Going "All In" for the Holidays -- A Bad Strategy for Best Buy?

A year ago, Best Buy (NYSE: BBY  ) was knee deep in operational losses and investors worried that the company's stores were becoming nothing more than showrooms for online competitor Amazon.com (NASDAQ: AMZN  ) . Since then, the company has fought back with a renewed strategy that has brought life back to the struggling retailer. However, investors are starting to question Best Buy's ability to continue its recovery against a formidable array of competitors ranging from Amazon.com to Wal-Mart (NYSE: WMT  )  after the company's third quarter earnings release.

A tremendous recovery in 2013
To be clear, 2013 has been a great year for Best Buy shareholders; the company has crushed the market as shown in the chart below:

BBY Total Return Price Chart

BBY Total Return Price data by YCharts

In 2012, investors had begun to think of Best Buy's struggles as the initial signs that it would join the ranks of Circuity City, Borders, and other victims of Amazon.com's quest to become the world's largest retailer

However, Best Buy has made a number of strategic moves to highlight the potential value to customers of the brick and mortar experience, through the expansion of "store within a store" concepts and the personal service of Best Buy's Geek Squad. The result? Third quarter non-GAAP earnings per share of $0.18, which were well ahead of the prior year non-GAAP earnings of $0.04 and analyst expectations of $0.12. 

Why the post-earnings decline?
With Best Buy's third quarter results reinforcing the belief that the company's recovery will continue, investors are likely puzzled by the sharp decline in price following the earnings release. This decline is mostly the result of the company's fourth quarter outlook; this quote from Best Buy CFO Sharon McCollam in the earnings release sums it up:

"But as we enter the fourth quarter, we are also highly aware of the public statements that are being made by our competitors as it relates to their promotional plans for Black Friday and the fourth quarter. We know that we will be facing an increasingly promotional environment. As such, we want to give you color on our response to this competitive situation and our perspective on how these pressures could financially impact the fourth quarter..."

Best Buy has made the strategic decision to offer a low price guarantee in an effort to attract customers. While the message to the consumer is positive, the company is playing a dangerous game. For starters, this low price guarantee has limited restrictions; as a result, Best Buy has agreed to match the price of loss leaders designed to bring consumers to competitors' stores to buy other goods. If Wal-Mart and other competitors such as Target pick different items to heavily discount in order to attract shoppers, Best Buy will be stuck matching prices on money-losing transactions without the benefit of the margin contribution from the customers' purchase of food, clothes, and other items while the customer is already shopping at these more diverse retailers. Plus, there's little argument that the best wholesale prices are being given to Wal-Mart, the world's largest retailer; this puts even more pressure on Best Buy's margins.

Best Buy has also agreed to take on Amazon.com on price. This is a risky move given that the online distributor has a lower cost structure as a result of not having brick-and-mortar store-related expenses. Moreover, Amazon.com has routinely sacrificed profit to gain market share and customer loyalty with great success. Thus far, companies seeking to beat Amazon.com on price have not fared well.

In total, Best Buy is seeking to match bigger competitors on price while providing higher-quality service and incurring higher brick-and-mortar expenses than larger rivals. The result is a potentially dramatic reduction in margin.

International struggles
Within the third quarter earnings release, another piece of bad news for investors is Best Buy's continuing struggles internationally. Once a key to Best Buy's growth plans, international revenue declined over 11% over the prior year, headlined by same store sales decreases of over 6% and the closure of locations in China and Canada. In addition to top line pressure, management reported a 60 basis point decline in international gross margins.

Struggles internationally are never a good thing, but at least Best Buy isn't alone; the company's vendors, including Rosetta Stone, Activision Blizzard, and others have experienced severe declines in international revenues in recent quarters. Given the general weakness experienced by many companies internationally in recent periods, Best Buy's results aren't necessarily a red flag for investors yet. It will be important to monitor the company's progress internationally on both the top and bottom lines going forward.

Looking ahead
Best Buy's management acknowledges that its determination to provide a low price guarantee will impact gross margin; in total, the company estimates that gross margin will be negatively affected by 80 to 90 basis points as a result of its strategic moves to remain competitive. This is particularly concerning to investors as the company is entering the holiday season, which is expected to generate three quarters of the company's net income for the year. 

After a tremendous year of recovery, shares of Best Buy are already priced to reflect the company's turnaround. As a result, the significant pressure on gross margin in the all-important holiday quarter creates more downside risk than upside at this point in time. This scenario doesn't preclude investors from making money on an investment in Best Buy, but it does make the likelihood of significant market-beating performance in the next few years remote.

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