FOOL ON THE HILL
An Investment Opinion
Digital Products Electrifying Best Buy Warren Gump (TMF Gump)
September 14, 1999
Consumer electronics retailer Best Buy (NYSE: BBY) announced another excellent quarter this morning, with earnings per share (EPS) up 33% on a 23% sales improvement. Same-store sales, a measure of store performance that excludes the impact of new locations, were up a strong 11.1%, driven by digital technologies such as DVD, digital camcorders, and Digital Broadcast Satellite Systems. This marks the seventh quarter in a row that the company has posted comp sales increases higher than 10%. In the wonderful tradition of often-illogical short-term stock price movements, Best Buy's stock fell $5 3/4 to $54 3/4 in trading today.
Best Buy has executed one of the most comprehensive turnarounds of any retailer over the past 2 1/2 years. Its stock price today is up from less than $2 per share in early 1997 as it overcame inventory control problems and the threat of bankruptcy by revamping supply management systems and rolling out a more consumer-friendly store prototype. Learning from its near-death experience, the company has been fanatically focused on controlling inventories and reducing debt.
Reducing the amount of inventory maintained in its stores frees up the company's money to be spent on other uses like expansion, debt reduction, and share repurchases. The best measurement of inventory management is inventory turnover, which takes the company's sales and divides it by inventory. Best Buy has dramatically increased this number over the past three years and continued to do so in the latest quarter, where annualized turns were 8.4x, compared to 7.5x in last year's second quarter. Looking at longer-term trends, the company's inventory turns three years ago were only 4.9x.
All the numbers related to inventory turns may sound like mumbo-jumbo, but they represent a lot of real dollars. To get a better picture of what's being discussed, let's take a look at what would have happened to Best Buy if it had not improved its inventory practices. While in reality the company probably would have ended up in bankruptcy court if this improvement hadn't occurred, this exercise provides some perspective as to how operational improvements have helped the company's financial structure.
Best Buy's August 1996 balance sheet included merchandise inventory of $1.4 billion, which supported Q2 sales of $1.8 billion. During this year's just-reported second quarter, the company recorded sales of $2.7 billion. If Best Buy needed merchandise based on 1996 inventory turns, the company would have needed $2.2 billion worth of merchandise. Instead, its inventory stands at only $1.3 billion -- a savings of almost $900 million. Put another way, despite increasing sales 50% over the past three years, the company has reduced its level of inventory by $100 million.
Instead of plowing that $900 million into inventory, Best Buy has used those funds to clean up its balance sheet. It repaid about $400 million in debt and converted a convertible preferred security into equity, leaving it basically debt-free. The company used some of its remaining cash to buy back $100 million in stock over the past few months. In addition (this is like a luscious cherry topping off a sweet chocolate sundae), the company has amassed a cash horde of nearly a half billion dollars that can be used to fund expansion efforts or repurchase more stock.
Best Buy's operational improvement tells only half of the story of its recent success. The other part of the equation is the tremendous sales growth that the company has been able to achieve, thanks to effective merchandising and a booming economy. As mentioned previously, the company has seen same-store sales rise at double-digit levels for seven consecutive quarters. Part of this success has nothing to do with Best Buy management, but lies in the fact that consumers have gone gaga over purchasing electronics the past couple of years.
Nonetheless, a good portion can also be attributable to effective merchandising strategies and product selection. To get a rough idea of how much of the company's same-store sales improvement can be attributed to market conditions rather than management decisions, I compared same-store sales for Best Buy over the past six quarters with its main competitor, Circuit City Stores (NYSE: CC).
Best Buy Circuit City Difference Q1:98 15% 4% 11p.p. Q2:98 18% 6% 12p.p. Q3:98 12% 9% 3p.p. Q4:98 11% 10% 1p.p. Q1:99 13% 9% 4p.p. Q2:99 11% 10% 1p.p. (Notes: Although the quarters are listed as calendar quarters, the sales numbers are actually based on each company's respective fiscal quarters; p.p. stands for percentage points.)This comparison indicates that Best Buy has been doing a better job than Circuit City of capitalizing on the overall improved environment for consumer electronic retailers. The tremendous relative gains reported in early 1998 are probably tied to the fact that Best Buy had easy comparisons due to its 1996-1997 operational problems. Outside of those two quarters, Best Buy has still maintained a 1 p.p. - 4 p.p. lead over its main competitor. In addition to higher sales gains, Best Buy also has beaten out Circuit City in inventory management practices. During the first quarter (the last reported period for both companies), Best Buy's annualized inventory turnover of 8.6x sales was significantly better than Circuit City's 6.5x sales ratio.
Best Buy is not resting on its recent laurels. It has been working hard to develop a prototype store that will allow it to enter many of the smaller markets that can't support a full-size store. In addition, it is breaking into the last few major cities where it doesn't have a presence. The company just entered the San Francisco market this year and plans to hit San Diego, Jacksonville, and Albany, NY during the third quarter. Next year it will begin opening stores in metropolitan New York City.
Acknowledging the importance of servicing customer needs over the Internet, the company announced yesterday that it created a new subsidiary to expand on its existing e-commerce initiatives. Some news reports attributed the stock's downward price movement today to the fact that the company's expanded Internet initiatives weren't going to be ready until after this year's holiday season. While this could be a modestly negative factor over the next couple of months, it shouldn't have that big of an impact over the long term, assuming the company creates a competitive site.
Where does all of this information put Best Buy from the perspective of an investor? Best Buy appears to have much better operations relative to its major competitor. In addition to higher sales and inventory turns, the company also boasts higher operating margins. These differences are known by the market, however, and Best Buy trades for a hefty 35x earnings estimates for the current year while Circuit City garners only a 24x price-to-earnings (P/E) ratio. Assuming that Best Buy maintains its operating advantages over competitors, I would be inclined to pay a higher multiple to get the industry's top player.
You can't forget, however, that market dynamics in electronics retailing can shift rapidly. Over the past 2 1/2 years, Best Buy has risen from its deathbed to achieve its current dominant position. Another retailer could come along and do the same thing. Before taking the plunge into Best Buy stock, an investor needs to be confident that the company's management will continue out-executing its competitors, and the robust growth in the overall consumer electronics will persist for many more years.