2023-05-20 23:55:44 ET
Summary
- Best Buy is an electronics retailer, which has expanded into the healthcare space.
- We expect serious headwinds from current economic conditions as demand is forecast to slow.
- The business has built a competitive edge against low-cost retailers by investing in customer service, rewarding employees, and focusing on ESG.
- BBY's healthcare expansion has the ability to double their current revenue, according to Morgan Stanley. Unfortunately, the current business has unattractive financial metrics relative to its peers.
- Although BBY is trading at a discount, we only see an upside of 5%. Given that demand is falling, it would be unwise to invest now.
Company Overview:
Best Buy Co. ( BBY ) retails technology products in the United States and Canada. The company operates in two segments, Domestic and International. Best Buy sells computing products, consumer electronics, appliances, entertainment products, gaming hardware, software, as well as other products.
In recent years, the business has expanded beyond its traditional expertise, moving into the Healthcare industry and outdoor furniture. This is part of an overarching expansion strategy, looking to grow the business in a diversified fashion and reduce reliance on its current offering. This is important as several years ago, it looked like BBY might be in trouble. Online retailers (Mainly Amazon - AMZN ) were offering better pricing and convenience, taking customers in their droves. BBY was able to turn this around (we will discuss how later) but has cemented the need for greater diversification.
Looking at BBY's share price, the business has seen periods of growth and stagnation, seemingly one after the other. In the most recent instance, the business has aggressively corrected from its ATH, falling over 40% back to its early 2020 level. Essentially, all post-COVID gains have been wiped out.
With the pre-COVID share price in mind, we will look to assess the development of the business and its current trading environment. This will involve an assessment of the current economic conditions alongside a view of current retail trends. Further, we will consider the financial profile of the business and its relative performance against other similar retails. We will conclude with a valuation of the business and provide our outlook.
Macro considerations:
During the COVID-19 period, consumers were locked indoors with nothing to do but entertain themselves. Those who had office jobs were able to add working from home to this list. It is unsurprising that once income support checks were provided, consumers began splashing the cash on multiple forms of entertainment and WFH tools. This caused a spike in retail sales and especially in the technology space. BBY managed to post an 8.3% increase in revenue, despite the initial disruption and complete lack of footfall.
This boom was never going to last forever, and we saw things begin to slow in 2022. There were two interconnected reasons for this, firstly we experienced increasing interest rates, which meant it was more expensive for consumers to borrow. Not only this but their cost of servicing current debts may have increased, reducing discretionary income. The second reason is also the reason interest rates have had to increase, that is inflation. Increasing inflation is driven by energy costs, supply chain issues, and increased money supply. This has had the impact of reducing consumers' discretionary income as they settle their required commitments. Further, this has contributed to margin contracting as businesses have experienced several operational cost increases (transportation, labor, and energy).
We believe that things will continue to trend downwards in 2023, as inflation remains target number one. This will continue to act as a two-way attack on consumers' finances, whittling away at discretionary income. Retail sales look to be flat since early 2022, suggesting we could see a decline.
This is clearly not good news for BBY, as declining discretionary income will mean a lower pool of demand for technology products. With this in mind, competition will increase and there will be many retailers who are discounting products to attract sales. Therefore, we would predict that sales fall in 2023, alongside a contraction in margins.
Best Buy's culture:
If sales are going to fall, we need to consider how BBY will mitigate the impact of this to outperform relative to its peers. Just because demand is falling, it does not mean a business is unattractive.
One of BBY's biggest selling points in the industry, and how it has managed to take the fight to online retailers, is through its customer service. The business has invested heavily in providing customer care and support throughout the purchase / post-purchase process to add value. Examples of this include the expansion of their "Geek Squad" support team, the ability to extend warranty with many products, the ability to price match, and the ability to pick up in-store easily.
BBY has only been able to achieve this with buy-in from its employees. They need to go above and beyond and ensure they put effort into providing each customer with advice. BBY has thus invested significant time and resources into their employees to create an environment that is conducive to this. They have recently invested in supporting disabled staff in the workplace and pay above-market-rate salaries. This has led to the business being awarded as one of the best employers in the country under various categories . The impact of this has been very low staff turnover relative to their competitors.
The benefit to BBY from this is severalfold. Firstly, online retailers cannot challenge their support services due to the lack of employees, giving them a tangible edge. Secondly, remunerating staff in such a way has meant recent wage inflation and staff shortages have been less impactful on the business compared to its peers.
Healthcare expansion:
In 2018, BBY acquired Greatcall for $800M . Several years later, they acquired Current Health for $400M. Why on earth with a technology retailer be expanding into healthcare? The following two quotes may shed some light on BBY's current strategy:
- "The acquisition is a manifestation of the Best Buy 2020 strategy to enrich lives through technology by addressing key human needs."
- "The future of consumer technology is directly connected to the future of healthcare".
Both businesses utilize technology to provide individuals with health support services at home, conveniently similar to how the Geek Squad provides tech support to consumers. BBY sees its expertise in technology support services as leverageable in this space, with the healthcare support coming from the businesses acquired.
With an ageing, tech-savvy population, this looks to be a service that the majority of consumers will one day have. We can easily see partnerships with hospitals and other institutions to bundle these services within an individual's healthcare. It is not surprising that many tech businesses including Amazon ((AMZN)) and Apple ( AAPL ) have healthcare departments.
Morgan Stanley Analyst Simeon Gutman estimates that this healthcare segment could bring $11BN-$46BN (24%-99% of LTM revenue) in future revenue.
BBY does not disclose the revenue from each of the healthcare businesses but includes them within the "Services" line. This income stream is the only one to see growth in Q4, suggesting quality during difficult trading conditions.
Revenue mix (Best Buy)
This segment currently comprises c.5% of revenue for the business and so is unlikely to move the needle. We have discussed it because it is likely to be a large part of BBY's future offering. Further, we occasionally see large corporates conduct M&A for incorrect reasons, and seeing a tech retailer purchase a healthcare business may create this impression in the minds of investors. We would like to make clear that this is a very smart business and does come with synergies. Our view is that if BBY can grow this to scale quickly, to avoid the build-up of competition, Morgan Stanley's forecast is certainly possible. A healthcare tech business would trade at a significantly higher valuation to BBY and so if we took the average of MS' estimate and a 0.5x multiple, the segment would be worth 73% of BBY's EV.
Environmental impact:
Society has quickly moved towards more environmentally friendly behavior, with many industries coming under fire. Technology is one of them, due to the components that go into the production of goods.
BBY once again is ahead of the curve in this respect, having become one of the US' most sustainable businesses ( Top 5 by Barron's ). BBY has invested a significant amount in carbon and waste reduction and recycling. Recycling is the key here due to the ability to reuse components and the damage to the environment from tech going to landfills. BBY operates the largest recycling program in the US .
For consumers who care about sustainability, which is estimated at 2/3 , BBY would be the go-to retailer for technology. This is another selling point for BBY and is currently leading the market in this regard.
Financials
BBY - Financials ( Tikr Terminal )
Presented above are BBY's financial results for the last 10 years.
Revenues have grown at a CAGR of 1%, which is underwhelming given it is below inflation for the period. The reason for this is greater competition from online businesses and a slowdown in brick-and-mortar footfall. In the most recent quarter, BBY reported declining sales as economic factors continued to deteriorate demand.
With this in mind, margins have marginally contracted, falling to 21/22% compared to 24/23% in the first half of the previous decade. BBY has relied more greatly on discounting and price matching to retain customers, which is likely the driver of this.
In our view, once we get to an EBITDA / NI level, things look far more impressive. The business has invested in the many initiatives we have highlighted above yet has managed to maintain a flat margin on both metrics. Downward-trending S&A expenses are the primary contributing factor to this.
FY23 performance as a whole is down on FY22 due to cooling demand. This is an industry-wide issue, with BBY's decline in line with the more elastic retailers.
Moving onto the balance sheet, the business boasts an impressive 49% ROE, as total equity has trended down across the historical period due to consistent buybacks.
BBY's inventory turnover has fallen noticeably, with the knock-on effect of increasing its CCC. This further supports the fact demand is slowing and inventory is now harder to shift. There is a great risk that the business may need to discount inventory to sell, which could further deteriorate margins. Management highlighted that this occurred at a greater than expected amount in Q4. We see no real credit risk with the business given its level of profitability.
What we find slightly strange is Management's cash management during certain periods. We have seen large dividends and buybacks, resulting in a net distribution of cash in excess of the cash generated. This isn't necessarily a bad thing if there is no other appropriate capital allocation. This could mean the coming years' dividends / buybacks are far lower than previously seen, as the company becomes more defensive.
Outlook
Outlook ( Tikr Terminal )
Analysts are forecasting a 1.9% increase in revenue, with EBITDA margin increasing slightly. Our expectation would be for a margin bump given the steep decline in FY23. Regarding sales, it is very difficult to forecast given the ever-changing market conditions, but this looks appropriate.
Looking further, the moderate growth in the later periods suggests analysts are pricing in little to no impact from its healthcare segment.
Peer analysis:
Peer group analysis ( Tikr Terminal )
Presented above is a comparison of BBY with several retailers with significant brick-and-mortar operations within the US.
In many instances, we see relative uniformity in the group's performance. This is not a surprise given the industry is in maturity.
From a profitability perspective, we see BBY completely outperformed, even at a FCF level. Even on a normalized basis, the best BBY can achieve is a 5-7% EBITDA-M and 3-5% FCF-Y.
When looking at forecast growth, things look even worse. Taking a 5-year growth period, BBY is forecast to grow 2% v. 4% of the peer average.
Overall, our view would be that BBY must trade at a discount to this peer group, reflecting its lack of profitability and growth.
Valuation
Valuation ( Tikr Terminal )
BBY is trading at a discount to its peer group, reflecting its relative performance. The business currently has the highest yield of the group but as we have established, this may not be sustainable.
When considering BBY's valuation, we have considered 3 separate calculations. First, we have calculated a fair value EBITDA multiple based on the average of the most comparable peer group members (excl. TJX and Costco above) and discounted the superior company's multiple (20%). Secondly, we have taken the Wall St. target price. Finally, we have considered what BBY would trade at should we apply our fair value multiple to its forecast NTM EBITDA.
Based on this, we see a current upside of 5%. Given that the general market sentiment is bearish, and we have not identified any immediate positive catalysts, our view would be that this is not a significant enough upside to warrant a buy rating.
Investors interested in BBY are likely better off remaining patient and observing price action in response to declining demand.
Conclusion:
BBY is evidence that not taking a cost-first approach in retail can still be successful. They have taken the fight to online retailers and reached a stalemate, which is a win in our view. We think the business has genuine differentiation through its customer service, employee schemes, and environmental causes. We find it unlikely that the business would suffer a decline that is observed with other brick-and-mortar heavy businesses.
We are very bullish on the healthcare expansion, as the idea and service behind it have real scope to be in every household. This said, it is in its infancy, and we believe it would be foolhardy to attribute any value currently.
Unfortunately, to be competitive, BBY has had to compromise on the financial side of the business. Relative to its competitors the business is just not attractive enough to justify its current valuation.
For further details see:
Best Buy: A Good Business With Headwinds Ahead