Best Buy has room to run higher
The stock's fair value is overshadowed by a turbulent year.
The founder of the company, Richard Schulze, had to resign as chairman in May following revelations that he did not report former chief executive Brian Dunn's improper professional conduct to the board despite being fully aware of it. Dunn resigned in April after an internal investigation exposed a close personal relationship with a female employee that violated company policies, according to the New York Times.
There are two important structural changes in the electronics retail industry that continued to impact Best Buy's performance in 2012.
Retailers such as Wal-Mart (WMT) and Amazon (AMZN) are taking business away from pure-play consumer electronics stores by offering huge discounts. Customers are still using physical stores to check out products and gain hands-on experience with gadgets. However, a large number of customers then proceed to buy from online stores like Amazon at cheaper prices. This phenomenon of showrooming has hit companies like Best Buy hard. The past year was no different. In fact, surveys and studies have revealed that in the ongoing holiday season online sales have grown a lot while store sales have failed to gain much traction over last year. A significant volume of this traffic is going to Amazon.
A quarter of shoppers who said they had showroomed had done so at Best Buy, according to a recent Harris Poll. Thus far, the company has been unable to persuade many shoppers to buy online from its website than from those of its competitors.
2) Changing product mix
Shoppers are no longer snapping up as many TVs and desktop computers that are more profitable for retailers. They are instead opting for gadgets like cellphones and tablets which are less profitable for Best Buy.
TVs still constitute a major portion of its sales but average selling price has been falling even though the number of units sold are rising. This is due to higher contribution of small and mid-sized TV's to the product mix. TVs and PCs come with high-margin yielding warranty and service attachments so lower sales hurt margins.
Profitability in the smartphone category is primarily driven by the money Best Buy receives from the carrier and from the attachment of accessories in services that go with it. The price point of the smartphone is almost irrelevant in the calculation of gross margins because it's a heavily subsidized product (transcript on SeekingAlpha). So when looking at gross margins, even with a higher value smartphone Best Buy is still getting the same amount from the carrier and the same attachment at the end of the day.
While the company remains a large seller for tablets, Windows and Apple notebooks, and its share of smartphone sales increased by 50% last year, empirical evidence from previous quarters' results suggests that the higher volumes have failed to compensate for lower margins thus far. Tablets and smartphones do provide opportunities for high margins on warranties, service contracts, and accessories, but we think that it will take time for Best Buy to monetize these at the same level as TVs and PCs, according to the StarTribune.
What Best Buy did to meet these challenges
In all fairness to Best Buy, it did try out a few things in response to challenges. None of them seem to have clicked thus far though.
1) Expansion of Geek Squad's services
In a bid to open a new stream of revenues, Best Buy partnered with eBay (EBAY) and Target (TGT) to offer its popular Geek Squad services (read on Trefis). EBay added service plans on its website for customers wishing to gain from the Geek Squad's services while trials were conducted at some Target stores in Denver and Minneapolis.
The Geek Squad division already earns over $1 billion in revenues for the company and diversification represents a major business opportunity. However, it's too early to comment whether Best Buy has managed to score a home run with this strategy.
2) Price matching
This holiday season, Best Buy is matching match the lower prices offered by Amazon and other online retailers in its brick-and-mortar stores. It is also offering free shipping for items which customers find out-of-stock in its stores. Earlier, e-commerce players were largely exempt from paying sales-tax in most states. This loophole is being plugged by many states and fewer states now permit themselves to be used as sales-tax havens (read on Trefis). The increased costs are being passed on to the customers, reducing the price differential between online and physical retail stores. Thus, Best Buy may have found it easier to match these prices. It may have thought that customers who value the whole experience of shopping and interacting with knowledgeable sales staff may now opt to buy from a Best Buy store if they are getting products at the same price.
While a comprehensive assessment would only be possible at the end of the holiday season, it is not difficult to see that matching online prices will impact the company's profit margins. Best Buy seems to be making a bet on its ability to withstand the onslaught from online retailers even at the cost of a short-term hit to its profitability. The move seems designed to retain its customer base more than anything else.
In addition, Best Buy has been spending considerably on providing training to its employees to upgrade their skills and improve customer engagement and interaction.
The biggest buzz was caused by something else
Best Buy's stock price movement was quite volatile in 2012 due to speculation that Richard Schulze, in collaboration with a group of private equity players, would come up with a buyout offer to take the company private. He was initially given time until December 16 to make an offer to the board but one day prior to the deadline, an extension was provided until the end of February. The stock first rose a few days before the deadline in anticipation of an offer and then fell by as much as it rose when the news of the extension was received (read on Trefis). We believe that an extension was provided to allow both sides to look at the holiday season performance of the company in order to gauge its true value.
A good performance this holiday season may be rewarded with a better valuation from the private equity investors Schulze is in talks with. This may help shore up the stock price and allow the Best Buy board to demand a significant premium if and when a buyout offer comes up for evaluation. On the flip side, a good performance will make the acquisition pricier for Schulze. We think that Schulze might actually prefer this over a lower price tag and the possibility of his bid being rejected by Best Buy's board.
On the other hand, a sub par performance this holiday season may cause Best Buy's stock to plunge further and scare off the investors who are in talks with Schulze.
Many people think that the best course for Best Buy shareholders would be a buyout offer by Schulze at the right valuation. Next year, all eyes will be focused on Best Buy's performance during the holiday season. The outcome will decide the future course of action on both sides.
We have recently revised our price estimate for Best Buy to $16 after the third quarter earnings results. The stock currently trades at $12 a share.
Copyright © 2014 Microsoft. All rights reserved.
Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.
Longtime market bull Jeremy Siegel says investors could realize the market is behind the curve on interest rates.
VIDEO ON MSN MONEY
Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.
Contributors include professional investors and journalists affiliated with MSN Money.
Follow us on Twitter @topstocksmsn.