Best Buy's Holiday Results Are a Setback, Not a Disaster

Given the way that the market reacted to Best Buy's (NYSE: BBY  ) holiday sales report, you'd think that the results were on par with the disastrous holiday period for regional consumer electronics retailer hhgregg (NYSE: HGG  ) . Shares of Best Buy opened down a whopping 30% on news that same-store sales declined by 0.8% during the holiday season, a result which, while certainly not good, is far from catastrophic. Retailers in general have had a tough holiday season, with increased promotional activity driving down profits. But the weak holiday sales for Best Buy are a setback, not a disaster, and it doesn't change the long-term story.

A look at Best Buy's results
Total revenue fell by 2.6% in the nine weeks ending on Jan. 4 compared to the same period last year, with domestic revenue falling by 1.5% and international revenue falling by 8.1%. Same-store sales fell by 0.9% in the domestic segment, a worse result than the flat same-store sales last year, with factors such as weak store traffic, supply constraints for key products, and a weak mobile-phone market, combined with aggressive promotional activity, driving down results.

The international segment showed some improvement, with same-store sales rising by 0.1%, compared to a 10.3% decline last year. Total revenue fell mainly due to store closings in Canada and China, with the rise in same-store sales partially offsetting the lost revenue.

One bright spot for Best Buy was online sales, which jumped by 23.5% year over year, a far better result than the 10% increase last year. Online revenue totaled $1.3 billion for the period, a significant piece of the total revenue, and it's clear that continuing to grow online sales is key to Best Buy's continued turnaround efforts.

Best Buy's results are very different from those of competitor hhgregg. hhgregg reported a same-store sales decline of 11.2% during the holidays, likely losing some market share to Best Buy in the process. A refusal to fully match the promotional activities of competitors was the main culprit behind this decline, and although the quarter will be profitable for hhgregg, results will be lower than last year.

hhgregg is pushing to further diversify into other categories, like appliances and home furnishings, and this may result in further share gains for Best Buy this year.

What this all means
The massive decline in Best Buy's stock following the announcement was an equally massive overreaction. While the results weren't great, they were mainly caused by the retail environment. Best Buy actually managed to gain market share, as pointed out by CEO Hubert Joly in the press release, even though the the consumer electronics market unexpectedly contracted slightly during the holiday period.

This came at a cost, of course, with Best Buy needing to match the promotional activity of other retailers, and operating profit during the quarter will be lower than last year as a result. Best Buy estimates that the non-generally accepted accounting principles operating margin will decline by between 175 and 185 basis points compared to last year's 5.7%.

Best Buy still had a profitable holiday season, excluding restructuring charges and the like, making Best Buy very different from other struggling retailers posting big losses. Through the first three quarters of the year, Best Buy recorded owner earnings of about $620 million. Owner earnings are essentially net income plus most of the non-cash stuff that gets taken out, like restructuring charges and depreciation, minus capital expenditures. I think this gives a better picture of a company's real profit, and it's especially useful in Best Buy's case.

Even before the holidays, Best Buy was sitting on about $1.75 per share of owner earnings through the first three quarters. With a 4% non-GAAP operating margin, the holiday season should add about $450 million in operating profit. Slice off 35% for taxes and add that to our owner earnings number, and we arrive at a little more than $900 million. This, by the way, doesn't even include the rest of the fourth quarter, so for the full year this number should be closer to $1 billion, or nearly $3 per share.

Of course, this isn't the number that will be reported, since earnings per share includes a bunch of non-cash stuff, but I think it's more useful for analyzing Best Buy. From this, it's clear that the opening market price of Best Buy after the announcement of around $27 per share, or just nine times owner earnings, is assuming the worst. Let's not forget that same-store sales increased in the third quarter, with the domestic segment showing a 1.7% rise. I think it's more likely than not that Best Buy's holiday weakness was caused by the environment, and that the decline in same-store sales during the holidays is a blip, not a trend.

The bottom line
Pessimism had been building ever since retailers began reporting weak results, and the massive drop in Best Buy's share price due to a bad, but by no means terrible, holiday season, is an overreaction. The long-term story hasn't changed, and Best Buy will continue to cut costs and grow its online business in 2014. If anything, the decline in the stock price is an opportunity for value investors.

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