Best Buy's Dividend Increase Doesn't Make Sense

Best Buy faces serious difficulties due to competition from and other online retailers, so management should have waited for a viable turnaround before boosting its dividend.

Jun 14, 2014 at 8:00AM

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Best Buy (NYSE:BBY) on Wednesday announced that it would raise its quarterly dividend by 12%, from $0.17 to $0.19 per share. Although management explicitly cited the move as a sign of confidence in the company's future, investors should keep in mind that Best Buy still faces considerable challenges as online retailers such as (NASDAQ:AMZN) actively gain market share from brick-and-mortar stores in electronics retail. Maybe saving the cash would have been a better way to go.

Against the wind
Best Buy and other retailers focused on electronics are going through a remarkably difficult time. Electronics are particularly prone to showrooming, in which consumers test the products in a physical store before placing an order online -- often on Amazon -- for home delivery and competitively low prices.

Competitor RadioShack (NYSE:RSHCQ) this week reported a dismal financial performance for the quarter ended on May 3. The retailer announced big declines in both sales and earnings, and it faces significant financial pressure due to a highly leveraged balance sheet.

Total revenue declined 13.2% to $736.7 million during the quarter. Even worse, RadioShack delivered a worrisome drop of 14% in comparable-store sales versus the same period in the prior year. RadioShack also suffered from a falling profit margin, and its operating loss widened from $10.3 million in the same quarter of 2013 to $81 million in the last quarter.

Best Buy is not under the same level of financial stress as RadioShack, but the company is being materially hurt by Amazon and the online retail revolution. Best Buy announced a 3% decline in sales, to $9 billion, during the quarter ended on May 3, while global comparable-store sales fell 1.9%.

Sales in the U.S. fell 2.1% to $7.78 billion on the back of a 1.3% drop in domestic comparable-store sales. Domestic online sales increased by 29.2% versus the prior year, to $639 million, which was one of the brightest spots in the earnings report. However, online sales are already included in same-store sales calculations, so the increase was not enough to compensate for the decline in sales at physical locations.

Besides, if online is the name of the game in the industry, Amazon has a natural advantage, so Best Buy and other traditional electronics chains will be fighting an uphill battle against the online retail juggernaut.

On dividends and signals
In its press release, Best Buy was quite explicit about the reasoning behind the dividend increase: "Our decision to increase the amount of cash we are returning to shareholders is indicative of our improved cash position and our confidence in the cash-generating power of our multi-channel business model."

However, Best Buy still forecasts that sales will continue declining over the coming quarters. From the company's recent earnings release:

As we look forward to the second and third quarters, we are expecting to see ongoing industrywide sales declines in many of the consumer electronics categories in which we compete. We are also expecting ongoing softness in the mobile phone category as consumers eagerly await highly anticipated new product launches. Consequently, absent any major product launches, we are expecting comparable sales to be negative in the low single digits in both the second and third quarters.

Best Buy operates in a cyclical and very difficult environment, sales are declining, and management is not foreseeing a turnaround in the medium term. The company has embarked on an aggressive low-price guarantee program that requires Best Buy to match the prices offered by multiple competitors, including Amazon. This may be a necessity to compete effectively in the current industry environment, but it also means profit margins will remain under heavy pressure over the coming quarters.

The company has a healthy balance sheet, and there is no reason to believe the dividend will be financially unsustainable. But profitability is razor thin, and Best Buy could easily turn to a loss if the situation continues to deteriorate for the industry in general and the company in particular. Management should have waited for clear and sustainable signs of a turnaround before raising the dividend.

Foolish takeaway
Dividend increases make sense when a company's financial soundness is unquestioned and when it generates more than enough cash to operate the business and make the necessary investments to sustain growth. Best Buy still faces difficulties in turning the business around, so making growing capital distributions to shareholders does not seem like the best use for the company´s cash.

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Andrés Cardenal owns shares of The Motley Fool recommends and owns shares of 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.

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