2023-09-07 22:13:43 ET
Summary
- Q2 FY 2024 showed better-than-expected profitability for Best Buy, but declining revenue and online sales raised long-term concerns.
- Consumer shift to direct-to-consumer models and e-commerce giants like Amazon threaten Best Buy's intermediary role and in-store pickup strategy.
- Pandemic-driven demand surge led to market saturation, affecting Best Buy's sales. Challenges may subside unless recession hits, offering glimpses of potential growth.
- Discounted cash flow valuation suggests BBY could yield a $120.69 target price in 5 years, offering a 10% CAGR.
Investment Thesis
I believe Best Buy ( BBY ) is a hold, given the mixed signals from its Q2 FY 2024 performance. While the company exceeded profitability expectations, it also reported concerning declines in revenue and online sales. Best Buy is grappling with significant industry headwinds, particularly the shift in consumer behavior towards direct-to-consumer models. Brands like Apple and Samsung are increasingly bypassing intermediaries like Best Buy, which threatens its traditional business model and in-store pickup strategy. This is exacerbated by the competitive pressure from e-commerce giants like Amazon.
Moreover, the pandemic-induced demand surge for electronics seems to have saturated the market, further dampening sales prospects. Although some of these challenges may lessen if economic conditions remain stable, the long-term outlook is far from certain. A discounted cash flow analysis suggests a potential 5-year target price of $120.69, offering a 10% CAGR. However, this projection doesn't provide a margin of safety and hinges on the company's ability to turn around its declining revenue and profitability. Therefore, until Best Buy shows more definitive signs of successfully navigating these challenges, it remains a hold.
Company Overview
Best Buy is a leading retailer of technology products, operating in two segments: Domestic and International. The company offers a wide range of products, from computing and mobile phones to home appliances and entertainment products. Headquartered in Richfield, Minnesota, Best Buy was incorporated in 1966 and currently employs around 52,200 people. Recent developments around the company have presented a mixed bag. While the company has shown resilient performance in earnings, the cautious full-year outlook and job cuts indicate that there are challenges ahead. The expansion of its membership program and participation in big sales events like Black Friday in July are strategic moves to boost consumer engagement and spending, but their long-term impact remains to be seen.
Better than Expected Earnings but Concerns Remain
On the 29 August the company announced its Q2 Fiscal Year (FY) 2024 results and let's just say it was a mixed bag. On the brighter side, the company reported that financial results were better than expected and were at the high-end of the outlook they shared in May, particularly with profitability which exceeded expectations citing the company's effective operational strategies. CEO Corie Barry also commented about the most recent quarter potentially being the low point in tech demand which offers a glimmer of hope for future growth, especially as she anticipates stabilization and potential growth in the consumer electronics industry next year although I imagine this will have a lot to do with macroeconomic conditions. The gross profit rate in the Domestic segment improved to 23.1% from 22.0% in the same quarter last year. The improvement was attributed to favorable product margins and the financial performance of the company's membership offerings. Probably the biggest positive for me was the company's dividend and buybacks which saw BBY return $279 million to shareholders through dividends and share repurchases, the dividend alone is yielding 4.8% based on current prices. That being said there was also plenty to be concerned about.
The most glaring issue for me is the decline in revenue across both the Enterprise and Domestic segments, with a 6.2% drop in comparable sales. This decline is not a one-off event but rather a continuation of a trend, as indicated by the comparison with Q2 FY23. The company's decision to lower the high-end of its full-year revenue outlook is another red flag. While CFO Matt Bilunas tried to put a positive spin on it by saying they are effectively raising the midpoint of their previous annual guidance for non-GAAP operating income rate and non-GAAP diluted EPS, the fact remains that they are tempering expectations. This suggests that the challenges Best Buy is facing are not short-term hiccups but may be indicative of deeper issues within the retail electronics market or the company itself. Another concern is the decline in online sales, which decreased by 7.1% on a comparable basis. In today's digital age, I would expect a tech retailer like Best Buy to excel in the online space, and while I recognize that consumer spending is down across the board, the fact that online sales were down more on a comparable basis than the Enterprise and Domestic segments is a concern to me.
Shifting Consumer Behavior Towards Digitalization
I believe in the past few years we have seen significant shifts in consumer behavior which has been exaggerated by the COVID-19 pandemic. One of the most significant shifts in consumer behavior is the growing preference for direct-to-consumer ((DTC)) models. Brands like Apple (NASDAQ: AAPL ), Samsung, and Sony (NYSE: SONY ) are increasingly selling their products directly through their own online platforms or retail stores. This trend undermines Best Buy's traditional role as an intermediary between electronics brands and consumers, potentially leading to reduced foot traffic and sales over time. Additionally, these companies are moving towards subscription and service-based models where they are offering services like AppleCare, Apple Music, and Apple TV+ as part of their ecosystem. These services are often bundled with hardware purchases, making third-party service providers like Best Buy's Geek Squad less appealing to consumers. I believe the trend is set to continue, for example, the share of Apple sales generated from its direct channels have grown from 29% in 2018 to 38% in 2022 , with the trend being similar for other major technology brands.
The rise of e-commerce giants like Amazon (NASDAQ: AMZN ) and their impressive logistic network also poses a significant threat to Best Buy's business model. These platforms offer a broader range of products, often at more competitive prices, and with the added convenience of quick delivery options. Currently, over 40% of online sales continue to be picked up in-store and almost 60% of packages are delivered within two days, emphasizing the importance of their physical locations in complementing their digital strategy. This strategy in contrast with a company like Amazon which can offer same day delivery and unmatched convenience and prices, as well as the current consumer environment where consumers are very deal-focused compounds my concerns around the company.
While Best Buy has implemented strategies such as building out their digital assets and their membership program, which have seen some success, I remain skeptical as to the long-term effectiveness and the company's ability to compete with the DTC model and e-commerce giants with their same day deliveries.
Pandemic Pull-Forward Still Persists
Best Buy has continued to struggle to revitalize consumer confidence and encourage consumers to spend which is reflected in their most recent earnings which saw declines in sales across the board. The consumer electronics industry is currently navigating a complex landscape shaped by the pandemic and its aftermath. The pandemic led to a surge in demand for consumer electronics as people adapted to remote work, online education, and home entertainment. This "pull-forward" effect means that many consumers have already upgraded their electronics and may not need to make new purchases for some time. While I think was a massive tailwind for the company during the pandemic, with the initial rush to buy laptops, smartphones, and other gadgets, I believe the market is now at a bit of saturation point which has been a headwind for Best Buy in past year and I anticipate will continue to be a headwind for a little while longer. Other factors like longer replacement cycles and return to service purchases, in addition to consumer sentiment being at levels well below that of 2021 , I believe has contributed to declines in purchases in consumer electronics.
That being said, while I do believe that these headwinds resulting from consumer sentiment and the pandemic pull forward will persist for a little longer, much of these headwinds should subside in the coming quarters assuming we do not fall into a recession. I will be interested to see whether the company can return to growth once these headwinds alleviate.
Financial Analysis
Over the past 5 years, the company has demonstrated strong financial performance. Its revenue has shown a steady growth, increasing from $42.88 billion in 2019 to $44.37 billion in the last 12 months ((LTM)), representing a compound annual growth rate ((CAGR)) of approximately 0.7%. The earnings per share ((EPS)), has been volatile, peaking at $9.84 in 2022 before dropping to $5.82 in the LTM. Based on LTM EPS the EPS has experienced a CAGR of 2.3% in the last 5 years. The book value per share has experienced substantial variation in the past 5 years, increasing from $11.65 in 2019 to a peak of $17.44 in 2021 where it has since slid to $12.78. This suggests that the company has struggled to increase its intrinsic value over the period.
As of the most recent quarter, the company reported cash and cash equivalents of $1.09 billion which is down from previous years The company's total debt stands at $4.03 billion. While the company does have a significant amount of debt, it's important to consider this in the context of its overall financial health and its ability to service that debt. As I mentioned the company has $1.09 billion in cash and cash equivalents but has also generated $1.83 billion in free cash flow ((FCF)) during the LTM.
Looking at their LTM FCF as well as their historical FCF levels in addition to the cash the company has on hand gives me confidence the debt should not be an issue, especially given that the management team have been prudent in actively repaying debt over the past year. Much of the debt does not mature until 2028 which gives the company plenty of time to pay off the remaining balance.
As I mentioned, I expect Best Buy's upcoming quarterly earnings results to continue to be mixed bags with struggling revenues due in large to the factors I discussed previously. I will be keeping a close eye on whether management maintains their current guidance going forward or if they continue to revise down which I believe would be concerning for investors and may suggest the company's struggles are worse than once feared.
Looking beyond the next 12 months, assuming stable macroeconomic conditions, the company's revenues and earnings should stabilize, and consumer behavior normalize as the pandemic pull-forward alleviates which could see the company return to growth although I do not anticipate this growth being as strong as the COVID years.
Valuation
When considering valuation, I always consider what we are paying for the business (the market capitalization) versus what we are getting (the underlying business fundamentals and future earnings). I believe a reliable way of measuring what you get versus what you pay is by conducting a discounted cashflow analysis of the business as seen below.
Best Buy's LTM FCF per Share as of Q2, FY24 is $8.28. Once the headwinds impacting the business reduce and as cash flows normalize and margins expand, I believe that BBY should grow conservatively at 3% annually for the next five years. Therefore, once factoring in the growth rate by Q2 FY29 Best Buy's Cashflow per Share is expected to be $9.60. If we then apply an exit multiple of 10, a multiple the company has traded at frequently during the past 10 years, then the price target in five years is $120.69. Therefore, based on these estimations, if you were to buy BBY at today's share price of $73.74, this would result in a CAGR of approximately 10% over the next five years.
While a 10% return can appear attractive to some investors it is important remember this valuation doesn't offer any sort of margin of safety. Additionally, I would like to see the BBY show stronger signs of turning their revenue and profitability decline around before I can be more confident of their longer-term future.
Conclusion
Best Buy's Q2 FY 2024 results presented a mixed bag, with better-than-expected profitability but concerning declines in revenue and online sales. The consumer electronics retailer faces significant headwinds from shifts in consumer behavior, notably the growing preference for direct-to-consumer models from brands like Apple and Samsung. This undermines Best Buy's traditional role as an intermediary and poses challenges to its in-store pickup strategy, especially in the face of competition from e-commerce giants like Amazon. Additionally, the pandemic-induced surge in demand for electronics has led to market saturation, further impacting sales. While some of these challenges may subside in the absence of a recession, the long-term outlook remains uncertain. A discounted cash flow valuation suggests a potential 5-year target price of $120.69 for Best Buy, offering a 10% CAGR. However, this projection lacks a margin of safety and is contingent on the company successfully navigating its revenue and profitability challenges.
For further details see:
Best Buy: Remains A Hold Amid Mixed Q2 Results And Industry Headwinds