Fool on Call: Ni Hao, Best Buy!

Best Buy's (NYSE: BBY  ) latest quarterly numbers were solid (especially considering Circuit City's (NYSE: CC  ) woeful situation). As you will recall, comparable same-store sales in the second quarter were up a respectable 3.6%, while net revenues advanced 15% compared to the same period a year ago.

Looking closer, we find that comps and net sales in the domestic market were up just 1.7% and 9%, respectively. Again, these numbers are nothing to sneeze at given that Best Buy's most significant competitor is being thoroughly clobbered. But if you compare domestic growth against its international opportunities, in which comps and net sales accelerated 16.3% and 54%, respectively, you can see that the success of Best Buy as an investment opportunity comes from its ability to capitalize in new markets.

And there's no more important market than China. Best Buy's Q2 conference call offered important detail into the gains and growing pains of this growth opportunity.

Forcing Best Buy on the world?
"We're very clear it's not our plan to force Best Buy on the world, but to bring the best of the world to Best Buy," said Chief Operating Officer Brian Dunn in his prepared remarks. "And then to continuously share what we learned back and forth in pursuit of offering the best possible experience no matter where you are."

One criticism leveled at U.S. businesses as they expand internationally is that American ways are being imposed on other cultures, and there is some substance to these concerns. But the most successful American businesses operating in China are the ones that have learned how to integrate in and with local culture.

Yum! Brands (NYSE: YUM  ) and its KFC biz, for instance, is building a dynasty with the Chinese public through localized birthday celebrations. Nike (NYSE: NKE  ) has figured out China and has enjoyed tremendous success there by tailoring and branding products specific to the local market. And Google (Nasdaq: GOOG  ) adapted to censor itself to satisfy authorities in Beijing.

Dunn said the process of becoming a better Best Buy is accomplished while traveling a two-way street of exchange and learning. For him, the fine-tuning of the Best Buy business model comes via reciprocal relationships between its maturing domestic segment and the new, dynamic opportunities in China and other emerging markets.

"The results we're enjoying there [in Canada and China] and, more importantly, the lessons learned along the way will benefit the entire enterprise because we are applying what we learn across borders and oceans, even while they continue to adjust and improve upon that as we go," Dunn explains. "What we learn also informs and guides our expansion plans in other countries because each market is unique. ... No company, or country for that matter, has a monopoly on good ideas."

As Best Buy expands its Chinese operations, the gains that will not show up on quarterly earnings reports are the lessons of this new market. Applying that knowledge across the company's operations is what will make a better Best Buy for both customers and shareholders alike.

The margin effect
Where the China effect does make visible imprints on Best Buy's numbers is both on the revenue line and margin metrics; for example, the high double-digit sales growth. As revenues continue to accelerate, Best Buy's gross margin is being pushed lower. In Q2 the gross profit rate declined 60 basis points. Half of this decline was attributed to China.

Where China taketh, it also giveth back. The overall SG&A rate improved 80 basis points, and of that, China's lower operational costs contributed 30 basis points.

Nothing from the call suggests that either of these two trends will dissipate anytime soon. As sales from China increasingly become a more significant part of the company's net revenues, I suspect that gross margin will continue to be challenged. But on the operating side, as both Best Buy and Five Star stores expand across China, the company should be able to leverage its operating expenses there, which in turn should continue to provide a nice boost to the company's overall operating margins.  

Best Buy and Apple team up in China
Dunn also explained more about Apple's (Nasdaq: AAPL  ) partnership with Best Buy. It was revealed that the store-in-store concept used with Apple is not limited to domestic Best Buy stores. In fact, Best Buy's new four-story store in Shanghai also incorporates an Apple store-in-store model.

Bob Willet, CEO and international chief information officer for Best Buy, described results of this approach in Shanghai as "spectacular." He adds, "I don't want to disclose the share that we've got of Apple's business in Shanghai, but let's just say it's pretty big." The Apple effect should become even more pronounced because Best Buy plans to open two more stores in the city.

What goes around, comes around
The success of this "dual-branding" strategy in China and Canada has encouraged the company to continue the approach in any future markets that it enters, Willet said.

Best Buy has enjoyed tremendous success in the U.S. Now with a footprint in China from a majority stake in Five Star stores as well as Best Buy stores, it will be exciting to see if Best Buy can replicate its success through its strategy of a reciprocal relationship business model, and dominate in the most important market of this century.


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