Best Buy (BBY) has been marked for dead for years.
The demise of Circuit City and strategic concerns about excess floor space are two of the biggest red flags for a business model such as that of Best Buy. But the dagger in the Best Buy long thesis has always been that the company is merely a showroom where consumers flock to in order to try out new gadgets only to buy them at online competitors such as Amazon (AMZN) or eBay (EBAY) for a discount. Best Buy revealed in its third-quarter results, however, that it is handling the tumultuous competitive market quite well, and we think the firm’s fundamental resilience speaks to the general health of the brick-and-mortar big box retail space heading into the holiday season, something we had highlighted earlier this week.
In the firm’s third quarter, the consumer electronics giant reported modest top-line growth, but we were most encouraged by its 2.2% increase in comparable store sales, with the domestic segment leading the charge with a nice 3%+ advance. Comparable online sales jumped nearly 22%, accelerating from the 15.1% pace registered in the third quarter of last year. A common theme among the big box retailers this third quarter from Walmart (WMT) and Target (TGT) to Best Buy and others has been the strength of their e-commerce strategies. Brick-and-mortar is clawing back some market share from online competitors, and we think a continued focus on digital bodes well, at least in the near term, for the group.
On the operating line, both Best Buy’s GAAP and non-GAAP measures improved by a ~2% clip, and non-GAAP diluted earnings per share from continuing operations leapt to $0.32 from $0.18 in the year-ago period. The bottom line beat expectations by $0.07, or 28%. That’s a large gap of outperformance, and management credited the top-line expansion and SG&A cost-cutting initiatives for earnings strength. The impact of cutthroat online competition was still apparent in the period, as Best Buy’s gross margin dipped 40 basis points. However, the pressure appears to be slowing, as through the first nine months, the company’s gross margin is down 150 basis points.
Best Buy is doing a lot of things right at the moment, and its strength in televisions, computing, and tablets coupled with growth in gaming and appliances have been the primary drivers behind the same-store expansion. The firm’s value proposition – Expert Service, Unbeatable Price – seems to be gaining more traction these days as the allure of buying a whole bunch of gadgets from home without any help has, at least, lost some of its luster. Still, no matter how well Best Buy is executing at the moment, faster-growing and lower-margin products, higher incentive comp, and the intensely promotional environment will not be easy to handle.
Looking ahead, Best Buy is content with merely holding the line this holiday season. The company is looking for near flat year-over-year revenue and comparable sales growth, but year-over-year expansion in non-GAAP operating income rate of approximately 50 basis points during the fourth quarter. In an environment where e-commerce expansion is growing at a fast clip, standing firm is quite the accomplishment for the embattled consumer electronics retailer. Best Buy was free cash flow positive in the third quarter, and the firm retains a healthy net cash position on the balance sheet.
Wrapping Things Up
Best Buy is trading roughly in line with our fair value estimate of $35 per share at the moment, so we’re not seeing much of an opportunity from a valuation standpoint. We were pleased with the firm’s comparable store sales expansion during the third quarter in light of the competitive environment, and we like that its balance sheet is still very healthy. Its Dividend Cushion ratio is a whopping 4, and for a company yielding north of 2%, that’s saying something. But as we outline in the firm’s dividend , the dividend is only as safe as long as Best Buy continues to fend off Amazon and other online discount retailers, which can never be guaranteed.