2023-11-15 14:31:04 ET
Summary
- Best Buy's stock has remained nearly unchanged despite a decline in operating income, with its Q3 earnings report expected to trigger volatility.
- The company's sales have benefited from the liquidation of competitors, but its market share is now slipping as Walmart advances in the electronics market.
- Best Buy's revenue growth is stagnant, and its gross and operating margins have been declining, making it vulnerable to the failure of the in-store electronics market.
- A weakening outlook for holiday and 2024 consumer activity may be Best Buy's "straw that breaks the camel's back."
Roughly one year ago, I published "Best Buy: Understanding 'Last Man Standing' Bias" regarding my bearish outlook for Best Buy ( BBY ). Since then, the stock has been roughly unchanged despite a continued decline in its operating income. The company is expected to report its Q3 earnings report next week, which I expect will trigger significant volatility in the stock given its technical position. BBY is trading at the support level it held for most of the past two years, which is also the same general support level from 2018 to the 2020 crash.
Historically, BBY has bounced back up after racing around $65 per share; however, a disappointing Q3 report or Q4 guidance could be sufficient to cause a significant decline in the stock due to potential capitulation. Conversely, if its Q3 report is better-than-expected, we could see another sharp rebound for BBY. As such, I believe it is an excellent time to analyze how the firm and its macroeconomic backdrop have shifted over the past year. In my view, there is potential that BBY is a value opportunity. That said, due to strains in the consumer credit market and its falling sales, my long-term view is that the company will continue to lose value.
A Company Losing Its Competitive Edge
When I covered the stock last, I pointed out what I believe to be a key issue among many analysts and investors looking into Best Buy. Many investors point to the firm's sales resilience over the past decade despite the immense increase in online electronics shopping. However, the fact is that Best Buy benefited tremendously from the liquidation of its competitors, such as Fry's Electronics, Circuit City, and many others. To a great extent, Best Buy is the "last man standing" in a fundamentally dying market. Now that virtually all of Best Buy's direct competitors are gone, it cannot maintain its sales as long as total electronics store sales continue to decline.
On an inflation-adjusted basis, total electronics and appliance store sales peaked around the 2000-2005 era, as many may remember that era of electronics stores fondly. Since then, real electronics store sales have fallen in half, with Best Buy's market share rising by around 50%. See below:
Note Best Buy's revenue is annual while the electronic store sales data is monthly, so the "5.77X" figure implies BBY's sales are ~48% of the total. Of course, these data are not telling because around 30% of Best Buy's sales are online, though it is struggling to compete in that market. Interestingly, Best Buy's market share peaked around 2021 during the solid retail sales period during the "stimulus spending binge" among many retailers around then. Since then, its market share has slipped as Walmart ( WMT ) has continued to advance in the electronics market.
Best Buy's revenue growth overall is lackluster, with stagnancy since 2010. Of course, that is much more pronounced if we adjust for inflation, which shows how its sales have crashed over the past year. See below:
After its 2021 sales spike, Best Buy's inflation-adjusted sales are now well below the range from 2014 to 2019. In my view, this stems from the fact that Best Buy's lack of direct competition makes it more exposed to the general failure of the in-store electronics and appliance market. The fact is that most people are comfortable purchasing these items online, mainly when both Amazon and Walmart are consistently cheaper than others. Of course, Best Buy also has higher overhead costs than online-only competitors due to rent, power, wages, and theft, though it is more successful than most in combating shrinkage .
Best Buy's gross margins and operating margins have slipped in recent years. Compared to Walmart, Best Buy has lower gross margins but slightly better operating margins, likely stemming from its focus on higher-price items. Notably, both firms are seeing declining operating margins, with Walmart's pattern being particularly telling because it sells a broader base of goods. See below:
Fundamentally, Best Buy's lower operating margins give it slim room for mistakes. The long-term negative trend in its gross margins and inflation-adjusted sales are problematic because that could quickly push its gross profits below its overhead costs if it continues too long. Best Buy has made an effort to lower its operating expenses in recent quarters, but such measures generally can only go so far before creating other issues; for example, cutting marketing spending can temporarily improve profits, but at the expense of future sales.
The company is closing underperforming stores while expanding and renovating its more successful ones to improve its profitability. That is the general trend of most large retailers today, focusing on catering to "experience shopping," given that most people will shop online over in-store. That is likely the best approach the firm can take at this point; however, it is increasing its capital spending to 2% of its sales (or ~2/3rds of its OpEx), a decent but manageable investment cost. At the same time, Best Buy continues to pay a decent dividend, giving it a 5.5% yield, as around 55% of its operating cash flows go back to stakeholders. See below:
From a cash-from-financing standpoint, which includes debt repayment, dividends, and share buybacks, BBY's true "yield" is closer to 10.3% of its enterprise value. Best Buy has no net financial debt (debt minus cash), so its yield is around 10% of its market cap if we include dividends and buybacks. That is, to me, a strong point in Best Buy's favor, which does give the firm room to continue to raise CapEx by reducing buybacks if need be. Still, I personally doubt that these renovations will fix the core competitive issues against e-commerce, given its inability to make a significant foothold in the online market.
Prepare for Disappointing Holiday Sales
Most of Q3 saw a rise in retail sales. However, retail sales slipped during October , potentially due to student loan repayments. Target's Q3 report was better than expected due to increases in efficiency, but its comparable sales fell by around 5%, a potentially troubling figure for Best Buy. Like many retailers, Best Buy has also faced increased credit card delinquencies on its store cards. That is not necessarily a significant financial risk for the company, but it does indicate a general decline in consumer spending power.
As I've discussed in many articles, high consumption growth has occurred primarily due to increases in consumer credit debt, as personal savings levels crumble due to higher prices and slower wage growth. Today, consumer credit is declining rapidly as consumer sentiment and personal savings also reverse. See below:
In my view, in 2022, we saw consumption activity supported by consumer borrowing, as low savings indicate a lack of disposable income. In 2023, we've seen indications of an impending decline in consumption activity as personal savings and consumer credit growth slip together. To me, that indicates that a growing portion of people cannot borrow more than they already have.
Around 2021, consumer credit defaults were extremely low due to pandemic stimulus and improved savings (due to a lack of travel). Today, we're seeing a massive rise in delinquencies, as auto loan delinquencies reach a ~30-year high and subprime auto delinquencies hit a record high. We're beginning to see similar trends in credit cards, particularly as interest rates rise higher and potentially exacerbated by student loan repayments restarting last month.
I believe that we're just passing over the "peak" for consumption activity. Most data, including business and banking activity, points toward an impending economic slowdown, with consumer trends likely being among the more alarming. The Federal Reserve's interventions in the banking system since 2020 and the associated inflation issue create uncertainty around my outlook because of those unprecedented actions. As one example, many people see the decline in inflation as a positive; however, that may be due to spending slowdowns (see inventory buildup and the Q3 GDP ). Additionally, I do not believe inflation is that low, considering the decline in gasoline prices since late 2021, given fuel prices impact core inflation indirectly (as retailers adjust for fuel costs).
The Bottom Line
Overall, I remain generally bearish on BBY and believe it is more likely to decline in value than increase. Regarding its Q3 report, I am roughly neutral on it and do not firmly have a bias toward a beat or miss. Most retailers have thus far performed in line with expectations during Q3, and consumption and retail trends were roughly stagnant. However, I see Q3 as the "peak" for economic activity, with a sharply declining outlook going into Q4 and Q1 next year.
I personally would not short BBY ahead of its Q3 report since it has the potential to bounce above its support or break below it, likely creating significant volatility in either direction since it is trading at a critical position. However, I would be surprised if it remains above its support level by next spring. I believe the holiday sales season will be disappointing, as growing consumer delinquency trends indicate. While many were stating the pattern was a "normalization," we're now seeing consumer delinquency figures that surpass normal levels . Of course, when people are not saving as they were in the past, inevitably, consumption will not continue to rise.
In my opinion, Best Buy cannot afford a recession in consumer activity today. While its balance sheet is not a "red flag," its low operating margins will likely become negative quickly in such a slowdown. Further, as we saw in 2008, I expect these declines to be permanent and result in many more store closures due to its stores' relatively weak competitive position against both Walmart and Amazon. Further, Best Buy's focus on "experience" stores may not prove profitable in a slowdown as that would cause people to become more price-sensitive, benefiting e-commerce over in-store. Additionally, although Best Buy has expanded its online segment, it has no clear competitive edge against its peers in that market.
I am bearish on BBY but do not see it as a short opportunity due to its decent valuation and shareholder yield. I also believe its Q3 report could create significant negative or positive volatility. That said, by Q4-Q1, I see weak holiday sales as likely creating renewed profitability and business pressures on the firm, potentially setting it up for an even weaker 2024.
For further details see:
Best Buy: The Electronics Store Era Is Coming To An End