The seasonality of specialty retailers Best Buy (BBY) and GameStop (GME) is no secret, and both are depending on strong holiday shopping to buoy full-year results. Let’s take a look at recent performance to get a feel for how both are trending heading into the holidays. Electronic sales remain a bright spot, so we’re paying very close attention to what’s flying off the shelves and what’s not, but with all the promotional activity going on, the biggest question is whether margins will hold up.
In the third quarter of fiscal 2016, ended October 31, Best Buy reported total revenue falling 2.4% from the year-ago period to ~$8.8 billion. Comparable sales grew 0.8% (down from the 2.9% pace in last year’s quarter), and domestic online comparable sales advanced more than 18% thanks to improved conversion rates and increased traffic, but this, too, decelerated from a near-22% pace. Online sales continue to be an area of emphasis for the company, as it recently rolled out a new mobile site and continues to invest in online capabilities. Online revenue now accounts for nearly 9% of total domestic revenue, compared to 7.5% at the same time in 2014, and this percentage should grow over time.
Domestic sales, which account for more than 90% of total revenue, advanced 1.2% on a year-over-year basis, while international sales fell by nearly 30% mainly due to weakness in the Canadian economy and Canadian brand consolidation. Best Buy is rebranding Future Shop stores in an effort to improve business in the country, something other retailers have failed at doing, the latest being Target (TGT), among others. Foreign exchange rates continue to generate headwinds in the international segment. The firm’s ‘Services’ revenue category continues to be a weak point (comparable sales in the segment dropped more than 11%), as a reduction in the frequency and severity of claims on extended warranties reduced repairs revenue.
Best Buy grew comparable sales in computing, major appliances, health and wearables, and large-screen televisions in the quarter, but it did experience declines in comparable sales of tablets, mobile phones, and digital imaging; it is reasonable to expect mobile phones and tablets sales to pick up in the holiday season, however, and we’re watching such a trend closely. The retailing giant drove 40 basis-points of operating income margin expansion in its fiscal third quarter thanks in part to better product mix, helping drive non-GAAP diluted earnings per share 21% higher, to $0.41. The holiday season, however, will put pressure on Best Buy’s gross margin due in part to investment in services pricing and higher distribution costs. This wasn’t the best of news for shareholders.
Though it is not uncommon for Best Buy to report negative free cash flow through the first three quarters of the fiscal year, it reported a significant drop-off in cash from operations in the year-to-date period. Compared to the same period in 2014, cash from operations fell more than 40% to just over $460 million. While notable, however, the decline was mostly due to restructuring charges and higher income taxes in the period, two items we don’t view as tragic, if one-time in nature. Best Buy maintains a pristine balance sheet with a ~$1.7 billion net cash position.
Though shares of Best Buy slid on its third-quarter report, Best Buy received a boost compared to many of its peers in the high-volume shopping days immediately following the Thanksgiving holiday thanks in part to strong demand for Apple (AAPL) products. Some reports claimed Apple experienced the strongest Friday sales in its entire history on Black Friday. Best Buy is hoping to carry the momentum through the rest of the holiday shopping season, but a conservative outlook given recent sentiment around the broader retail industry is probably prudent. Gross margins will be of utmost importance, especially if it finds itself discounting its television line-up too aggressively.
GameStop reported a similar trajectory through the first three quarters of 2015, as it, too, is dependent on a strong holiday season. In its fiscal third quarter, ended October 31, the company reported a net sales decline of 3.6% from the year ago period to ~$2 billion, while comparable store sales fell 1.1% due to lower than expected new software and hardware sales (comp sales were greater than 8% in last year’s quarter). Delays in its Technology Brands new store openings impacted the firm’s net sales growth, but its full-year expectations have not changed. Shares were pummeled on the report nonetheless.
In its fiscal third quarter, new video game hardware sales fell by more than 15% on a constant-currency basis and new video game software sales decreased more than 4% on a year-over-year basis in constant currency. Pre-owned video game sales growth of nearly 5% on a constant currency basis was not enough to offset the weakness in new game sales, but it still represented the seventh consecutive quarter of pre-owned game sales expansion on a constant-currency basis. Diluted earnings per share declined 5.3% in the quarter from the year-ago period to $0.54, below consensus estimates.
Despite GameStop’s comparable store sales falling by more than one percent in the third quarter, it continues to expect full-year same store sales growth of 2%-6% due to hopes of a strong holiday season. However, the company’s relatively wide range of comparable store sales of -1%-6% for the fourth quarter suggests it is not entirely confident in its holiday season. Fiscal fourth quarter earnings per share are anticipated to be in a range of $2.12-$2.32, slightly below consensus expectations, but it’s likely performance will be at the low end, as it was during the third quarter.
A key driver for GameStop in the holiday season will be the release of the new Star Wars game, which is expected to generate a nice buzz given the anticipation surrounding the upcoming Star Wars movie to be released December 18. The firm also has a strong relationships with AT&T (T) and Apple through its Technology Brands operations; the Technology Brands segment grew sales more than 64% in the fiscal third quarter from the year-ago period as it opened 105 new stores during the quarter. This segment is expected to be a growth driver through the holiday season as well.
Demand for Apple products remains as strong as ever, and GameStop is selling all of the latest products, such as the iPad Pro and Apple Watch in its Technology Brands stores, which include Simply Mac and Spring Mobile stores. Also in its Technology Brands stores, the firm is selling DirecTV through its partnership with AT&T, offering an additional source of revenue. GameStop bought 239 AT&T and Apple reseller stores for ~$112 million. The strategy to grow its presence in the highly-fragmented dealer space will be vital to its business model.
Best Buy offers a slight valuation opportunity for investors, based on our fair value range, but we are not ready to hitch our wagon to a company that is facing fundamental gross margin pressure and whose shares have fallen out of favor. We’re maintaining our long-held view that a decline in GameStop’s long-term profitability is probable when considering the impact that streaming and other cloud-based activities will have on the future of the way people play video games. The firm’s success as a secondary dealer of AT&T and Apple products is something the now-defunct RadioShack had once tried, which doesn’t give us a lot of comfort. We’re comfortable watching these two from the sidelines.