Best Buy Needs To Tune Out The Haters

By Stephen D. Simpson, CFA | September 15, 2011 AAA

Much to the chagrin of a lot of shorts, hedge funds and commentators, Best Buy (NYSE:BBY) stubbornly refused to go out of business this past quarter. That's hyperbole, of course, but perhaps not by much - there is no shortage of commentary out there saying that Best Buy is utterly doomed, needs to close stores and/or start subletting space in order to survive. (Learn more in The 4 R's Of Investing In Retail.)

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While it is true that Best Buy is indeed going through some hard times and it likewise true that consumer buying preferences have changed, a panicked attempt to pacify institutions is not what the company or its shareholders need. Best Buy is still producing positive cash flow has not yet reached a point of no return.

Challenging and Disappointing Second Quarter Results
That is not to say that Best Buy is doing well, as it clearly is not. Revenue was flat for this quarter (the company's fiscal second quarter) despite a nearly 3% decline in comp-store sales. Although domestic sales were down (down 1.5% on a 2.7% comp decline), international sales rose 4.6% despite a greater-than-3% decline in comps.

Poor sales performance seems to have been driven by poor sales of computers, TVs, other assorted electronics and difficult comps in mobile phones. Although products like tablets seem to be selling reasonably well, TVs and PCs are not and the company had a difficult comp versus last year because of the impact of Apple's (Nasdaq:AAPL) iPhone and the Sprint (NYSE:S) EVO phone. If there's a bright note, it's that online sales were up 13%.

Profitability was not encouraging. Gross margin slid 40 basis points and operating profit stumbled to the tune of 30% as SG&A spending actually increased 3%. (For a better understanding on Best Buy's financial position, check out How To Analyze A Company's Financial Position.)

Guidance Won't Help Matters
Bad enough that Best Buy missed on the top and bottom line, but lower guidance isn't going to help matters. Worse still, at least for the short-term outlook for the stock, management does not appear to have any new plans to radically change how the company operates.

Panic Not the Answer
With all of the calls out there for Best Buy management to "do something," particularly something radical, you would think that Best Buy is a major laggard in a strong consumer market. Clearly that is not the case. Sales at hhgregg, Inc. (NYSE:HGG) fell 1% in its last quarter and comps were down a whopping 13.2%. RadioShack (NYSE:RSH) is arguably in even worse shape with recent comps down about 8% and yet another restructuring underway. Likewise, discounters like Wal-Mart (NYSE:WMT) and Costco Wholesale (Nasdaq:COST) are certainly grabbing share with their prices, but even here the growth is not great.

In contrast, Amazon (Nasdaq:AMZN) is on fire - sales were up more than 50% in the last quarter, with North American electronics (and other "general sales") revenue up 67%. More and more, people have less issues buying major electronics online and the compelling price advantage outweighs any sort of "in store" experience. The fact remains, though, that consumer spending is miserable on the whole and stores of every stripe are struggling to get consumers to part with cash for all but the essentials.

What can Best Buy credibly do in this kind of environment? A renewed focus on lowering operating costs would be a very good start, and some of that may involve trying to drive hard bargains on occupancy and employee costs. Longer term, the company arguably needs to take the Trader Joe's/Aldi approach to merchandising, or at least the part that focuses on stocking only high-demand merchandise that can be quickly turned over. And longer still, the company really needs to figure out a better strategy for markets like China and Brazil - there is no reason to let Gome, Wal-Mart, or Pao de Acucar win the battle in those markets.

The Bottom Line
The clock is ticking on Best Buy, just as it was ticking on Circuit City and Borders; the retailing world has changed and Best Buy has to change with it or be left behind. Best Buy is likewise not alone; other stores like GameStop (NYSE:GME) have to figure out how to navigate an increasingly online world with an in-store infrastructure.

That said, the company is producing positive free cash flow that buys time. Wall Street seems to no longer believe that there's any point in operating big box retailers, but Wall Street is not noted for developing brilliant long-term plans (for themselves or others). The worst thing Best Buy could do, then, would be to grab for short-term eye candy at the expense of creating a long-term model for the new retailing world. Still, absent a clear plan (beyond hoping to wait out the storm), investors should be cautious of the seemingly low valuation ratios at Best Buy and only approach from an aggressive, turnaround investment viewpoint.

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