How This Retailer Actually Makes Money

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Best Buy (NYSE: BBY  ) makes more than half of its profits from selling extended warranties, based on company data and my estimates. If you've been in a store recently, that might not surprise you. This dependence on warranty profits suggests that Best Buy's business model might not be sustainable over the long term.

Let's take a closer look.

Would you like a warranty for that?
Ever wonder why the friendly blue-shirts at Best Buy push extended warranties so hard? It's become a huge profit stream for the company -- potentially even more lucrative than the actual business of selling electronics and appliances. If you check out the footnotes on Best Buy's most recent 10-K (page 74, if you're looking), you'll see that the company's "revenues earned from the sale of extended warranties represented 2.8%, 2.7%, and 2.6% of revenue in fiscal 2013 (11-month), 2012, and 2011, respectively." That might not seem like a lot, but the margins on extended warranties are very high. Best Buy doesn't disclose its profitability on warranties, but they are estimated to be 50% or higher. In the past year, Best Buy had revenues of $48 billion and operating profits of $1.2 billion. If you assume that 2.8% of revenue came from warranties with a 50% operating margin, then that's approximately $670 million in operating profit. In other words, more than half of operating profits came from warranties.

So what's the problem? Warranties are just smart business.
The money spends the same, regardless of how the company generated it. Lots of respected retailers make money outside their core operations of selling merchandise. Costco (NASDAQ: COST  ) generates most of its profits from membership fees. CarMax (NYSE: KMX  ) generates a good chunk of its profits from financing and service plans. New-car dealers such as Penske Automotive Group depend on parts and service, not the sale of new cars, for profitability. Savvy gas-station operators such as Wawa and Sheetz make most of their profits on convenience store sales, not gasoline sales. The clever operators in retail look for creative new ways to make money, beyond just selling goods.

It might not be sustainable, and it's unfair to customers
While others might not penalize Best Buy for being largely dependent on warranty sales, it does bother me. It's another indication that Best Buy's core business isn't viable -- I'm not sure Best Buy would even exist without the profit stream from warranties. Second, it's my opinion that extended warranties aren't worth the cost (Consumer Reports agrees), and I'm skeptical of a long-term business model that depends on such a consumer-unfriendly tactic.

Foolish bottom line
Obviously, you can decide for yourself whether Best Buy's dependence on warranty profits matters. I don't like the idea of investing in a showroom for warranties. It doesn't seem like a sustainable business model over the long-term.

The future of retail
To learn about two retailers with especially good prospects, take a look at The Motley Fool's special free report: "The Death of Wal-Mart: The Real Cash Kings Changing the Face of Retail." In it, you'll see how these two cash kings are able to consistently outperform and how they're planning to ride the waves of retail's changing tide. You can access it by clicking here.

Read/Post Comments (3) | Recommend This Article (2)

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  • Report this Comment On November 23, 2013, at 6:57 PM, Drichter wrote:

    Extended warranties aren't for everyone.

    However, generally speaking, given the benefits of the geek squad protection best buy offers you'd be a fool not to get it on certain products.

    All told my family currently has 12 active protection plans among our devices, large and small.

    After you total up what I've gotten in replacement products (not even counting the occasional repairs, which can be costly - only full replacement), and then subtract what I've paid for plans, I'm about $1500 up.

    And as you said, your data on the profitability is speculation and estimation - not something I'm going to be basing any purchasing decisions on, myself.

  • Report this Comment On November 25, 2013, at 8:41 AM, rayrod1031 wrote:

    To each its own. What Best Buy sells are not extended warranties but service plans and I don't buy them on everything but on things I know can be expensive to repair, replace or get heavy use by my kids. I have had excellent service with my appliances, headphones (3 teenagers), printers, gaming consoles. You don't have to buy them but then don't blame the retailers when the manufacturer's warranty doesn't cover the cracked screen in your phone / ipad / ipod etc....

  • Report this Comment On November 25, 2013, at 9:35 AM, Rippenbocker wrote:

    By your estimates then the remaining $46.656B in revenue or $528M in profit would be from selling items at a 1.13% operating margin.

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