2023-10-10 05:13:24 ET
Summary
- Best Buy's stock has dropped 15% this year due to declining revenue and underperformance compared to the S&P 500.
- The company is not adapting quickly enough to the changing economy and is at risk of losing profits as revenue declines.
- The company only plans to close ~2% of its 1,000+ store fleet annually despite having one-third of its sales accrue online.
- Best Buy's dividend yield is not safe, as high payout ratios and continued revenue decay put it at further risk.
It's been no big shocker this year that dividend stocks have been under tremendous pressure as they compete with 5%+ yields from risk-free Treasuries. The S&P Dividend Index ( SDY ) is down ~10% year to date, versus a low-teens gain for the S&P 500. It doesn't help, either, that many of the big-ticket dividend stocks are in legacy industries that have seen many weaknesses exposed in the current macroeconomy.
Best Buy ( BBY ), the once-powerful electronics retailer, finds itself in this rut. The Minneapolis-based company has seen its stock shed ~15% this year:
Given the sharpness of Best Buy's descent and sharp underperformance versus the S&P 500, many investors have wondered whether it's time to buy the dip. The core appeal of Best Buy is as a bargain-basement value stock, as the company is currently generating a 5.4% yield and trading at just a 10x FY24 P/E (Wall Street analysts are projecting Best Buy to generate $6.73 in pro forma EPS next year, representing 8% earnings growth on flat revenue growth; data from Yahoo Finance ).
In my view, however, Best Buy is a value trap and not a value stock. While acknowledging the cheapness of its valuation metrics plus the relative appeal of a 5% yield with potential upside from multiples re-rating, I think there are two core risks that investors can't ignore:
- Best Buy isn't moving fast enough to reshape its business in a changing economy. As device replacement cycles lengthen, the company's pace of store closures isn't enough to safeguard its profits as revenue declines.
- Best Buy's yield isn't safe, as payout ratios look high and will be at further risk if revenue continues to decay.
I am bearish on Best Buy and recommend staying on the sidelines here. I'd be willing to revise my thesis if the stock drops down to $60 (which offers a greater margin of safety at a ~9x P/E and a 6% yield), but until then I'm content to avoid this name.
Large store footprint amid revenue declines
The first thing to know about Best Buy: the company is experiencing steep sales declines. On a comparable sales basis (excluding the impact of changes in its store fleet, whether new openings or closures), revenue in its most recent quarter fell -6.3% y/y in the U.S. and -5.4% y/y overseas. On an as-reported basis, revenue fell -7.2% y/y to $9.58 billion.
Best Buy revenue by category (Best Buy Q2 shareholder letter)
The chart above shows a helpful breakout of the major decliners. As you can see, computers, phones, and other consumer electronics make up the bulk of Best Buy's sales, contributing more than two-thirds of overall revenue. Both are in decline, down roughly -6% y/y in the U.S.
Appliances, the company's third-largest category, is down a sharp -16.1% y/y in the U.S. The driver here is clear: amid a tough macro environment with consumers struggling to make ends meet, people are stretching out their devices for longer - especially as technology improves, we can afford to keep older devices around (this Black Friday season will be very interesting: in my view, we'll probably see the lowest sales of new TVs in years, despite what I'm sure will be a very promotional environment for most electronics retailers).
Best Buy's core strategy to reverse revenue declines is to focus on services, which largely comprise its membership programs. The company is now offering two membership tiers of "My Best Buy" at either $50/year or $180/year, offering a range of benefits including free shipping and exclusive deals to priority tech support on the premium plan. But while these are longer-term goals to drive more recurring revenue and improve margins, today's services still represent only ~5% of overall revenue.
Amid these large and secular declines, Best Buy still maintains a massive store fleet. As of the end of fiscal 2023 (the year ending for Best Buy in January 2023, and corresponding to most of calendar 2022), the company listed 978 domestic stores and 160 international stores in its 10-K:
Meanwhile, it also reported that e-commerce represented 33% of revenue in FY23, up sharply from 19% at the beginning of the pandemic:
What this signals to me is that Best Buy has been slow to adapt to an increasingly digital retail environment. Yes, the company has closed 70 stores this year and is planning on closing 15-20 per year going forward , but that pace is not quick enough to match the shift of revenue from retail to online and to make up the margin hit from Best Buy's steep revenue declines.
Is this 5% dividend safe?
The other worry we have to consider: can Best Buy sustain its dividend?
Year to date in the first two quarters of FY24, Best Buy has spent $560 million on its capital returns program, of which $402 million are dividends and $158 million in share buybacks.
As can be seen above, GAAP net earnings in the first six months of FY24 were $518 million. Expressed as a function of net earnings, the company's total payout ratio was 108%, or 79% counting just dividends.
Payout metrics look even worse when looking at just free cash flow alone. Operating cash flow in the first six months of FY24 was $181 million, lower than net earnings, driven primarily by increased inventory (a function of more tepid sales); free cash flow was -$214 million after considering capex.
The company will need to achieve a turnaround in top-line performance to keep its capital returns program afloat (we note that Best Buy is currently about cash-neutral, with $1.09 billion in balance sheet cash roughly counterbalanced by $1.16 billion in debt).
Management is hopeful that trends will turn around in the back half of the year. Per CEO Corie Barry's remarks on the recent Q2 earnings call :
Our full-year guidance implies a wide range for Q4 comparable sales of down 3% to slightly positive. There are a number of factors supporting our belief that our Q4 year-over-year comparable sales will improve and could potentially turn positive. We expect growth in-home theater as we expect to be better-positioned with inventory across all price points and budget spends last year. We are starting to see signs of stabilization in our home theater business.
For example, TV sales trends improved in Q2 and units returned to growth. We expect performance in our computing category to improve as we build-on our position of strength in the premium assortment will not exactly linear. We are also starting to see signs of stabilization in this category as Q2 laptop sales trends improved materially and units were flat to last year. We expect to see continued growth in the gaming category as inventory is more readily available and there is a promising slate of new software titles expected to be released in the back half of the year."
Still, I wouldn't count any chickens before they hatch: especially as I see replacement cycles continuing to elongate and more and more customers buying from brands directly online rather than going through retailers.
Key takeaways
For me, there's more risk than reward in Best Buy. The way I think about it is that Best Buy is offering the same yield as risk-free assets (~5%), but at the same time, the stock has more downside potential as revenue continues to see pressure. While acknowledging the value opportunity in its current ~10x P/E, I'd rather not take a stake in a business struggling against changing consumer preferences.
For further details see:
Best Buy: 5% Yield Is At Risk In A Changing World