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Wednesday, July 14, 1999

An Investment Opinion
by Louis Corrigan

Momentum Is the Best Buy in Retail

Like many investors, I've occasionally become enamored of complicated technology businesses promising snazzy growth rates. Yet, no matter how much I read about semiconductor fabrication, I'm just not in a great position to understand the competitive challenges facing such companies.

But the Gap (NYSE: GPS) I can tell you about, from a short course on The Modern History of Cargo Pants to a list of other retailers suffering from the company's success. I'm not at all handy, but I can confidently predict that 10 years from now Home Depot (NYSE: HD) will remain a dominant retailer in its niche because it's the only place I shop for home fix-it stuff and the store is always packed.

Simply put, Peter Lynch's "buy what you know and use" approach makes sense because it helps you avoid major disasters while finding those no-brainer investments that are likely to outperform the market. You're a smart customer. If a company makes you happy, it must be doing something right. And it will likely continue doing something right. In retailing, especially, business momentum tends to breed more momentum.

The consumer electronics retailers have grabbed headlines recently due to their stellar performance. In the last year, Best Buy (NYSE: BBY) has soared 285%, from around $20 to $77. And that gain came after the stock had already rocketed 900% in the previous fifteen months. Meanwhile, Circuit City (NYSE: CC) connected for a 100% gain, from $50 to $100, and Tandy (NYSE: TAN) ran up 110%, from $26 to around $55. These are rightfully the best of times for such retailers. The economy has been super strong, with real wages rising and employment at record levels. Also, a whole new wave of cool, relatively inexpensive digital devices (DVDs, wireless phones, etc.) and falling PC prices have driven consumer interest.

Getting in early on one of these happy stories may involve some special insight. When Best Buy traded down to a split-adjusted $2 a share in February 1997, for example, some smart short-sellers thought the company was headed for bankruptcy. Rapid expansion had distracted management from the task of running the individual stores. The company had loaded up on PCs for the holiday season just before Intel (NYSE: INTC) introduced its Pentium MMX chip and so it was stuck with huge inventories consumers didn't want. Worse, the creditors were calling.

But you didn't have to be smart enough to predict a turnaround when things looked really bleak. Even after the easy money had apparently been made, there was still plenty more easy money to be made. Let's look at the company's results over the last couple of years.

Sales SSS Gross% SG&A% Operating% Op. Profits FY96 42% 5.5% 13.0% 11.3% 1.70% 0.5% Y97 8% (5.0%) 13.6% 12.9% 0.68% (57%)
1Q98 (2%) (8.0%) 15.4% 15.1% 0.32% (60%) 2Q98 1% (5.6%) 16.1% 15.0% 1.11% 1% 3Q98 5% 0.0% 16% 13.5% 2.51% ** 4Q98 21% 16.9% 16% 12.2% 3.81% 359.5% 1Q99 21% 15.3% 18.2% 16.8% 1.44% 438.1% 2Q99 22% 17.9% 18.8% 15.5% 3.34% 265.3% 3Q99 18% 12.2% 17.9% 14.2% 3.67% 73.1% 4Q99 21% 10.8% 17.9% 12.9% 4.97% 58.1% 1Q00 23% 13.3% 19.4% 16.4% 3.04% 158.2%

*The columns show fiscal year periods; year-over-year percentage changes in sales and same-store sales (SSS); gross profits as a percent of sales; sales, general and administrative (SG&A) expenses as a percent of sales; operating income as a percent of sales; and year-over-year changes in operating profits.
**$52.9 million profit vs. a $3.1 million loss in 3Q97

Best Buy's fiscal year ends in February, so the stock hit its low of $2 a share at the end of FY97. The numbers above offer only a glimpse of the company's troubles, but one can see pretty clearly that overall sales growth slowed to just 8% in FY97 versus the rocking 42% gain of FY96. Gross margins improved to 13.6% from 13.0% partly because the company added higher margin appliances. But the firm's expenses increased as a percent of sales, causing operating profits to decline, mainly because same-store sales declined.

The same-store sales metric (also called comparable store sales) is a key one for most retailers because it tells you whether the stores that were open a year ago (or, in Best Buy's case, 14 months ago) are generating more or less revenue. More is better because that means the company can spread its fixed operating expenses (store leases, sales clerks, point-of-sale inventory management systems, etc.) over a larger revenue base.

Clearly the third quarter of FY98 showed improvement, with flat SSS versus the declines in previous quarters. But the real breakthrough came in Q4 FY98 with the 16.9% comp store gain. That began a series of six straight quarters of double-digit SSS increases that have contributed to soaring profits.

Comp-store sales are one of the easiest things to follow, but they're always just an intimation of the full story. For example, you would normally expect to see such SSS gains accompanied by dips in SG&A expenses due to the leveraging of fixed costs over increased per store revenue. Though the above table doesn't show year-over-year comparisons until the first quarter of FY99 (when SG&A expenses were 16.8% of sales vs. 15.1% the year before), it's clear that SG&A costs have risen as a percent of sales despite the soaring SSS. On the other hand, gross profit margins have jumped sharply to 19.4% last quarter from 18.2% in Q1 FY99 and just 15.4% in Q1 FY98.

This anomaly can be explained by Best Buy's change of strategy. It's disconcerting to see overall sales rising due to new store openings while comps are declining. You always want the basic business managed for ever greater sales and profits, and when that's not happening management needs to cool the expansion and regroup. That's what Best Buy did following the difficult FY97. It started spending heavily on outside consultants and better systems to manage inventory. Management boosted spending to hire floor clerks who could really explain and sell the new digital goodies. All of this led to higher sales expenses but improved gross margins because the fresh products were more profitable and because Best Buy could now turn them over faster, saving on inventory expenses.

In fact, inventory turns have jumped from 4.6 per year in FY97 to 5.6 in FY98 to 6.6 last year. Although sales vaulted 48.5% between Q1 FY98 and Q1 FY 2000, Best Buy had just $1.1 billion in inventory at the end of the May period, nearly identical to the amount carried two years ago. That's simply amazing and is reflected in earnings. Profits have bounced from just $0.01 per share in FY97 to $0.52 in FY98 to $1.07 last year. With first quarter results of $0.22 crushing last year's $0.08 per share, analysts project Best Buy will do $1.51 this year

Tying up less cash in inventories relative to sales while increasing the profitability of those sales has unlocked a flow of cash that's allowed Best Buy to pay down nearly all of its debt and accumulate a pile of cash.

May 1999 May 1997
cash $510.9 million $94.9 million
LTD $28.4 million $212.6 million

Indeed, the company is so flush, it bought back $52 million worth of its stock last quarter. The main caveats are that Best Buy has again started offering attractive financing deals for major purchases, helping push overall receivables up 93% to $145.7 million this past quarter from $75.6 million a year ago. The company sells these receivables to third parties, and bears no risk regarding them. Still, such financing packages can goose same-store sales today at the expense of tomorrow. It's something to watch. Moreover, it's hard for any company to sustain double-digit same-store sales gains quarter after quarter because the year-over-year comparisons become tougher.

Yet, given the company's terrific momentum, I'm hesitant to say it's too late to make money on Best Buy. One might have thought the same thing in April 1998 when the strong Q4 FY98 results were made public. The stock had already soared 800% in the previous year to $18. It's up over 300% since then.

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