The financial management of Best Buy (BBY) has been excellent this millennium. The management team is committed to keeping large swaths of cash on hand, and the company boasts $3.4 billion in cash against $1.3 billion in debt. It has kept the dividend payout ratio low in the 30% range, and has retired gobs and gobs of stock since 2004. Approximately 490 million shares of Best Buy stock has been reduced to 317 million shares over the past twelve years, meaning that each share of Best Buy represents 35% more ownership in the business than it did in 2004.
Sounds like a decent investment opportunity, right? Au contraire, prospective investor.
The high share repurchases at Best Buy have masked the fact that revenues are in decline, net profit margins have been decreasing, and the growth of the e-commerce platform has an illusory element.
In the 1990s, Best Buy had a solid market niche by offering a wide variety of electronic products to the middle-class demographic. It could get away with 8-10% net profit margins because price sensitivity wasn’t an issue–the convenience of making a purchase from a well-known retailer meant that Best Buy could charge 25% more than its peers and get away with it. The diversity and accessibility of its products were the source of the corporation’s pricing power.
The rise of viable alternatives like Amazon mixed with increasing customer sophistication mean that Best Buy’s former competitive advantage now turns it into a sitting suck–the diversity and accessibility of its platform can now be used by customers to find the product they want, and then they can visit a site like camelcamelcamel.com to price compare or just go straight to Amazon to buy their products at a lower price.
This is analogous to the situation that Barnes and Noble and Border’s found themselves in a decade ago. People didn’t want to pay $25 to $30 for a hardback book when they could get it for $17 on Amazon. So they go to Barnes and Noble, maybe get a cup of coffee, browse what they want, and then find it online. Heck, Amazon created an app that lets you scan the barcodes of items and figure out whether their price is more attractive. For the frugal, tech savvy consumer with no sense of duty to patronize the business they’re physically at, this effectively turned Barnes & Noble into a warehouse to showcase Amazon’s wares.
Best Buy is the tech version of this, and the trend is in the third inning.
You can see it in the numbers. Just five years ago, Best Buy was selling $50 billion worth of merchandise. Now, it is down to $39 billion. Those 8-10% net profit margins dropped to 5% net profit margins in the 2000s and now sit at 2.4%.
This cost structure is a big concern. Everyone has the intuition that Best Buy prices are inflated, and then this intuition is verified by doing a subsequent price comparison with online retailers. And yet, the profit margins are razor thin at this point in time. It is one thing to learn that Wal-Mart is only generating 3% net margins on a seventy cent candy bar; it is another to learn that the $1,200 laptops eke out even less. The former is far more sustainable than the latter because people will abandon your business when they find a $999 offering which is readily available.
Today specifically, Best Buy shares are up 8.5% on the earnings beat that shows revenues up by 1.5%. The Best Buy management team is directing the attention of investors to the fact that online sales are up 35% in the past year. I’m not going to ring the cathedral bells in celebration just yet. This is being driven by Best Buy’s price-match guarantee program, which has a net loss of about 2% per item sold. This is the definition of an unsustainable business practice. Furthermore, Jeff Bezos of Amazon has indicated that his goal is same-day delivery for electronic items during the Christmas season within the next five years.
No one is going to buy things at bestbuy.com without checking on amazon.com concurrently, and you cannot rely on customers paying more for the Best Buy version. Therefore, the question becomes: How will Best Buy make its input costs for electronics competitive with Amazon? I bet you can’t come up with a plausible answer to that question, and that is why I think Best Buy’s business model is ultimately doomed.
If you are looking at Best Buy stock over the short run, I have no opinion. But if you look out five or more years, serious trouble is looming because Best Buy has too much in common with Barnes & Noble. The past five years have provided fertile soil for the sale of electronics, and yet, Best Buy’s revenues are down 20%. Even in good times, and at higher than the low cost seller’s prices, the net profit margins are only at 2.4%. Broadly speaking, I don’t expect customers to continue paying higher prices for Best Buy’s version of electronic goods, and I don’t expect it to lower its cost structure so that the inputs are competitive with Amazon.
The balance sheet has a surplus of $2 billion, and profits are currently at $1 billion annually. Best Buy will remain on the landscape for a while. But the headwinds are becoming so extreme that I’d rather make money elsewhere. The stock is up to around $43.50 at the time of writing. Five years from now, it wouldn’t surprise me to see the stock still trading below $50.
Originally posted 2016-11-17 09:59:37.