2023-09-11 08:34:27 ET
Summary
- Best Buy is facing challenges in the current economic environment and struggles to offer compelling long-term returns compared to other options.
- The company's strategies, such as membership programs and in-store services, are commendable but may not be enough to navigate current challenges.
- Despite its strong dividend history and healthy balance sheet, caution is advised with Best Buy and better opportunities exist with a more favorable risk-reward ratio.
Introduction
In June, I wrote an article titled Best Buy's 5% Dividend: High Yield Haven or Risky Bet? A part of my conclusion can be seen below.
[...] I personally wouldn't consider buying this company. While Best Buy is insulated from some consumer trends, its long-term risk-adjusted return has been disappointing compared to other dividend stocks.
The stock's performance has been volatile, and its dividend growth doesn't come with long-term free cash flow growth.
Additionally, mounting consumer troubles have impacted the company's revenues.
Although Best Buy's dividend yield is tempting, I would explore alternatives like the Schwab High Yield ETF SCHD, which offers better diversification and the potential for superior total returns.
In this article, I'll update my Best Buy ( BBY ) thesis, as the company's stock price has fallen roughly 7% since June, underperforming the S&P 500 by 900 basis points.
Essentially, the company continues to confirm my suspicion. It's not a bad company, as even in this environment, it is able to achieve progress through new membership programs, smart inventory management, and rightsizing, which stabilizes margins.
The company also expects to encounter less sales contraction, which is somewhat good news in this environment.
The problem is that its 5% yield still isn't a great deal.
Although I wouldn't make the case that Best Buy is a bad company, there are simply better alternatives with similar yields and lower risks.
In this article, we'll discuss all of this and more.
On a side note, even if investors don't care for BBY, listening to its management and taking a look at its numbers tells us a lot about the health of the consumer.
So, let's get to it!
Best Buy Isn't Bad, It's The Environment
Best Buy is not a bad company. Ignoring the current environment of sticky inflation, elevated rates, and related consumer weakness, the company is doing well in a very competitive industry.
The best consumer stocks over the past decade were online-focused companies like Amazon ( AMZN ), companies further up the supply chain like Nike ( NKE ), and companies that had wide moats in the brick-and-mortar business like Home Depot ( HD ). After all, most home improvement products are bought in stores.
While Best Buy has done a great job with its membership programs and in-store services, it's operating in a very tough environment with a lot of competition.
Over the past ten years, BBY has returned 169%, including dividends. The S&P 500 has returned 220%.
On a side note, BBY has a history that includes some very steep rallies, which are often caused by accelerating consumer sentiment and (related) improving economic growth. It's why I make the case that BBY is a buy on severe weakness despite its weak longer-term risk/reward.
That said, right now is a terrible environment for consumer-focused stocks. Everywhere I look, the data is bad. My railroad holdings report very weak intermodal volumes, dollar stores see contraction for the first time in decades, smartphone sales are under pressure, and car manufacturers are struggling for the first time since the pandemic.
Using University of Michigan data, we see that consumer confidence is at very distressed levels - despite a recent surge from multi-decade lows.
Unfortunately, the surge is mainly caused by higher-income spenders, which is hard to see in the chart below.
When adding that student loan payments are coming back, crude oil is close to $90 again, and the Fed isn't convinced that its job is done, I do not believe in a continuation of the consumer confidence recovery.
This brings me to Best Buy.
How's Best Buy Doing?
At the end of its 2023 fiscal year, BBY had more than 1,100 stores. I'm not breaking any news when I make the case that this $16 billion market cap retailer has a large footprint.
I just wanted to reiterate it, as it means that the chances of avoiding consumer weakness are slim to none.
In the second quarter of its 2024 fiscal year, the company did slightly better than expected, yet it was highly impacted by poor consumer sentiment.
BBY's comparable sales performed at the high end of their guidance, which is a significant improvement from the previous quarter's 10% decline.
In 2Q, comparable sales were down 6.2%. Gross profit rates expanded by 110 basis points, which was attributed to improved product margins and profitability in the company's membership program.
Furthermore, June saw the best performance, with a year-over-year decline of approximately 5%, while May and July both experienced declines of around 7%.
In the Domestic segment, revenue decreased by 7.1% to $8.9 million, primarily due to a 6.3% decline in comparable sales. The decline was most notable in categories such as appliances, home theater, computing, and mobile phones, although it was partially offset by growth in gaming.
The blended average selling price declined slightly compared to the previous year.
Also, despite challenges from lower consumer demand due to the pandemic and inflation, BBY has managed to strategically balance its promotional plan and pricing competitiveness.
According to the company, its stronger performance than expected was due to several factors, including lower cost to serve membership offerings, increased profit-sharing revenue from a private-label credit card arrangement, and reduced supply-chain costs. The gross profit rate improvement was driven by better product margin rates, enhanced membership offerings, and improvements in health initiatives.
Having said that, in addition to general consumer weakness, the company mentioned another factor influencing its performance: the lasting pull-forward impact of the pandemic.
Our industry continues to experience lower consumer demand due to the pandemic pull-forward of tech purchases and the shift back into services spend outside the home like travel and entertainment. In addition, of course, persistent inflation has impacted spending decisions for a substantial part of the population. - BBY 2Q24 Earnings Call
The company also dealt with inventories quite efficiently.
Inventory was down compared to the previous year, aligned with sales decline. Customer satisfaction with product availability has improved, and BBY highlighted its success in digital assets, including the mobile app, which contributed significantly to domestic revenue.
Buy Online-Pickup-In-Store accounted for over 40% of online sales, and rapid delivery with a 60% two-day delivery rate emphasized the importance of the company's digital and physical combination.
On top of this, the company made more improvements.
How BBY Is Improving Its Business
During its earnings call, the company elaborated on a number of ways it is improving its business. For example, the company introduced changes to its membership program, offering three tiers: My Best Buy, My Best Buy Plus, and My Best Buy Total.
These changes aim to provide customers with more flexibility and lower costs while maintaining customer satisfaction.
According to the company, early indicators suggest these changes are driving growth in paid membership sign-ups, with My Best Buy Total resonating strongly in physical stores.
The company also highlighted the continued success of its free membership tier, with customer metrics validating the decision to shift benefits.
On top of that, Best Buy emphasized its commitment to evolving its omnichannel capabilities to adapt to the digital age. The company plans to close some stores while implementing large-format Experience Store remodels and expanding outlet stores.
The focus is on improving merchandising presentation in stores, especially with the shift to digital shopping, by installing new premium end-caps that allow for better product presentation with less in-store inventory. The company is also making strategic changes in its gaming and digital imaging spaces to accommodate growing categories.
This is a Wall Street Journal headline from April 2023:
I believe this is a fantastic strategy that combines the inevitable long-term decline of brick-and-mortar stores with top-tier assistance that BBY brings to the table.
Having said that, this strategy is only effective if the company's operations are running smoothly.
BBY is addressing this.
During its 2Q24 earnings call, the company also discussed its efforts to balance cost efficiencies with employee flexibility and development.
For example, the company has made structural changes to allocate labor more efficiently while providing employees with opportunities to gain additional skills.
These changes have resulted in more than 100 basis points of rate improvement in domestic store labor expense as a percentage of revenue compared to the 2020 fiscal year.
BBY also highlighted its employee retention rates outperforming the retail industry, which is important, as retail employee satisfaction has fallen off a cliff, according to Bloomberg .
Last but not least,
BBY is also looking to drive profitability through optimization efforts across other areas, including the reverse supply chain and AI-driven customer care.
In this vein, we are exploring Geek Squad as a service opportunities with several large companies, including Accenture, Intel, and Lenovo as we have created differentiated B2C and B2B services capability.
Device lifecycle management is a specific example of the service we can provide to others and necessity for all companies, device lifecycle management refers to the process of providing tech devices like phones and laptops to employees. This is not a core competency for most companies and the recent hybridization of work has made it even more complicated. - BBY 2Q24 Earnings Call
So, what about its outlook?
Outlook & Dividend
Best Buy revised its fiscal 2024 outlook.
- The company lowered the high end of its full-year revenue outlook while keeping the low end unchanged.
- Enterprise revenue is expected to be in the range of $43.8 to $44.5 billion, with a comparable sales decline of 4.5% to 6%.
- Non-GAAP operating income rate is projected to be in the range of 3.9% to 4.1%, and non-GAAP diluted earnings per share are estimated at $6.40.
On August 30, the company declared a $0.92 per share per quarter dividend. This translates to a yield of 5.0%.
On March 2, the company hiked this dividend by 4.5%.
Over the past five years, the dividend CAGR was 17.9%, which is quite impressive. Using FY2024 guidance, the company has a 58% payout ratio, which is healthy.
The company has a history of 12 consecutive annual dividend hikes. It did NOT cut its dividend during the Great Financial Crisis. I do not expect a dividend cut in the next few years unless we get a Great Depression-like recession, which I do not expect.
The dividend is also protected by a stellar balance sheet, which sets BBY apart from a lot of other retailers. This year, the company is expected to end up with $1.4 billion in net cash (more cash than gross debt). It has a BBB+ credit rating, one step below the A-range.
Because of this balance sheet, its healthy dividend payout ratio, and the fact that the company is expected to maintain a free cash flow yield close to 9%, the company is able to buy back stock.
Over the past ten years, BBY has bought back 37% of its shares. This makes BBY one of the most aggressive buyback companies on the market, which significantly adds to its stock price performance.
So, what about the valuation?
Valuation
One can make the case that BBY is undervalued. However, not by a lot.
This year, the company is expected to see its second consecutive year of EBITDA contraction. After FY2024, EBITDA is expected to grow by 3.4% in FY2025 and 4.3% in FY2026. The company's free cash flow is expected to gradually increase to more than 10% of its enterprise value.
These numbers support moderate dividend growth and a fair valuation of roughly $85 per share, 16% above the current price.
In this case, I'm using a 6x EBITDA multiple, which is roughly the longer-term median.
The current consensus price target is $82.
Despite this fair valuation, I'll stick to my Hold rating. I do not see enough evidence to make BBY a compelling investment. While I believe that BBY is taking the right steps to survive in a tough environment for many more decades to come, I wouldn't bet against lower guidance in the 2-3 quarters ahead.
This environment is vicious, and a 5% yield isn't enough to get me excited about this stock.
If I were looking for yield, I would prefer the Schwab U.S. Dividend Equity ETF ( SCHD ), which yields 3.5% and has a better long-term total return than BBY. I also frequently discuss other attractive high-yield opportunities on Seeking Alpha.
So, I'm not making the case that BBY is a bad company (it is not). I'm also not trying to get anyone to sell BBY. If you're happy with your investment, don't sell.
I just continue to dislike the risk/reward.
If the stock were to drop to $50, I may change my mind. However, for now, that remains a long shot.
Takeaway
Best Buy faces significant challenges in the current economic environment. While it's not a bad company, it struggles to offer compelling long-term returns, especially compared to other options. The 5% dividend yield is tempting, but it doesn't outweigh the risks.
While Best Buy's strategies are commendable, they may not be enough to navigate current challenges.
Despite its strong dividend history and healthy balance sheet, caution is advised with Best Buy.
In this climate, better opportunities exist with a more favorable risk-reward ratio.
For further details see:
How Juicy Is Best Buy's 5% Yield?