lower – beneficial to cash generation. BBY generated $3.8 billion of cash from operations in 1H21, up from $625 million a year earlier. Net earnings were higher. Inventories were a source of cash. Best Buy made FY19 dividend payments of $1.80 per share. On February 27, 2019, the company raised the quarterly payment by 11% to $0.50 per share. FY20 dividends totaled $2.00. BBY announced a 10% dividend increase to $0.55 per share in its 4Q20 earnings release on February 27, 2020. We are maintaining our FY21 dividend estimate of $2.20 per share.
MANAGEMENT & RISKS
In its annual report, management said that the outbreak of COVID-19 would adversely affect business and financial results. The company expressed concern that coronavirus could disrupt its supply chain, and result in significant costs. BBY said that the impact on the business was highly uncertain. BBY has implemented curbside service and appointment shopping to bolster its business.
On April 15, 2019, Best Buy announced a succession plan in which Chairman and Chief Executive Officer Hubert Joly became executive chairman following the meeting of shareholders on June 11. Corie Barry, the company’s CFO, is now CEO. Ms. Barry also became a member of the board, which was expanded to 13 directors. U.S. Chief Operating Officer Mike Mohan has become president and COO.
She ably replaced the irreplaceable Sharon McCollam as CFO, and stands out as one of the most accessible CFOs in our coverage universe. She joined Best Buy in 1999, and helped to engineer $1.4 billion in cost reductions as the leader of the successful Renew Blue program. At 45, she became one of the youngest CEOs of a major company.
Mr. Joly did a superb job leading Best Buy’s comeback. He will be missed when he steps down at the shareholders meeting on June 11, 2020. We are pleased that the company is promoting and securing the talents of Ms. Barry, whose skills would be in demand as either a CEO or CFO.
In July 2019, the company promoted Matt Bilunas, the senior VP of Enterprise and Merchandise Finance to the position of CFO. He has been at Best Buy since 2006.
On February 4, 2020, the WSJ reported that the investigation by an outside law firm was complete and the board decided to keep Ms. Barry in her position. The company did not provide any findings from the investigation in an effort to maintain the confidentiality and integrity of the process, the Journal said.
While members of the leadership team and the company’s strategy have changed over the last several years, the challenges Best Buy faces have not. The management team will still need to deal with the effect of intense internet competition on its big-box stores, grow its own internet business, provide more exclusive products and services to differentiate itself from internet competitors, profitably grow the appliance business, maintain market share in televisions and mobile phones, and cope with the growing market power of vendors like Apple.
Mr. Joly has done a superb job. He has recognized the harsh reality of the competitive environment, made unsentimental decisions and taken the hard medicine to position the company to survive.
Best Buy faces numerous risks. On a macro level, sluggish personal income growth could reduce the willingness and ability of Best Buy’s customers to make largely discretionary purchases such as a new home theatre system or a new video game system. Tight credit conditions could also constrain spending.
Another long-term risk is the deflationary nature of the company’s product mix. Best Buy could fail to recapture on volume the ongoing decline in the average selling price of products such as computers and televisions. New products are also forcing the company to rethink the usage of store space and promotions. There is probably no better example than CDs and DVDs, which were almost completely replaced by downloadable media. As a side note, downloadable songs and albums have been hurt by streaming music services. Years later the company is seeing a similar pattern, with gamers downloading new releases rather than buying them in shrink-wrapped packages. This has significantly changed the allocation of floor space and diminished a popular tool for driving store traffic – deeply discounted music and movies. The company currently stages big products like televisions and appliances along the outside of the building and uses the middle of the store for products that can be repositioned more easily.
Another challenge is that the fourth quarter and the Christmas season is extremely important to BBY. Unfortunately, some broad line retailers bring in more electronics products to compete in 4Q and are also willing to sell some electronics at very low margins to drive traffic to other departments, like clothing, decorations and home goods, which have higher margins than electronics.
The company has been aggressive in trying to gain market share in the appliance business. We believe that much of the gain has come from Sears, which once had the number-one market share by a wide margin. This is obviously a slightly different operating model, because delivery, installation and service are so important. We also think that BBY has an opportunity to sell more small appliances, like microwaves, vacuum cleaners and air conditioners.
One important question is whether BBY, or anyone else, can reap high returns from explaining, simplifying and integrating suites of products. The prospect makes intuitive sense and services tend to generate higher gross margin than products. The counterpoint is that companies like Apple are earning some of the profits by creating devices like the iPhone and iPad that already integrate a camera, a music player, a web browser, contact lists, calendars and gaming. Services represented about 4% of BBY’s domestic sales in FY18 and FY19. There is clearly upside in the fragmented market for services and the company’s new Total Tech Support offering could help.
Best Buy faces intense competition. The company competes against brick-and-mortar consumer electronics chains, a category it dominates following the demise of Circuit City; department stores and discounters, such as Walmart and Target; computer sellers; home office retailers, such as Staples; entertainment stores: high-end boutiques; and Lowe’s, which aims to be the number-one seller of appliances. We also believe that Best Buy is likely to see pressure from Costco, Sam’s Club and BJ’s as the warehouse clubs sell more electronics. The company also faces online competition from Dell, Amazon, eBay, Apple and a range of niche players. These retailers could be an increasing threat if electronic products continue to get smaller and easier to ship.
BBY gets 79% of the merchandise it sells from its 20 largest suppliers and approximately 56% from five suppliers: Apple, Samsung, Sony, Hewlett-Packard and LG. Lenovo dropped out of the top five in the 2020 annual report. Apple is both a supplier and a competitor through its Apple retail stores.
Best Buy Co. is a leading retailer of consumer electronics, with FY20 sales of $43.6 billion, including about 8% from international operations. Total square footage is about 43.5 million, down from 50 million in FY11. In the Domestic segment, Consumer Electronics generated about 36% of FY20 revenue; Computing and Mobile, 42%; Entertainment, 8%; and Appliances, 10%.
The company’s fiscal year ends on the Saturday closest to the end of January. FY18 was a 53-week year.
BBY shares are up about 21% this year. Intuitively, we think that intense competition, margin pressure, the cyclical nature of the business, and online competition argue for a below-market multiple on a normalized basis. The S&P 500 currently trades at about 25-times consensus for calendar 2020. We believe the discount for Best Buy reflects concerns about the competitive environment for consumer-electronics retailers as well as very high multiples for a handful of growth stocks.
The five-year average P/E for BBY is about 13-times forward earnings. The multiple rebounded from a low of less than 5 at the end of calendar 2012. We think a normal multiple of about 15 is fair based on expectations for five years of growth at 7% followed by steady growth of 3% with a 75% payout and an 8% discount rate. There are a number of points that could be argued here. Is 3% too low? Based on the investor day guidance of 3% sales growth and a flattish operating margin, it may not be, especially when we look out beyond five years, and with the assumption that 75% of earnings will be paid out as dividends rather than split between a lower dividend payout and buybacks. The company’s pre-COVID balance sheet argued for a lower discount rate than 9%, and we are currently using 8%. The company has been able to generate sales online and with curbside pickup.
Here is another way to understand the valuation with a very simple, but transparent discounted earnings model. If EPS reaches $9.00 in FY25. Our rating on Best Buy remains HOLD.
On December 4 at midday, HOLD-rated BBY traded at $105.55, down $0.99.