When Best Buy Fails, This Is How It'll Happen

Why do retail companies with otherwise solvent balance sheets go out of business?

The answer has to do with a peculiar dynamic of the retail industry that makes companies like Best Buy (NYSE: BBY  ) and Barnes & Noble (NYSE: BKS  ) as fragile at certain points in their existence as highly leveraged hedge funds.

Coming to terms with the inevitable
If you're a student of history, particularly as it relates to retailing, then you'd be excused for concluding that companies such as Best Buy and Barnes & Noble are living on borrowed time.

It's no secret that their business models aren't sustainable. In short, specialty retailers that sell commoditized products must compete on price to survive. And those that rely on bricks-and-mortar stores for the lion's share of business simply can't do so against competitors with dramatically lower fixed costs -- namely, Amazon.com (NASDAQ: AMZN  ) .

For instance, the "aggressive promotional activity" over the holidays caused both Best Buy's revenue and gross margin to contract. A similar picture formed at Barnes & Noble when it released sales figures for the same time period, which declined on a year-over-year basis. 

To make matters worse, Best Buy CEO Hubert Joly acknowledged on the company's earnings call, albeit in a circuitous manner, that the pressure is here to stay, saying that a "permanent component" of the highly promotional environment is likely, well, permanent. 

However, while falling sales and contracting gross margins certainly fuel a retail company's failure, they're not the inciting cause.

The lesson of Circuit City
The now-defunct electronics retailer Circuit City serves as an appropriate example. Falling sales weren't the reason the Virginia-based company filed for bankruptcy protection in November 2008. Nor was it the reason the company was forced into liquidation at the beginning of 2009.

The precipitating factor in both cases concerned financing -- and, specifically, vendor-supplied financing.

Here's a quote from the company's management at the time (emphasis added): "While management is working diligently to secure the support of its vendors and believes it has maintained good relationships with these important partners, the current mix of terms and credit availability is becoming unmanageable for the company." 

Indeed, while it isn't as widely known, most big-box retailers work on a consignment-type basis with suppliers. That is, they're not obligated to pay for merchandise until it either sells or some other predetermined deadline expires.

In the book industry, the customary practice consists of "Net 90" agreements, which require a company like Barnes & Noble to either pay publishers for the books it sells or return them within 90 days of receipt.

As the bookseller explained in a recent regulatory filing, "Consistent with industry practice, a substantial majority of the physical book purchases are returnable for full credit, a practice which substantially reduces the Company's risk of inventory obsolescence." 

This arrangement gives bricks-and-mortar retailers a vital source of liquidity, which, if constricted or altogether cut off, could stop the flow of new products and thereby trigger the at-that-point inevitable demise.

Here's how Best Buy phrases it in the risk section of its annual report: "Our liquidity could be materially adversely affected if our vendors reduce payment terms and/or impose credit limits." 

And here's the company explaining what could happen if its credit rating is further downgraded: "downgrades may impact our ability to obtain adequate financing, including via trade payables with our vendors." For the record, the term "trade payables" is the balance sheet line item tied to vendor-supplied financing -- though it's often subsumed within the more general "accounts payable" line item. 

Will you be left holding the bag?
My point in all of this is directed to short-term speculators in the stock of either of these companies -- or, for that matter, any other company similarly situated, such as, say, GameStop (NYSE: GME  ) .

Will they go out of business anytime soon? Probably not. My guess -- though it's only a guess -- is that they each have a handful of years left to try to turn things around.

When they do go, however, and this is an important point, it will likely take on the urgency of a bank run. The net result is that then-existing shareholders will be left unwittingly holding the bag.

Do you want to be one of these? My guess is, no.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 27, 2014, at 11:01 AM, hambone1969 wrote:

    And what IF best buy fails?? Who is there to take its place?? Ok book stores are not really needed, as one can buy e-books or order a hardcover from amazon. You know what you are getting, and it won't be destroyed in shipping (usually). However, a 60" plasma screen TV??? Can't really see that online and compare it to the rest of the field. And shipping one?? I for one would never consider that. I'll buy it at a boutique shop and pay for individual human delivery and setup.

  • Report this Comment On January 27, 2014, at 1:12 PM, saidnuff wrote:

    Bust Buy and Barnes and Noble should MERGE. They could combine stores. Lots of opportunity to bring in a variety of customers

  • Report this Comment On January 27, 2014, at 7:19 PM, frellmedead wrote:

    There are four Best Buy stores within a 15-mile radius of my house. That is two stores too many.

  • Report this Comment On January 27, 2014, at 7:25 PM, frellmedead wrote:

    And I still will not buy an item like an appliance or a big screen TV from Amazon or other online retailer. I want to have a local store that I can return it to if there is a problem.

    I did notice that Best Buy's special financing deal on big screen televisions this year is good for only two years. Four years ago, I bought a TV from there and the deal was zero percent for three years.

  • Report this Comment On January 27, 2014, at 11:58 PM, dgontjes1 wrote:

    I think this is a "lead the field" opportunity. Take a look at Brick and Mortar stores vs. Cyber Monday sales increases. To get to brass TACKS, I would formerly agree that my piece of mind for that 70 inch TV is falls in the hands of the Brick and Mortar Store. I have somewhere to go, and a person to speak with that will satisfy my needs. I did just that, and when my TV failed, it was the Cyber folks that came and took my faulty TV then set up a new one that works perfectly at no cost to me. This happened with a few keystrokes and not a ride to the store and a long line in front of me. I might add that the cyber folks did that in a time frame that was agreeable to me. The online retailer changed my perspective, and possibly many other consumers. I can now tell my friends and family that the online retailer took care of me with an email and a weeks wait. Versus explaining how inconvenient it was to box up and return my TV, then wait in that ridiculously long return line while someone eventually carted up my new tv for me to drive home and set up.. again. Some circumstances may dictate an immediate remedy, most do not. The brick and mortar retailer most likely needs to wait the same amount of time for replenishment which takes less off the floor for the customer to buy. I don't know, just a thought.

  • Report this Comment On January 28, 2014, at 2:33 AM, roaddog wrote:

    They have been saying this about Sears for over 15 years and they are still here? so whats your point. people want to go into stores. the best Buy by me is slowly turning into stores inside stores and is always busy! they have a samsung area, Apple area, a microsoft area a Pacific sales area a Magnolia showroom and they are always busy. on weekends hard to find parking. there is no amazon store here so people shop where they can buy and take it home today. true amazon is hurting areas but shopping in person is not going away just the way they do business will change.

  • Report this Comment On January 29, 2014, at 6:55 PM, Jec3 wrote:

    Best Buy, Barnes & Nobel, and the like should take a leaf from Bed, Bath & Beyond's retail model. They compete successfully with Amazon simply because between of their couponing and customer service. By this, I mean that their coupons and discounts, which they distribute aggressively, brings sir prices in line with Amazon's; and they stand behind their products 150% by simply replacing any returned merchandise, anytime, even years after purchase, with no questions asked. So, the price and customer experience at BB&B's brick and mortar stores is even better than at Amazon. Yes, the remaining drawback is sales tax, but coupons reduce the bite.

  • Report this Comment On January 30, 2014, at 9:19 AM, mikecart1 wrote:

    This might be true if Best Buy had little to no online presence. However, because they price match now, have that whole store-within-a-store mentality, still drive business through appliances and big items like washers, dryers, super big TVs that no one wants to have shipped to their homes when they are at work, etc., I think they will be around for several more years. Not saying they will make a ton of money, but they won't go bankrupt like many are saying.

  • Report this Comment On January 30, 2014, at 8:53 PM, beetlecat77 wrote:

    In the automobile business as well as the yacht business (with which I am intimately familiar) this is called floor plan. Often it is not the actual manufacturer, but a finance wing such as GMAC. On these big ticket items, someone comes around every 2-3 months to make sure the inventory is still around. I have known boat dealers who have flummoxed the checkers on $200,000 boats. I am sure that a Best Buy or B&N can shuffle a bunch of tvs and books. When it happens, it will happen very quickly and a lot of suppliers will be stuck for phantom inventory.

  • Report this Comment On January 30, 2014, at 11:21 PM, blablableh wrote:

    I noticed a few months ago that Best Buy drastically reduced the number of products it carries. They have very few products on the shelves now. Whoever made the decision to stock very few products wasn't very smart...

  • Report this Comment On January 31, 2014, at 6:46 AM, snipe15 wrote:

    I bought my TV from Amazon, and I'll do it again, no worries. It was awesome to not have to leave the house to get the tv I wanted. Didn't even showcase at BBY.

  • Report this Comment On January 31, 2014, at 10:30 AM, hughde wrote:

    I buy at lot of stuff from Amazon and with a Prime membership, I get stuff fast. But there are many times I want something even faster. I need it now, or I want to look at the products, so I got to Best Buy.

    I'm a woman in my 50s. Years ago, I used to like to go to Circuit City. At one point, all the staff they hired were teenagers or early 20s. I couldn't get any service. I guess I reminded them of their teachers or their mother's friends. Trying to catch their attention or get them to stop chatting with each other was a chore.

    I got better service at Best Buy, so I went there instead of Circuit City. Now, I'm getting the same attitude and lack of service at Best Buy.

    Last year, my husband and I went to Best Buy to buy a new TV. Three young male sales reps were in an animated conversation with one customer. We waited 20 minutes at least before we interrupted their chatting and asked for help. During this time, we discussed the option of ordering online. As someone mentioned above, we didn't want to order a TV online.

    Over the last year or so as service at Best Buy declines, I keep asking myself why didn't I just order the product online and forget dealing with unhelpful teenagers.

  • Report this Comment On January 31, 2014, at 10:42 AM, Maelona wrote:

    Your article is very interesting. Thank you.

  • Report this Comment On January 31, 2014, at 4:25 PM, Diaz1229 wrote:

    i'm a new member of supernova and was surprsed to learn that Swir was about to defend themselfs in a patten infringement case. I.ve been following Suprnova 's in depth analysis on this company and never heard of this lawsuit. Can anyone fill me in with the details on this matter? User name, rbones4

  • Report this Comment On January 31, 2014, at 4:37 PM, kforred wrote:

    Agree, hughde, customer service has fallen off precipitously. I bought two tablets there in April. Trouble w both. Went in, Geek looked in computer re the Asus and said, "Oh, we don't send these for repair, we replace". Took me over to customer service and they pulled a new one. Someone in a blue shirt, presumably management, came out, they had a huddle and took the new one back, told me I'd have to deal with Asus direct. No explanation,no nothing. If they couldn't handle sending it back for me, let alone explain why the change up, why not shop online? Different reasons, but same outcome with the Note 8. I got a lemon and am left having to contact Samsung.

    Their customer forum just reiterated that the retailer is under no obligation to honor or help with manufacturers' warranties.

    I might use Best Buy in a crunch for a gift CD or something, but, after years of happy transactions my electronics and computers will be purchased elsewhere in future. If this experience is common, I wonder i it will drive people to Apple. They have brick and morter stores where you can play with the toys and get expert help. I don't know why I've never gone over to the dark side (after all, I'm an AAPL stockholder), Maybe it's time????

  • Report this Comment On January 31, 2014, at 5:30 PM, Dejan wrote:

    Since 2006 I have been shopping almost exclusively on Amazon and Ebay and I couldn’t have cared less for the fate of Best Buy. But things have changed in 2013. I made only few purchases on Ebay, and although Amazon is still my favorite store I purchased 30% less than a year before. Six months ago I discovered Best Buy and since then I have been shopping electronics exclusively at Best Buy. The motivation is convenience of immediate availability and the price that is at least as low as the one on Amazon, and sometimes even lower. On top of it their Geek Squad warranty is better and cheaper than the one offered by Square Trade, at least in my case. Can they keep doing this and stay profitable? Best Buy will not survive just on price cuts, there ought to be more, and I believe we will see more from Best Buy in the near future. Good about Best Buy is that there is so much that can be done better, and as long as there is a room for improvement there is a future. Will Best Buy see the opportunity? Time will tell.

  • Report this Comment On February 01, 2014, at 11:33 AM, geezer27606 wrote:

    Best Buy and similar retailers have enormous advantages over pure online competition.  Customers can shop online and immediately pick up at a store.  Customers can touch and feel the goods. Every store is a distribution point.  Shipping to stores with customer pickup can be lower cost and much faster than UPS delivery.  Delivery, setup, and repair service can be offered.  Customer returns are easier.  

    Pure online retailers have only one inherent advantage;  they can enable tax cheating so long as states don't enforce their "use taxes" which are supposed to be paid on out of state purchases.

  • Report this Comment On February 01, 2014, at 1:18 PM, jrj90620 wrote:

    I don't see anyone to take the place of Best Buy.I worked in the consumer electronics business,for several years.It always happened,that the leader would be dethroned by some other company.Like Circuit City knocked off the previous leader and later was knocked off by Best Buy.I don't see anyone,that is going to take the lead from Best Buy.I don't think everyone wants to buy online.

  • Report this Comment On February 01, 2014, at 3:24 PM, Dino wrote:

    The picture here for Best Buy is the same for virtually every company and job in the developed world. Europe may be the first to go, but the US is not immune.

    We are in a global downward spiral with too many workers, too many unemployable people. It took only one decade for my clients of 40+ years to evaporate in the universal quest for lower prices.

    There is no such thing as a national economy anymore. Like a century ago when people thought trade would eliminate wars — this will likely end as that in August 1914.

    This is what happens when politicians screw up everything…FUBAR!

  • Report this Comment On February 01, 2014, at 3:41 PM, Dino wrote:

    testing

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