Charting Best Buy (BBY)
(November 13, 2008)
Dear Subscribers and Readers,
I want to start off with a quick "back-of-the-envelope calculation" on the impact of the latest decline of crude oil prices on consumer spending and GDP:
According to the Energy Information Administration, the US imports about 10 million barrels/day of crude oil and about 13 million barrels in total hydrocarbon liquids. Simply taking the crude oil number, we know that for every $10 drop, this adds about $100 million a day to the domestic economy. On an annualized basis, this equates to $36.5 billion, or 0.27% of GDP or 0.40% of US consumer spending. During the 3rd quarter, the spot price of crude oil averaged US$119. Since then, it has plunged to $55 a barrel. That equates to $64 a barrel or an addition of $233 billion (1.8% of GDP, or 2.6% of consumer spending) to the domestic economy on an annualized basis. While “long duration” purchases such as auto sales and consumer durables have literally fallen off a cliff, retail sales excluding autos and gasoline may not turn out as bad as expected come this Christmas season, assuming global policy makers continue to be aggressive in easing both monetary and fiscal policies over the next three to four weeks.
Despite our relative optimism, companies such as specialty retailer Best Buy and lodging giant Marriott International have already projected plunging sales for the foreseeable future. While Christmas sales will no doubt be bad, my sense is that it is premature to extrapolate current trends (Best Buy based their forecasts on the 7.6% decline in October same-store sales) into Christmas and 2009. As the title implies, I want to devote this commentary to a (fundamentals-based) discussion of Best Buy (BBY).
According to the US Department of Commerce, retail sales for the first six months of 2008 totaled $2.01 trillion. About 86% of these sales occurred in businesses under the “specialty retail” category, including the motor vehicles and parts industry ($440 billion in six-month sales), gasoline stations ($255 billion in six-month sales), clothing and clothing accessory stores ($208 billion in six-month sales), and the building materials, garden equipment, and supplies dealers industry ($166 billion in six-month sales). While the consumer electronics industry is barely in the top ten of the largest sub-sectors within the specialty retail sector, it is nonetheless a sizable sector, racking up about $80 billion in sales in the first six months of 2008. Best Buy operates in this sector. While Best Buy's sales are mostly US-centric, it has expanded in Canada in recent years and is on-track to expand in Europe and China over the next five years, although the recent global slowdown may dampen their expansion plans as the company may need to conserve more cash. Following is a breakdown of Best Buy's market share (note that these are annual numbers) in each of the geographical regions it currently operates in (following chart courtesy of Best Buy):
Expansion into overseas markets (in particular Asia) has been a very popular trend among many sub-sectors of the specialty retail sector in recent years, as many markets in the US have become saturated. For example, the urbanization and increasing homeownership in China have opened up many growth opportunities for do-it-yourself (DIY) retailers. In December 2006, Home Depot moved into the Chinese market by acquiring a local 12-store home improvement retailer named Home Way. According to Home Depot, the Chinese DIY market is currently worth around $50 billion annually, with a projected 20% compounded rate of growth for the next five years. Despite the recent slowdown in the Chinese retail estate sector, I estimate that the Chinese DIY market is still set to grow by at least 15% annually over the next five years, given the secular trend of urbanization and demographic trends in China. Best Buy itself acquired Jiangsu Five Star Appliance for $180 million (China's third largest electronics chain with 2007 sales of $1.3 billion) – and has plans to open up more Five Star stores as well as stores under the Best Buy brand name. Given continuing urbanization and the projected rise in disposable income, the consumer electronics market is ranked by analysts as one of the top (if not the top) growth sectors in China. As long as the Chinese economy is able to grow within a 7% to 9% range, I expect Best Buy (and other US retailers with Chinese presence) to focus its aggressive growth strategy there given the fragmented nature of its markets (it is imperative for them to gain a “leg up” on competitors by achieving economies of scale as soon as possible).
On the domestic front, Best Buy is the number one consumer electronics retailer in the US, with a 21% market share (as shown above). Wal-Mart is number two, with a 20% market share. Circuit City is number three with a 7% market share, with Dell (6%) and Target (3%) rounding out the top five. Other competitors in this space include Amazon.com and RadioShack. Unlike the specialty retail stores of yester-years, Best Buy can be classified as a “Category Killer” within the consumer electronics industry. A “category killer” typically litters its niche market with giant superstores, integrating both industry expertise and the ability to streamline operations (such as the ability to negotiate with suppliers and a more efficient inventory management system). Toys R Us was the pioneer in this category – opening its first store in the late 1950s and managed to increase its market share for many years. These category killers started to come of age during the mid 1980s and include stores such as Home Depot, Office Depot, Bed Bath & Beyond, and AutoZone. The size of these stores typically ranges from 5,000 square feet for auto parts stores to more than 100,000 square feet for home improvement centers. As the label implies, category killers usually derive their success from the integration of its industry expertise, the ability to streamline operations, and most importantly, by gaining market share in a highly fragmented market, where competitors were typically small businesses which had no ability to compete.
Best Buy the Company
As discussed, Best Buy is the largest retailer in the consumer electronics industry with a 21% market share in the United States and a 37% market share in Canada. The company operates about 1,100 stores in North America and sells a variety of merchandise such as computer hardware and software, video and audio equipment, home appliances, and mobile electronics. Operationally, each of Best Buy's stores generally open for 78 hours a week (seven days a week), allowing for extended hours during holidays. Each store typically is operated by one general manager and five managers, with about 130 employees on average. Best Buy's store operations are streamlined by following a standardized set of operating procedures called “Standard Operating Platform” (SOP), which details procedures for inventory management, transaction processing, customer relations, store administration, product sales and services, and merchandise display. Best Buy has also continued to shape and transform its supply chain. According to the company, such “supply chain management” allowed it to lower product costs and negotiate better prices, resulting in a 1.3% increase in gross margins in fiscal 2006. With the possible exception of Wal-Mart, such an efficient system for inventory and supply chain management (the latter primarily because of its dominant market share) puts the company at a great competitive advantage over other consumer electronic retailers such as Circuit City.
As can be seen from the following chart (courtesy of the company), Best Buy has approximately doubled its revenues and income every five years:
More impressively, Best Buy's return on capital has remained in the high teens for the last ten years, despite the impressive rate of growth during the same time period. The following chart (courtesy of Goldman Sachs) shows this perfectly – note Goldman's estimates for the 2008 to 2010 fiscal years are also shown:
Interestingly, the Goldman analyst on Best Buy has been one of the more pessimistic analysts on Best Buy – and has in fact, reiterated for the last several weeks that Best Buy will revise its earnings estimates downwards, ahead of the actual downward earnings revisions by the company yesterday. Going forward, I too expect Best Buy to maintain its current margins and return on capital, given company's economies of scale and differentiated business model (specifically, its “Customer Centricity” model that was incepted in 2005) relative to Wal-Mart, its only major competitor. In addition, the recent announcement by Circuit City to close 155 of its stores should be beneficial to Best Buy. While the annual sales of these stores total only $1.2 billion (about 3% of Best Buy's fiscal 2007 revenues), subscribers should note that this mostly represents “gravy” as Best Buy would not need to open up new stores or hire more personnel to capture some of these sales. Best Buy could easily capture 25% of these sales (Best Buy's market share in the local markets that Circuit City have pulled out of), with about 15% of these sales directly flowing to the bottom line. This incremental “capture” should lift Best Buy's earnings by about 8 cents a share, or 3% - which is a welcome gain in this difficult retail environment. Assuming all of Circuit City's stores are liquidated after the Christmas season, we could easily see a 50-cent gain in Best Buy's EPS, or an 18% gain, directly resulting from the capture of former Circuit City's customers.
Based on the October 20th closing prices, Best Buy's valuation is near the bottom range among major hardline retailers in the US, as shown in the following table courtesy of Goldman Sachs:
In addition, the stock is also trading at an all-time low in terms of its P/E, P/B, P/S, and P/CF ratios relative to where it has been over the last ten years, as shown in the following table courtesy of Morningstar.com:
While the company will no doubt be hit by the consumer recession during the busy Christmas season and into next year, my sense is that Best Buy can still easily make $900 million in free cash flow during fiscal 2009. This still gives us a forward Price-to-Free-Cashflow ratio of approximately 9, given Best Buy's current market capitalization of only US$9 billion. Combined with the diminished role of Circuit City in the domestic market and Best Buy's streamlined and differentiated operations, I currently see no threat to Best Buy's profit margins. Finally, Best Buy's early international presence – in particular its Chinese operations – should provide growth for years to come as the consumer electronics industry is still one of the major growth sectors in the world today, despite its short-term challenges.
Henry To, CFA