2023-04-21 12:36:59 ET
Summary
- BBY has seen a stellar growth in stimulus-fueled economy leading to burgeoning savings and higher discretionary spends during pandemic.
- However, the spends are moderating to pre-pandemic levels in the current inflationary environment as consumers are tightening their purses.
- Electronic spends is the only retail segment where spends have declined to pre-pandemic levels.
- We remain negative on the stock in the medium term due to tepid demand outlook and margin pressure.
Background
Best Buy ( BBY ) is a consumer electronics company which has seen a stellar growth in stimulus-fueled economy as customers gobbled up latest smartphones and electronics during work/ educate from home era amidst lockdowns. The strong demand environment had led to Best Buy report comp sales of growth of around 10% in 2020 and 2021, its highest in almost three decades. However, with demand moderating and inflationary headwinds , the company's offering is seen out-of-sync with the market with its comp sales declining 10% in 2022, albeit on a higher base, and management further expecting continued downshift in the demand environment.
This has led to the stock price falling over 45% from a high of $136, it peaked in Nov 2021 and declining about 20% in last 1 year itself. However, the bad news does not appear to be fully priced in as demand environment continues to be negative, downside risks to gross margins remain elevated due to competition and higher promotional activity and SG&A remaining sticky will lead to margin pressure amidst lower sales.
Earnings Recap
BBY reported a sales decline of over 9% YoY for 4Q 2023 in a challenged holiday season, despite maintaining its profitability well. Gross margins remained a positive surprise at 20.0% vs 19.5% on the back of lower promotional spends overlapping with the rollout of the TotalTech membership program . Flat SG&A as % of sales helped to post better EBIT margins vs consensus during the quarter helped by incentive comp relief of $90 mn. BBY's guided for comp sales decline of 3% - 6% for 2023 with Q1 trending down almost 10% and expect H2 to ease slightly. We believe the company's top end of the guide appears slightly improbable to expect a significant turnaround in H2. Also, the sales for 2023 has been guided to before pre-pandemic levels with EBIT reverting to 2016 levels (at the mid-point of management's guidance of 3.7% - 4.1% margin), which is a significant step backward. Store rationalization, employee layoffs and reskilling and tighter SG&A management is expected to offset some of the sales decline with it expecting EPS of $5.7 - $6.5. However, higher than expected wage hikes on the back of rising inflation as well as competitive intensity to retain talent and drive up SG&A spends could put a check on easing SG&A margins.
Current Trends
Consumers built up over $2 trn worth of excess savings since the pandemic and had drawn down over a $1trn worth of them in 2022 leaving them with still about a $1 trn worth of savings. 2022 saw a boost of 6% in expenditure, but consumers would look to moderate their spending given the current economic backdrop and rising layoffs across the country . Retail spends continue to slow, with electronics spends reeling under pressure, down about 10% YoY in March and about 8% in Q1 2023. In fact, consumer electronics is the only segment where spends have gone below pre-pandemic levels which is a worrying sign.
Segment | YTD 2023 vs 2019 (pre-pandemic levels) |
Apparel and Accessories | 15% |
Department Stores | 1% |
Discount Stores and Warehouse Clubs | 26% |
Electronics and Appliances | (6%) |
Furniture and Home | 23% |
Grocery | 28% |
Home improvement stores | 41% |
Restaurants | 47% |
Source: US Census Bureau. Note: YTD = Feb-March 2023
This is also reflected in the continued down shift observed in BBY's foot traffic as well as web traffic on account of continued weakness in demand environment that does not seem to be abating.
Management expects CE replacement cycle as a compelling tailwind for growth going forward. However, tech replacement cycle is generally of about 3 - 7 years and with people having most of the tech upgrades during 2021-2022, the cycle is likely to be stretched to 2025 and beyond, amidst the current inflationary environment. We believe the company's margin would also come under pressure as e-commerce players such as Amazon would try to undercut and push sales while players such as Walmart and Target would have better recall providing a wider assortment to consumers.
The company has also been trying to tightly manage its SG&A and was recently reported cutting hundreds of staff across the stores nationwide . However, the news did little to cheer the street as the measures does not appear to be anything material and with the company's e-commerce sales contributing about 38% to the total (up from ~14% pre-pandemic), significant measures and store changes/ layoffs with renewed focus on e-commerce is warranted.
Valuation
BBY is trading at 11.6x PE which is at a slight discount to its long term average. Our target price of $61 yields at 10x 2023 EPS (at the midpoint of 2023 guidance), which is at a discount to BBY's long term average which we believe is warranted given the current subdued demand environment.
Risks to the target price include an improving demand environment leading to higher discretionary spending, higher gross margins on the back of lesser promotional activities as seen during Q4, tech replacement cycle beginning earlier than expected and higher than expected cost savings on SG&A front on the back of optimization of headcount, flexible scheduling and cross-trained staff.
Final Thoughts
We believe BBY has a strong moat within the consumer electronic segment having a wider network outreach and has demonstrated its ability to generate growth over a long time. However, with consumer spends curtailing their discretionary purchases, CE bore the brunt with spends reverting to pre-pandemic levels, being the only segment among the retail is a flashing red signal. Given the pullback on discretionary spends as well as competitive pressure due to other retailers amidst demand pull, we are negative on the stock and initiate as Underperform.
For further details see:
Best Buy: A Tough Sell