While Best Buy (NYSE:BBY) poured money into constructing its warehouse stores, its competitors grabbed electronic market share. And now, those missteps have put the pressure on profits and share price alike. Can Best Buy mount a turnaround?
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When looking at a declining business, it's important to consider an absolute worst-case scenario, where cash flow ceases to cover payments to debtors and suppliers. From this perspective, bankruptcy risk at Best Buy seems very low. Free cash flow is sufficient to pay off interest and debt, at $2.5 billion in its 2012 fiscal year. Furthermore, any additional cash flow can be used to reinvest in its current outlets to provide better training and new store formats. In addition, Best Buy hopes to generate between $1.25 billion and $1.5 billion in free cash flow for this coming year. Best Buy also has an interest coverage ratio of 6.8, meaning its earnings before interest and taxes can cover its interest payments almost seven times over. So if Best Buy isn't going bankrupt soon, then where is it going?
Looking at the store count since 2003, the number of Best Buy stores has doubled. In fact, each year it has added stores, which makes the announcement of closing so many even more significant:
The ill-fated Circuit City topped out at around 700 stores, while RadioShack (NYSE:RSHCQ) locations have declined from over 5,000 stores to around 4,400, not counting its kiosk locations. It's clear that Best Buy wants to transition toward the mobile-centered, smaller-store format. It has plans to double the number of mobile stores to 800 over the next three years. But many wonder why it would want to follow RadioShack's model, especially when RadioShack itself doesn't seem to be prospering.
Yet there are differences between a Best Buy Mobile and a RadioShack. A Best Buy Mobile is 1,200 square feet, while a RadioShack averages 2,400 square feet. Best Buy thinks that its fresher brand can out-compete RadioShack. It also believes more training for customer service will set it apart from competitors. However, many still think that even if Best Buy beats RadioShack at small-format retail, it will have won in a losing industry. Why?
Due to the rapid growth of showrooming, in which a customer evaluates a product inside a store and then buys it online, Best Buy loses a significant portion of sales. The current statistics paint a bleak picture for Best Buy:
- One study concludes that 5.4% of Best Buy shoppers buy online elsewhere.
- Another study shows that of the Best Buy customers who check online prices in-store before buying elsewhere, 21% buy from Amazon.com (NASDAQ:AMZN).
- When a customer visits BestBuy.com, only 31% buy something. This compares to an 81% conversion rate for Amazon.com.
- BestBuy.com ranks 11th in e-commerce sales.
To help break this trend, Best Buy wants to leverage its ability to provide customer service and help answer questions in person, which Amazon.com obviously can't match. The most drastic measure Best Buy has taken is that it plans to price-match items from major online retailers this holiday season. While this will hurt margins, it can also help bring in more customers who might not want to wait for a package to be delivered. And it gives Best Buy a chance to sell accessories or service contracts.
The other possible fate for Best Buy, even at its multibillion-dollar valuation, is an acquisition by its founder, Dick Schulze. Schulze led Best Buy away from potential bankruptcy twice under his leadership, but also led it to the brink as well. He needs to raise around $10 billion to purchase the company, and debt would make up a large part of any deal. So far, he has put up $1 billion of his own 20% equity stake. The details of a takeover can change quickly, but the deadline for an offer falls before 2013. At the low end of $24 per share, investors could earn a quick 40% return if a deal goes through -- although most recently the deal value has fallen to $5 billion to $6 billion. Fool Rick Munarriz has an update on the most recent acquisition news here.
In the end, there's no guarantee that the retail electronics industry needs a physical presence, especially with the generous return policies of some online retailers. But if Best Buy is able to optimize its operations, keep and grow customers through superior service, and fend off online competition, it could surprise the majority of the market and remain the preeminent electronics retailer for the future.
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Fool contributor Dan Newman has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com, Best Buy, and RadioShack and is short RadioShack. Motley Fool newsletter services recommend Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.