Circuit City? Gone. Borders? Gone. Linens 'N Things? Gone. CompUSA? Gone (though the brand was acquired out of bankruptcy and lives on). So, Best Buy (NYSE:BBY), how ya feeling? Any fever, chills or loss of appetite? With plenty of analysts and commentators fighting over the shovel and the privilege of throwing the next scoop of dirt on its grave, it may surprise some to know that it hasn't actually fallen over. The question, though, is whether the failure of Best Buy is inevitable, preventable or altogether unlikely. (For related reading, see The 4 R's Of Investing In Retail.)
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A Bad Holiday Season?
Best Buy has already announced that U.S. same-store sales were slightly negative for the 2011 holiday season. There was poor performance in gaming, digital imaging and TVs, and solid sales in phones and appliances could not compensate for it. So, once again the question arises as to whether Best Buy can drive sales without deep discounting and whether its business model can withstand high discounting.
Could They Become a Showroom?
There's ample talk of how Amazon (Nasdaq:AMZN) can, is and will replace Best Buy as the go-to source for electronics. Certainly there are bargains to be had there and it's tough to argue that there's a reason to pay 10 to 30% more for the dubious privilege of buying something in a Best Buy store.
What I wonder, though, is if Best Buy is being turned into an unsubsidized showroom for online sales. I have no problem believing that people are comfortable buying TVs, PCs and all manner of electronics online, but I wonder how many of those people don't go to the local Best Buy (or hhgregg (NYSE:HGG) just to check them out and figure out what they want. This forces Best Buy to carry the inventory and pay the staff, but with little prospect of gaining the sale unless they can match the online price (and remember, some online companies don't have the store infrastructure, or for now, the need to charge sales tax).
Certainly something is wrong with the Best Buy as it is now. Inventory and asset turnover is weakening and the company is scrambling to figure out how to create an array of profitable merchandise that brings people into the stores. (To learn more, read Inventory Valuation For Investors: FIFO And LIFO.)
Private Label Could Be an Option
Perhaps Best Buy should take a lesson from the supermarket industry and look to promote private label electronics. There are certainly manufacturers in Asia that can assemble PCs, phones and so on with reasonable quality and allow Best Buy to slap a private label brand on them. Maybe that sounds bizarre, but there was a time when supermarket store brands were seen as bizarre and unlucky to thrive. More to the point, Wal-Mart (NYSE:WMT) has already started doing this and it seems to work well enough to be worth further exploration.
A Future, but at What Margin?
Best Buy is unlikely to go away entirely. As said, people like to check things out with their own eyes and hands and Best Buy makes that convenient. Moreover, consider the example of smartphones. If you go to the Apple (Nasdaq:AAPL) or Verizon (NYSE:VZ) store, you get the phones that they are willing to offer, or maybe Sprint (NYSE:S) has something better or maybe there's a Samsung phone that really suits your taste. Best Buy is arguably the best chance of getting a look at the widest array of options.
The reality is that Best Buy's future may have a lot more in common with Ingram Micro (NYSE:IM) or Tech Data (Nasdaq:TECD) than Whole Foods (Nasdaq:WFM) or Bed Bath & Beyond (Nasdaq:BBBY). Ingram and Tech Data are IT distributors that sell all manners of computers, networking, software and other IT products to corporate customers. It's a business with minimal margins and a premium on efficient operator. Granted, the comparisons are not completely fair (IT distributors generally don't have stores), but the point is that Best Buy may have to reconstruct itself around a much smaller margin assumption. (For additional reading, see Analyzing Retail Stocks.)
The Bottom Line
What if Best Buy does see operating margins fall to the sub-2% level of IT distributors? Would the company deserve a similar enterprise multiple of around four to five times? If so, that would actually be a notable improvement for the company.
Cash flow models also suggest that value could still lurk here. If Best Buy sees free cash flow (FCF) fall 6% a year for a decade and then flatten out to zero growth, the shares are still worth something north of $30 per share. You actually have to go to a decade of 14% annual FCF declines to get to today's share price, and if you assume a decade of 14% declines and then a drop to zero cash flow, the shares would still be worth north of $20. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)
This is not to say that Best Buy can't fail, but it does suggest that Best Buy does still have quite a lot of time to figure out a business model that works with the new realities of the retail world.
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.