On Tuesday, beleaguered electronics retailer Best Buy (NYSE:BBY) announced that it had reached an agreement to sell its 50% stake in Best Buy Europe for approximately $775 million. Best Buy Europe was a joint venture with Carphone Warehouse that previously operated a handful of Best Buy big-box stores, and has continued to operate Carphone Warehouse's retail operations. Best Buy investors cheered the news, sending the company's stock up by as much as 11%, to a new 52-week high.
Investors' enthusiasm for the deal is very easy to understand. The sovereign debt crises in Europe have led to sluggish growth at best -- and recession in many cases -- across the continent. This economic weakness, along with growing competition from e-commerce leaders like Amazon.com, led to the rapid demise of the Best Buy big-box stores in Europe. Even the more established Carphone Warehouse small stores have struggled; in Tuesday's announcement, Best Buy stated that they were not expected to produce a material profit this year. However, while this decision is a clear positive for Best Buy, the company's stock still seems overvalued in light of the challenges Best Buy faces.
Refocusing on the core business
Last fall, recently appointed CEO Hubert Joly unveiled his turnaround plan for the company, which the company calls "Renew Blue." The focal points of the strategy are: 1) improving customer service; 2) gaining share in e-commerce; and 3) cutting overhead costs. Joly's plan is an ambitious attempt to compete with e-commerce giant Amazon, as well as brick-and-mortar discounters such as Wal-Mart (NYSE:WMT)
Cashing out of the European venture has two main benefits. First, it will strengthen Best Buy's balance sheet, allowing the company to invest in its core North American business while maintaining its dividend. Having additional cash also provides some downside protection in case business trends deteriorate. Second, it will remove a potential source of distraction for management, allowing the team to focus on Best Buy's main business priorities. Since Best Buy Europe has not been very profitable, there is little apparent downside from the deal.
Is Best Buy the future?
While I think Hubert Joly has performed well since arriving at Best Buy last summer, it's not clear that the company's problems can be permanently fixed. Amazon has shown itself to be willing to accept razor-thin margins indefinitely in order to win market share. Wal-Mart has enormous purchasing scale, with global sales expected to approach $500 billion this year . Moreover, Wal-Mart often seems willing to position the electronics category as a loss leader to drive store traffic. For example, during the holiday season, Wal-Mart offered the iPhone 5 for $127 with a two-year contract (compared to the regular price of $199). Finally, Costco has rock-bottom operating expenses due to its warehouse model. Accordingly, Costco can make money despite a corporate gross margin between 12% and 13%; by contrast, Best Buy's operating expenses are roughly 20% of sales. Even with significant cost cuts, Best Buy will need to generate gross margins above 20% to earn a respectable profit.
Best Buy thus faces significant challenges from these competitors (for different reasons). Best Buy's main competitive advantage vis-a-vis all three is its trained sales staff, which should be able to provide superior customer service. It is, therefore, encouraging that customer service is one of the focal points of Joly's Renew Blue strategy. However, investors need to ask themselves whether this is really the future of consumer electronics retailing. The Internet has made information so ubiquitous that fewer and fewer shoppers actually want to discuss their choices with a salesperson. If consumers continue to move toward a preference for "self-service," doubling down on customer service today will not improve Best Buy's long-run competitiveness.
Selling its stake in Best Buy Europe will allow Best Buy to bolster its balance sheet while eliminating a potential source of distraction for management. However, Best Buy shares are not particularly cheap at 12 times analysts' current year earnings estimates. Furthermore, the company faces stiff competition from retailers like Amazon, Wal-Mart, and Costco, each of which has unique competitive advantages. Best Buy is planning to hang its hat on customer service; but, as consumers continue to become more knowledgeable, this may prove to be a fleeting advantage.
Fool contributor Adam Levine-Weinberg is short shares of Amazon.com. The Motley Fool recommends Amazon.com and Costco Wholesale. The Motley Fool owns shares of Amazon.com and Costco Wholesale. 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.