It wasn't so long again when the buy/avoid decision on Best Buy (NYSE:BBY) came down to the relatively simple discussion of whether you thought the company would be able to stabilize and continue on (with zero growth) or perpetually decline. With the shares up almost 50% from last year and 100% from the late December 2012 lows, now the question has shifted to how much growth the company's restructuring efforts will produce.
SEE: Cashing In On Corporate Restructuring
A Disappointing First Quarter In Some Respects
As befits a troubled turnaround story, there was good and bad news in the Best Buy fiscal first quarter report. If there's a positive spin, it's that at least sentiment has improved to a point where analysts and investors actually expect something from Best Buy again.
Revenue fell 10% this quarter, with U.S. sales down almost 10% as reported. Although that figure improves to negative 2.2% on a “same calendar basis” and the 1.3% comp sale decline was better than the Street expected (a decline of 1.6% to 1.7%), those aren't exactly encouraging numbers. On a more positive note, online sales were up 16% in the U.S. (though Amazon's (Nasdaq:AMZN) merchandise sales were up more than 28% in its first quarter).
Margins were iffy. Gross margin declined 180 basis points (BPs) and came in about 80bp to 90bp below the average sell-side estimate. Operating expense control was better than expected, though. While operating income fell 36% as reported and the operating margin fell 70bp to 1.8%, it looks like the average estimate was a little lower than (all the more impressive given the gross margin miss).
SEE: A Look At Corporate Profit Margins
Will New Policies Lead To A Sustainable Recovery?
Clearly the biggest question for Best Buy shareholders is whether or not management can rebuild and restructure this business to compete with alternative retail destinations like Amazon, Wal-Mart (NYSE:WMT), and Costco (Nasdaq:COST) and deliver worthwhile growth and free cash flow (FCF) again.
The same-store data this quarter was mixed. Consumer electronics were down almost 12% and entertainment was down 17%, while computing/phones were up 8% and and appliances were up 12%. That appliance growth figure is pretty encouraging given the weak results at hhgregg (NYSE:HGG) and Home Depot's (NYSE:HD) ongoing efforts to improve appliance sales, and likewise the computing/phone figure was pretty good given how weak PC sales have been for the industry.
But the real question is what happens next. Best Buy's relatively new CFO Sharon McCollam has apparently made quite an impression on the sell-side, as many analysts are repeating effectively identical talking points regarding the potential impact of moves like improving Best Buy's online efforts and promoting their price-matching. Likewise, a decision from Samsung and Sony to start pursuing unilateral pricing (where online retailers like Amazon are effectively not allowed to undercut store retailers on price) on some TVs is a big help.
Best Buy has a lot of work to do if they think consumers are going to value the in-store advice of their employees, and likewise the price-match guarantee isn't as strong as it sounds (it applies to one item per visit). On the other hand, various sites have already reported shrinking price gaps between the two companies and efforts to force online retailers to collect sales tax could help a little more.
SEE: Possible Effects Of The Online Retail Tax
I have incrementally more faith in some of Best Buy's other methods. I think supply chain and operating efficiencies could prove to be a valuable source of margin leverage, as has been the case at Home Depot recently). Likewise, I think expanded use of store-within-a-store formats like the recent deal with Samsung could significantly help Best Buy “right-size” it's selling square footage. I also believe that Best Buy got a decent price for its Best Buy Europe joint venture.
The Bottom Line
I've done well with turnaround stocks over the years, and one of the keys is to know when to take your winnings and call it a day. Right now, Best Buy's share price seems to be factoring in long-term revenue growth in the neighborhood of 1.5%, with free cash flow growth of around 5%. Both assumptions don't seem all that demanding at first glance, and Best Buy should be able to generate better than low single-digit free cash flow margins if this is really a viable business.
What I'm saying is that Best Buy could still be underrated here, but it's a less compelling case than it was when the stock was in the teens. Amazon is still a fierce competitor and shareholders shouldn't expect other manufacturers to follow the lead of Samsung and Sony on unilateral pricing. But if Best Buy can in fact improve its back-office operations and re-convince shoppers that there's a reason to come into the stores, this story isn't done yet.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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