Heading into the holiday season, many investors are eying major retail stocks carefully to gauge the health of the major retailers, and Best Buy’s (BBY: Charts, News, Offers) hugely disappointing earnings this week were a clear indication that its superstore rivals Wal-Mart (WMT: Charts, News, Offers) and Target (TGT: Charts, News, Offers) have gained on Best Buy’s losses. The electronics, appliance, video and music superstore posted third quarter earnings of 54 cents per share, well under the analysts’ consensus of 61 cents. Revenue came in at $11.89 billion, less than estimates of $12.47 billion. Same store sales decreased 5% domestically and 3.3% internationally, in Canada, China. Europe and Mexico. Sales of televisions, entertainment hardware and software all dropped significantly, but the increased sales of mobile devices such as tablets and smartphones helped offset these losses slightly. Its overall market share, however, eroded 1.1% against its primary competitors since last year.
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Best Buy also decreased its fiscal 2011 guidance, to an EPS between $3.20-$3.40, below analysts’ expectations of $3.59. The company announced that in its revised earnings, it had already priced in a 12 cent EPS benefit from stock buybacks, which cuts its actual estimated earnings down to the $3.08-$3.28 range. While it would have been easy to blame a fickle economy for the company’s current predicament, the U.S. Commerce Department reported on Tuesday that retail sales across the board had increased by 0.8%, better than its expected increase of 0.5%, and sales figures for October were increased to 1.7% from 1.2%. This indicates an improving retail environment which Best Buy is failing to capture. Investors were not waiting around to see if Best Buy could patch up its sinking ship, and drove the stock down nearly 15% during Tuesday trading. With memories of Best Buy’s doomed cousin, Circuit City, which was liquidated back in 2009 after it failed to find a buyer, fresh on investors’ minds, many question if Best Buy has any future against superstores such as Wal-Mart and specialty game retailers such as Gamestop (GME: Charts, News, Offers).
Best Buy’s strategy to offset declining margins and a strong U.S. dollar is to diversify into higher margin services. Geek Squad, Best Buy Mobile and Home Installation services are all intended to boost operating margins to make up for poor margins in electronics and appliance sales. Geek Squad, the company’s computer and electronics technician service center, operates with operating margins between 10-20% due to the low cost of hiring technicians and the high cost of repairs. This is a particularly resilient business in times of economic turbulence which force consumers to upgrade electronics and appliances at slower rates, instead opting to pay for repairs. Best Buy Mobile was launched at the end of Fiscal 2007, and is a standalone cellphone retail and service center, intended to capitalize on the growing popular of mobile products. This is particularly lucrative to handset manufactures and mobile carriers, as partnering with the high visibility of these centers in Best Buy stores is far more advantageous than strip mall or standalone mobile centers. Home Installation services, which is offered with the purchase of Best Buy electronics and appliances, can be considered an added cost to the purchase of these products that the company absorbs – similarly to Geek Squad, this is a high margin business. While these strategies are sound, to date they only make up 4-5% of the company’s overall revenue.
Best Buy also faces increasing competition in e-commerce, or online shopping. Sites like Amazon (AMZN: Charts, News, Offers) and eBay (EBAY: Charts, News, Offers) have become a viable threat to Best Buy’s traditional business model, and have begun to undercut Best Buy’s margins. Stores such as Amazon and eBay, in particular, are able to offer one-stop online shopping in a far wider spectrum of products that Best Buy is able to offer. Superstores such as Wal-Mart and Target have cut deep into Best Buy’s bottom line by offering steeper discounts in order to sustain their high-volume, low margin strategy. In addition, Wal-Mart and Target also offer online shopping, which often feature even steeper discounts than Best Buy. Another threat is Gamestop and its subsidiary EBGames, which have become one-stop shops for video games. These stores are particularly lucrative during the holiday season due to their large selection of used software and hardware, and trade-in services, and in times of decreased discretionary spending, they are often the first stop for cash-strapped consumers.
While the stock has been brutally punished this week, at its depressed price it only trades at nine times forward earnings, with a PEG ratio of 0.97. For those patient investors believing that Best Buy can turn around its domestic sales and invest more in international growth, there may be hope. However, for now the stock is forecast to trade flat well into next year with few catalysts but a myriad of dangers on the horizon.
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Leo Sun is long-time market follower and finance writer. He regularly contributes to the Stock of the Day analysis.
