3 Reasons Best Buy Needs to Rethink Its Strategy

When you gain market share in a declining industry, it's nothing to brag about.

Jun 6, 2014 at 5:30PM

Best Buy (NYSE:BBY) shareholders must be wondering just how long the company's turnaround is going to take.  Had you invested at the beginning of the year, you would be down nearly 30%. If that weren't bad enough the company's share price performance isn't the really bad news. In the company's latest earnings report, there were three problems that almost jumped off the page. The company will need to address these three issues if its turnaround is to remain intact. 

Competitive challenges and simple math
It's no secret that Best Buy is facing competition from all sides. Everyone knows that Amazon.com (NASDAQ:AMZN) presents a serious threat to most of Best Buy's sales. However, with a recent increase in gaming-console sales and expectations for strong software sales later this year, GameStop (NYSE:GME) is a serious threat as well.

Amazon's huge selection and low prices are a constant challenge to Best Buy's gross margin. Though the company can choose to price match Amazon and others, Best Buy has fixed costs that are a hindrance to its profitability.

GameStop's strength in hardware, software, and pre-owned games is a huge advantage with the popularity of the Xbox One and PlayStation 4. Best Buy devotes a significant portion of its big-box stores to game sales. With more than 6,000 locations compared to around 900 big-box Best Buy stores, GameStop's more knowledgeable sales staff and focused business are tough for Best Buy to compete with.

With all these competitive challenges, it's no surprise that Best Buy's gross margin dropped to slightly more than 22%. Relative to Amazon's gross margin of 29% or GameStop's margin of 31%, it seems like Best Buy is trying to outsell its competition at any price. Unfortunately for Best Buy investors, the company's bottom line is going to take a hit going forward.

The company said that the current quarter's tax benefit extinguished this line item for the future. The first issue facing Best Buy is that, "the company will have a higher income tax rate going forward." A higher tax rate combined with gross margin pressure is a recipe for lower earnings for Best Buy.

Is the point profits or market share?
In simple terms, most retailers invest their early earnings back into growth. They are willing to sacrifice short-term profits for long-term growth. Amazon for years ran into debt, and some wondered if the company would ever turn a profit. However, the company is still around, and many of its online competitors have disappeared.

GameStop is trying to grow by expanding beyond its gaming business. The company's expansion plans for Spring Mobile and Simply Mac mean that GameStop is attempting to diversify its revenue stream and grow revenue and earnings for the future.

Where Best Buy is concerned, CEO Hubert Joly's comments about the business should worry investors. He said, "[W]e achieved market share gains in the U.S. fueled by our improved price competitiveness." This statement was based on the fact that Best Buy's consumer-electronics business declined at a lower rate than the overall industry.

The second problem facing Best Buy is that if the company expects to grow by taking market share in a declining industry, investors had better be worried.

Dying on the vine
The third issue facing Best Buy is the most obvious: The company's international business is killing the company. Amazon's international sales increased by 18%. By comparison, Best Buy reported a more than 10% decline in international sales. This is one time where GameStop's primarily domestic business is a benefit to the company.

Best Buy generates about $8 billion in domestic and online sales compared to slightly more than $1 billion in international sales. The worst part is that only 20% of Best Buy's international comps increased. If this were an issue for just one quarter, it wouldn't be a big deal; but the company's international division has been a drag on the business for a while. With slightly more than 10% of the company's overall sales at stake, it's time for Best Buy to cut loose its international division.

The foolish bottom line
Best Buy's turnaround seems to have hit a wall. The company's willingness to match prices is putting pressure on the company's gross margin. Unfortunately, the elimination of the company's tax benefit will mean a higher tax rate going forward. Needless to say its hard for Best Buy to make much progress being squeezed at both ends.

When it comes to future growth opportunities, Amazon is willing to lose money to grow its market share in growing industries. GameStop is expanding into new businesses and growing due to a revival in the gaming industry. Best Buy on the other hand, is proud to be taking market share in an industry (consumer electronics) that is hurting and offers thin margins.

For investors hoping that Best Buy's international operations can be a growth engine for the future, that engine is going in reverse. In truth, Best Buy is doing worse overseas than at home. The bottom line is, unless Best Buy's management can come up with some solutions, a 30% decline in the stock might be just the start of the pain for investors.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Amazon.com. The Motley Fool owns shares of Amazon.com and GameStop. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

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