September 9, 1998

An Investment Opinion
by Louis Corrigan

Best Buy Is Right

Since plunging 70% from the split-adjusted June 1996 high of $13 to a low of $4 in February 1997, shares of giant consumer electronics retailer Best Buy (NYSE: BBY) have skyrocketed. After it hit the stratosphere, booster rockets kicked in and sent the shares into deep space. The eighteen month journey to the August high of $54 13/16 produced a nearly 1300% return. Even after the market's swoon, Best Buy remains one of 1998's top performers, up an incredible 166%. In early April, I opined in the Lunchtime News that, despite the company's terrific turnaround, the stock was "looking a little rich, trading at 27 times the recently revised FY99 estimates of [$1.32] with projections of 15% long-term growth." Uh-huh, sure. Even well off its high, the stock is still up 34% since then!

There are several lessons here. First, turnarounds can be surprisingly awesome investments. That's partly because just as negative psychology depressed the earnings or sales multiple investors were willing to pay when the business was going to hell, positive psychology can reverse the trend, producing a sweet multiple expansion as future earnings come to seem more likely. Of course, investors are really just keying off the fundamentals, and just as the ugliness snowballed before the turnaround, the good times can continue to get even better as operational improvements take effect. That's partly why momentum investing can work well. Like slugger Mark McGwire, winning companies can simply get on a roll, mixing good mechanics with keen concentration so that they consistently knock the cover off the ball. When a company that's been in a slump finds "the zone" again, investors can enjoy quite a ride.

The correlative is that companies on a roll often beat analyst earnings estimates. Barring some macroeconomic problem likely to hurt future earnings (for example, a recession), investors should key off the company's actual results rather than the analysts' expectations. That is especially true for a retailer with $8.4 billion in annual sales that's only beginning to deliver profits. As I well knew, Best Buy had plenty of room to continue improving margins and cash flows by altering its product mix, managing inventories better, leveraging operating expenses, focusing like never before on highly profitable warranties, and ditching the destructive buy-now, pay-next-year financing plans. In fact, with the economy pumped up and consumer confidence even stronger, there was no good reason to doubt that Best Buy would continue to deliver exceptional earnings.

And it has. Results for 4Q '98 released in April showed a 21.5% jump in sales that pushed earnings 550% higher to $0.64 per share, four cents ahead of estimates. That even took into account 16% more outstanding shares due to the conversion of preferred stock into common. Same-store sales increased 2%. Yet the ensuing quarters have been even better.

For the first quarter ended May 30, revenues vaulted 21% to $1.94 billion on a 15.3% comp-store sales gain. An improved product mix helped boost gross margins to 18.2% from 15.4%, but the company also continued to show skill at managing inventories, which actually declined by nearly 1% despite the tremendous revenue gains. Selling, general, and administrative expenses jumped to 16.8% of revenues from 15.1% due to higher labor costs in the tight job market and some one-time expenses for outside consultants who have helped improve operations. That spending helped not just in the sales and gross margins areas but in lower interest expenses, which also benefited greatly from the conversion of the preferred. As a result, net income soared to $15.7 million versus a loss of $2.6 million in 1Q '98. That was good for earnings of $0.16 per share, or two cents ahead of estimates.

The spectacular sales and margins gains keep coming. On September 3, Best Buy announced preliminary second quarter results. The company registered $2.18 billion in sales, a 22% jump driven by 17.9% higher comp-store sales. The margins keep improving, too, as the "other" category (including digital cameras as well as the lucrative service contracts) accounted for 9% of revenues versus just 7% last year. The net income figures aren't available, but the company expects EPS of $0.40 a share. That not only crushes the $0.07 a share reported in Best Buy's pivotal 2Q '98, but it also demolishes the consensus earnings estimates listed last week by Zacks at $0.17 per share. Indeed, no analyst had expected more than $0.20 per share!

Consensus estimates have since inched forward from $1.48 to $1.55 per share for FY99 (ending in February) and from $1.82 to $1.90 for FY00. But those numbers are still too low because they include only a few revisions. Analysts who have updated their numbers are looking for somewhere between $1.79 and $2.00 per share for FY99 and up to $2.50 next year. Still, perhaps Best Buy is now too richly valued given that it trades at 24 to 27 times estimated earnings six months out?

Possibly. The stock market's recent troubles may presage an economic slowdown that could hurt the company's sales. The consumer spending index fell in July for the first time in two years, and the Conference Board's consumer confidence reading fell slightly in August after being in record territory. The market's slump could dampen the wealth effect, too, slowing consumer spending even more. Then again, low unemployment and strong real wage growth are probably more important than the stock market in terms of the health of Best Buy's customer base. With Federal Reserve chair Alan Greenspan sounding more prepared to use interest rate cuts to head off a recession, it looks like Best Buy should continue to see strong sales.

Moreover, management says the company is gaining market share. That's easy to believe given that its top competitor, Circuit City (NYSE: CC), is being distracted by what thus far looks like classic "diworsification" into the used car business (CarMax) and a novel no-return movie-rental technology known as Digital Video Express (Divx). Circuit City's consumer electronics stores have done fairly well of late (though not as well as Best Buy), with second quarter sales up 17% on same-store revenue growth of 6%. Still, the stock hasn't gained any ground over the last three years, a period that's seen Best Buy's decline and dramatic recovery.

While Best Buy faces tougher year-over-year comparisons in the coming quarters, it is also returning to expansion mode now that operations are running smoothly. After opening just 13 new stores last year to bring the total to 284, the company will open 23 stores in the current quarter alone, making a total of 28 openings this year. Analysts expect Best Buy to open 40 new outlets next year.

What's more, there still appears to be room for margin expansion. Current FY99 estimates suggest net margins will nearly double this year, coming in just shy of 2%. While warranties soared from 1.9% of revenues in FY97 to 3% last year, they've continued to play a key role in the margin growth, making up 3.7% of sales in the first quarter versus 2.9% a year ago. Such service contracts accounted for 4.6% of Circuit City's net sales last year, and that represented a dip from the 5.1% level in FY97. This suggests that continued attention to these highly profitable contracts could do a lot toward boosting Best Buy's net margins into the mid 3% range enjoyed by Circuit City just a few years ago. So, barring a real dip in consumer confidence, Best Buy still looks well-positioned to offer investors some pleasant surprises.