Dueling Fools

Dueling Fools
Buy Buy or Bye Bye
May 12, 1999

Bull Argument
by Paul Larson (tmfparlay@aol.com)

Best Buy caught my attention last year when the company underwent a restructuring that had a startling impact on the company's profits. The retooling of Best Buy's operations also had a significant effect on the company's stock, which was one of the best performing stocks of 1998. Simply put, I don't think the good times will end anytime soon. Armed with an extremely strong operational model, a robust balance sheet, and existing units that are generating scads of free cash flow, I think it's a safe bet that Best Buy's innovative management will continue to conquer the electronics retailing world.

Best Buy has proven itself to be a true "category killer" in the electronics business. The company has left a long string of competitors in the dust over the past several years in the markets it enters. Best Buy's operating model of having large and bright stores, a wide product mix, and using a non-commissioned sales force is simply the best model out there today for the electronics business. Taking a page from Wal-Mart (NYSE: WMT), smaller firms can't match Best Buy's size and consistently low prices. Plus, not having salesmen wearing cheesy ties chasing customers around the store for a dime makes shopping at Best Buy, in my opinion, a much more enjoyable experience. Good price, good service, and good selection -- Best Buy has all traits of a winning retailer.

Whatever one's thoughts are about the attractiveness of Best Buy's stores, the company's performance over the past two years is hard to argue about. Simply said, the financial results are a thing of beauty. Same-store sales were up an impressive 13.5% last year on top of a 2% gain the year before. Increased sales of digital products such as DVD players and movies were behind much of this increase, and the digital revolution shows no signs of slowing. In fact, when High Definition Television (HDTV) becomes viable at the retail level over the coming year or two, few are set to benefit more than Best Buy.

Increased sales at its existing stores mixed in with a growing base of retail locations caused Best Buy's revenue to impressively jump last year. Profits also jived upward as the company's turnaround started to really gain some positive momentum. Check these figures out:

               Fiscal '99        Fiscal '98   Fiscal '97
Sales         $10,077.9 mil   $8,358.2 mil   $7,770.7 mil
Gross Profit   $1,827.8 mil   $1,332.2 mil  $1,058.9 mil
Net Income        224.4 mil      $94.5 mil      $1.7 mil
Gross Margin       18.1%          15.9%         13.6%
Net Margin         2.2%            1.1%          0.002%
Diluted EPS       $1.07           $0.52         $0.01
How did Best Buy achieve such a turnaround operationally? The largest improvement came from more efficiently managing inventory. The company not only tweaked its product mix a bit to increase its margins, but it also has much tighter control over what is sitting on the shelves. This becomes readily apparent when looking at Best Buy's inventory turns -- a key efficiency metric for retailers.
                    Fiscal '99    Fiscal '98     Fiscal '97
Cost of Goods Sold  $8250.1 mil   $7026.1 mil   $6711.8 mil
Average Inventory   $1053.6 mil   $1096.5 mil   $1166.6 mil
Inventory Turns         7.83x         6.41x         5.75x
Notice that over the past two years inventory turns are up about 36%, which is no small feat for any retailer. Inventories have actually been shrinking even as sales climb. In other words, the company is managing its inventory much more efficiently and has reduced surplus products (and subsequent clearances and write-offs) to a fraction of what they used to be. Even though sales are up nearly 30% over the past two years, inventories are actually at a lower level than what they were in 1997. Make no mistake, Best Buy is a much meaner and leaner competitor.

The improved profitability as well as some financial remodeling have also had quite an influence on the company's balance sheet, now one of the cleanest in the business. The company has reduced its preferred obligations and long-term debt from a combined $440.3 million all the way down to $30.5 million over the past year. Any way you slice it, that's one massive repayment of debt. Two years ago the company's interest expense rang in at $33.0 million. Last year, Best Buy actually earned more interest than it paid out. Cash on hand increased from $520.1 million to $785.7 million during the year, even while the company was repaying debt and opening two dozen new superstores.

I'm almost certain much of the bearish argument of my associate, Chris, will revolve around e-commerce and how Best Buy's brick and mortar stores are toast. Don't believe it. Best Buy has managed to grow and post these glowing numbers despite the explosion in online commerce. In fact, the company has actually embraced the Internet. Best Buy has recently moved to get a piece of the online pie by using its site at bestbuy.com to sell music and DVDs over the Web. With a good domain name and a strong brand that is already associated with music and movies, the company's entrance into the online arena should not be ignored.

With the continuing digital revolution, booming same store sales, 45 new locations expected this year, vastly improved operational efficiency, a sparkling balance sheet, and an online kicker... what's not to like?

Next: The Bear Argument