2023-06-22 10:13:02 ET
Summary
- Best Buy's valuation has been adjusted downward from $66-$123 to $52-$81 due to the rapidly changing macroeconomic environment and company-specific risks.
- Consumer confidence improvement is needed for the demand for Best Buy's products and services to pick up in the coming quarters.
- The company remains in a good position to hold in a dividend/dividend growth portfolio with a 4.6% dividend yield and acceptable levels of inventory and accounts receivable.
- We maintain our neutral view.
Best Buy Co., Inc. ( BBY ) retails technology products in the United States and Canada. In the past 12 months, we have published four articles on the firm, rating company’s stock as “hold” each time.
In these articles, we have been elaborating on both company specific and macroeconomic factors that are likely to have an impact on the firm's financial performance both in the near- and long-term.
To recap, our main discussions have been revolving around:
- Poor consumer sentiment, leading to lower demand for discretionary products and services
- Inventory management concerns
- Elevated costs, leading to margin contractions and declining profitability
- Attractive dividends and share buyback programs over the years
- Attractive valuation
Today, we will be focusing on the valuation of the firm, giving an updated view, once again using the Gordon Growth Model, to come up with a range of fair value estimates. Then, we will assess how the macroeconomic environment has changed over the past 12 months and discuss whether these changes justify a change in our current "hold" rating or not.
Valuation
To value Best Buy's stock, we have been using the Gordon Growth Model in our previous analysis, which is a simple, single stage dividend discount model.
Gordon Growth Model (wallstreetprep.com)
The two primary assumptions of the model were:
- Required rate of return: 8.75% - based on the company's weighted average cost of capital at that time
- Perpetual dividend growth rate: 2.5% to 5% - based on historical dividend growth figures and the overall long term growth of the economy as a whole.
These inputs resulted in a fair value range of $66 to $123 per share.
Dividend growth rate (Seeking Alpha)
Now, we believe that our assumption for the perpetual dividend growth rate was realistic back then, and remains relevant as of today.
But due to the rapidly changing macroeconomic environment, we need to revise the required rate of return. According to the latest estimates, the weighted average cost of capital has increased by about 1 percentage point.
This increase needs to be reflected in our required rate of return and will have an impact on our calculated fair value range. The following table summarizes the results of our calculations.
As BBY's stock is currently trading at around $78, the stock still remains in our fair value range, albeit on the higher end. Please note that this calculation does not take into consideration the positive impacts of the share repurchases.
We also need to mention that over the past two years, BBY's payout ratio has been consistently increasing, which also has an impact on the riskiness of the investment, and therefore further justifies our lower fair value estimates at this time. It needs to be highlighted, however, that a payout ratio of 53% is still not extraordinarily high and the dividend is likely to be safe and sustainable in the near term.
Scenario analysis
Now, as the macroeconomic environment remains largely uncertain - which we will be discussing more in detail in the next section - we have decided to conduct a scenario analysis with different dividend growth rate assumptions in a multi stage dividend discount model, as opposed to a single stage one. This helps us better incorporate risks into our calculation, for example, the risk of a recession in the near term.
Scenario 1. - Low case
In this scenario we assume that the U.S. economy enters a recession and the demand for BBY's products keeps falling. The dividend will need to be paused starting from 2024 for two years. Then the dividend will be resumed at the current level with an initial growth rate of 10%, which gradually falls to 2.5% over the course of several years.
This estimate results in a fair value of $52 per share, essentially in line with the lower end of our fair value range calculated using a single stage model.
Scenario 2. - High case
In this scenario we assume that the U.S. economy does not enter a recession and the demand for BBY's products starts increasing from next year onwards. At the same time, BBY will keep increasing its dividends at a much faster pace initially - at 15% somewhat higher than the TTM figure, just to indirectly account for the potential positive impacts of the share buybacks - before declining gradually down to 2.5% as in the previous case.
This calculation gives us a high estimate of $80 per share, somewhat below the higher end of our single stage estimate.
All in all, we believe that these scenarios capture the economic reality much better than just a single stage model. As the resulting range of fair values, however, is similar, it reassures our view on the valuation.
Price multiples
Last, but not least, we will take a look at a set of traditional price multiples to see what they say about the current valuation of BBY.
Valuation grades (Seeking Alpha)
When comparing BBY to the sector median of the consumer discretionary sector, the P/E, the EV/sales and the P/CF are indicating a substantial discount. When comparing the figures to the company's own 5Y historic figures, we see a similar trend. In our opinion, based on these multiples, a 5% to 10% upside potential may be present, about in line with the higher end of our single stage dividend discount estimate.
Macroeconomic considerations
As mentioned earlier, consumer confidence has been one of the economic indicators that we have been referring to, when trying to gauge the demand for BBY's products and services. Generally speaking, low consumer confidence likely leads to softer demand for discretionary products and services.
U.S. Consumer confidence (tradingeconomics.com)
While consumer confidence in the United States has somewhat improved compared to 2022, the readings remain around the 2008 - 2009 levels and far below the pre-pandemic levels. Best Buy has also pointed out earlier this year that they see the consumer becoming "more cautious" .
The negative impact on the demand is clearly visible on the firm's Q1 earnings results as well. Revenue, operating income and net income have all declined YoY.
Income statement (BBY)
At the same time, it is important to see that BBY seems to have inventory management under control. While inventories peaked before the holiday season in 2022, it seems to be a normal seasonal pattern. As of now, inventories seem to have come back to their normal levels, which means that the firm is not likely to be under pressure in the near term to reduce inventory rapidly and use high discounting to avoid obsoleteness. Also worthy to mention that BBY's accounts receivable have not skyrocketed. In some instances, companies try to boost/manipulate their sales by selling more on credit, for example, which has a direct impact on the accounts receivable. Best Buy does not seem to have done this, which is a good sign in our opinion, as they are not "pulling demand forward" from future periods.
All in all, we see that the macroeconomic environment has a direct impact on the firm's financial performance, but we still believe that the headwinds are temporary and once the consumer sentiment improves, Best Buy will be well-positioned to capitalize on that.
To sum up
Due to the rapidly changing macroeconomic environment and the company specific risks, we have adjusted our fair value estimates downward from $66 - $123 to $52 - $81. While the lower end of our range may be too conservative, as the single stage dividend discount model does not take directly into account potential near term growth opportunities and the positive impacts of the share repurchases, we would like to see the stock price pull back to the mid 60s, before we would consider upgrading to a "buy" rating.
From a macroeconomic point of view, we would like to see consumer confidence improving. As consumer sentiment is often regarded as a leading economic indicator, it could give us an early sign that the demand for BBY's products and services may start picking up in the coming quarters.
With its 4.6% dividend yield, acceptable level of inventory and accounts receivable, we believe that BBY remains a good position to hold in a dividend or dividend growth portfolio.
For these reasons, we maintain our neutral view.
For further details see:
Best Buy: An Updated View On Valuation And Headwinds