Dueling Fools

Dueling Fools
Buy Buy or Bye Bye
May 12, 1999

Bear Argument
By Chris Rugaber (tmfrfk@aol.com)

Best Buy may sell consumer electronic products at cheap prices, but its stock is as overvalued as yesterday's PC after the introduction of a faster generation of microprocessors. The company has executed well recently, but with a robust economy, low interest rates and rising incomes, it won't get any better than this. Investors considering this top-performing retailer should be prepared to pay premium prices.

Best Buy was floundering just a few years ago, getting carried away with a "no payments, no interest, no money down, no shirt, no shoes, no problem" policy (just kidding about those last three). Unfortunately this was producing no profits, and operating income was essentially flat in 1996, despite an almost 25% increase in outlets, and operating income fell by over half in 1997.

Nevertheless, the company worked hard to get its act together, and the last couple of years have certainly seen results, as I'm sure Paul Larson described in his Bull's Pen. Unfortunately for investors who don't yet own the stock, this turnaround was noticed and Best Buy experienced annualized share price growth of almost 279% in the past two years, with the stock jumping from a split-adjusted $3 11/32 in early May 1997, to $47 5/8 as of this April 30th. Now, investors who want in are looking at a trailing P/E of 45, and a forward P/E of 35.7, based on May 4th's closing price of $48.19.

Valuation may not matter for Rule Breakers, but Best Buy hardly qualifies as one. It's certainly no hyper-growth Internet company. Analysts' estimates are for 26% growth this year (the company's fiscal 2000) and 23% for fiscal 2001. Best Buy's stock is pretty expensive for a retailer subject to the health of the economy, technological changes in home entertainment and PCs, and facing increased competition from the Internet. Much of Best Buy's future is out of its hands.

After all, much of what the company sells is sold over the Internet, and it is as vulnerable to the threat of e-commerce, if not more so, as any other traditional retailer. Approximately 60% of Best Buy's sales are either in PCs, other home office equipment, or entertainment software such as videos, CDs, DVDs, and various games. Many of these items are being sold by Amazon.com, Onsale.com, and other e-commerce sites, and Best Buy may soon feel the pain of tightening margins.

Oh yes, Best Buy has a Web page, too, and you can even buy a few things on it, primarily CDs and DVDs. None of its PC, peripheral, or other hardware is available on its site, and information about what is available at its stores is extremely limited. When I checked, it only had information on three models of notebook computers. I assume they sell more than that at their stores.

Little information is available for the DVDs the company sells online. Picking the movie Stepmom completely at random (trust me), Best Buy has the following semi-literate review: "Julia Roberts, Susan Sarandon, and Ed Harris star in a touching story of unlikely friendship between two remarkable women. A hilarious poignant, heartfelt drama." Okay, thanks. Meanwhile, Amazon.com has a two-paragraph review from someone who seems to have actually watched the movie followed by 15 customer comments.

Best Buy's music CD selections had little information as well, and few even had audio clips, which is one of the best things about buying music online. Nor were there any recommendations for similar movies and CDs.

Meanwhile, Amazon.com includes recommendations based on whatever CD or book you might be looking at, and this has actually helped me find CDs I really wanted based on little more than a song title. I'm beginning to think that music is better suited to online commerce than almost any other product, yet Best Buy is light-years behind its competitors. And this is before we are even seeing the full impact of MP3 and other technologies that allow you to download music files from the Internet onto your own CD.

Finally, if you have any problems with your order from Best Buy's website, don't expect any help from your nearest Best Buy store. They won't accept returns from the online store, which to me seems to throw away one of the few advantages traditional retailers might have over Internet-only companies. Presumably that's why the Gap, Kmart, and many others do accept such returns.

It's true that the company has hired the COO of Peapod (Nasdaq: PPOD), the online grocery store, to be the new president of its e-commerce division. Oh goody -- Peapod's an Internet company that failed to even increase sales year-over-year in its most recent quarter, never mind earnings. Check out the two-year stock price chart for Peapod and see if you feel confident.

Before I get too carried away here, let me reiterate: Best Buy has performed excellently in the last couple of years, increasing its margins, its inventory turns, and as a result its profitability. But the company sports a high price tag without the growth rate to justify it, and it shows little sign of understanding the e-commerce threat. In addition, its recent outperformance is at least somewhat due to a healthy national economy that won't last forever. And even in good economic times, a technological innovation can also clobber the company, as happened in 1997, when anticipation for Intel's newest chip, the Pentium II, left the company with a glut of PC inventory.

Best Buy's a good store, but it wouldn't sell its own stock at this share price.

Next: The Bull Responds