Just a few years ago, Best Buy (NYSE:BBY) was a shining example of the traditional retail operation falling prey to e-commerce growth and the rapid rise of Amazon (NASDAQ:AMZN). However, new leadership and a smart turnaround plan have made the big box retailer's stock one of the best performers in the past five years.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and Motley Fool contributor Daniel Kline cover the turnaround at Best Buy before looking at where company will go from here. A full transcript follows the video.

This video was recorded on July 17, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, July 17th.

It's always a good day when I can chat with a guest who's actually here in person at Fool HQ. Motley Fool contributor Dan Kline has flown in from West Palm Beach, Florida to join us in the studio today. Thanks for traveling all this way, Dan!

Dan Kline: I came here, because it's 10 degrees cooler here, and 40 degrees cooler in the studio.

Shen: There you go. It's a 900-mile trip, I looked this up, for that 10-degree difference. I know it's probably scorching down there.

Kline: We do you have air conditioning down there. [laughs] 

Shen: But you guys have been spending a lot of time at the parks, a lot of time outdoors?

Kline: A lot of time. I have a 14 year-old son who is in-between ages, he can't really work and he's not really into a camp, so we've been spending a lot of time waiting in line for theme park rides.

Shen: I don't think I've ever known somebody who's gone to as many theme parks as you have in such a short period of time.

Kline: There are a lot of days where you'll text me about doing a show or Slack me about doing something, and I'll write back, "Answer in 15 minutes, riding King Kong." [laughs] 

Shen: [laughs] Exactly. Last week, when Asit and I talked about the Sonos IPO filing, I said my favorite shows tended to be IPOs and M&A deals. We cover those quite often, too. But I realized I forgot something, and that's mailbag questions. It's hard to beat addressing topics and concerns that come directly from our listeners, and that's exactly what we're going to do today. 

First off, for any Fools who haven't already heard the spiel, we're always taking questions. If you have something investing or business-related, anything on your mind, don't hesitate to reach out to us via email at industryfocus@fool.com, or on Twitter. Our handle is MFIndustryFocus.

Today's question comes from a Fool in Houston, Texas. Ryan wants to know the latest on Best Buy. He specifically asked, "I'd love to hear an updated view on Best Buy. Everyone is always talking about how Amazon is going to destroy all of retail, but I see Best Buy as a possible long-term value play. Thoughts?" 

There are a few different things to dissect in that question. Dan, you and I have spoken before about the Amazon threat and how they've disrupted plenty of industries, especially in retail, so there's no surprises there.

Kline: I also think it's important, we've talked about this a lot -- yes, Amazon is disrupting companies that didn't pay attention to Amazon. If you're Sears and waited until three months ago to do anything, and your plan was, "We'll have a sale," then yes, you were disrupted. A lot of ... I don't want to call them bad companies, but a lot of legacy companies that had always succeeded doing one thing ... but if you look at companies that went, "Yeah, Amazon and digital, these are threats. What are we going to do?" and truly had long-term plans to address it, those companies are thriving. 

There are other headwinds. There's mall traffic, there's things you can't control. But Best Buy and the big boxes -- Costco would be another example -- those are destinations. They don't have those same factors. Sears didn't have to be Sears. JCPenney didn't have to be hanging on this precipice of success or failure. Amazon is a menace, but it's a solvable menace.

Shen: Yes. We'll say, right off the bat, with Best Buy, this is a company that has most definitely defied a lot of bears and critics in the past decade. When the stock hit some of its worst lows back in 2012, a lot of market followers pointed to the company as a case study for the decline of big box stores as e-commerce stole a lot of market share.

But the stock at this point is up several hundred percent since then. It has set fresh all-time highs in the past year. If anything, I think the story has taken a complete 180, because Best Buy is now being pointed at as a case study for how a big box brick-and-mortar chain can adapt and succeed in today's environment.

Kline: I think, if you go back, on the Best Buy timeline --

Shen: Yes, let's walk through that.

Kline: -- they had a little bit of false security. I think the same thing has happened to Barnes & Noble. In 2009, Circuit City went out of business. It wasn't stunning, but there was a lot of thought that it would be a chapter 11 and a reorg, and that it would exist in some fashion. When they went fully out, I think the Best Buy mindset became, "We're going to get 80% of this business, so we don't have to worry about anything." 

The reality is, that business evaporated. It went to the internet, it went to alternate providers. Some of it went to Lowe's and Home Depot, which sells appliances and other things that overlap. It wasn't the sort of given that, "We are two competing chains. When one closes, we're going to get some of that business." Circuit City closed for some of the fundamental problems that Best Buy had, and it wasn't until late 2012, three years later, that they addressed some of those claims.

Shen: And it's not like Best Buy didn't aggressively try to take some of that market share, some of that business that was left on the table by Circuit City. Let's keep going through the timeline. We're approaching 2011, 2012. There are some changes with the company, some changes in terms of their view for their future. What did that look like?

Kline: In 2012, there was a shocking CEO removal. Brian Dunn, who had been the CEO, was, we'll call him one of the first #MeToo casualties. They never specifically said exactly what the personal issue was --

Shen: It was described as "inappropriate behavior."

Kline: Inappropriate behavior. We don't need to go into the rumors. When he was forced out, there was talks of taking the company private, there were some offers out there, there was turmoil. Then, they hired Hubert Joly to be their CEO. 

Now, to say this was an oddball pick at the time would be putting it mildly. His background was in hospitality -- restaurants, travel. Not hotels, not consumer electronics, not retail, so it was a head-scratcher. But Joly came in and he recognized that it was a customer service problem, it was a distribution problem, it was how we're dealing with people. And he put in a turnaround plan.

Shen: Yep. Around the time that Hubert Joly took the reins, the company was in a tough spot in terms of negative same-store sales being reported for many quarters, starting in late 2008. They didn't really recover to consistently positive levels until 2014, years and years later. You have to keep in mind, this is also a very challenging period when profitability was hurt by weaker operating margins. Shareholders had to have an iron will to stomach the stock, and it lost 80% of its value.

Kline: This is where we should bring up the word "showrooming." Around this time, as Amazon was becoming ubiquitous, and most people had accounts, you weren't going to buy a TV sight unseen. There wasn't this level of trust where, on Prime Day, we're all buying stuff we've never seen, we don't know what it is. You would go to Best Buy and waste Best Buy resources by having the salesman show you the TV, take you through the features. Then, you'd go, "Hmm. I'll come back tomorrow and buy it." And you wouldn't. At that time, in 2012, you'd probably go home and buy it on your computer rather than buy it on your phone. But there was a decent chance that you were doing all this work. When I ran a toy store, as we've talked about, we experienced this sometimes. Someone would take us through two hours on a $1,200 train set, and then we'd never see them again, until a year later, they came with a broken train, and they had bought the train set somewhere else. 

That was happening. Best Buy had to take major steps to deal with that. They dealt with it in two ways. Price matching was one of them. We've both talked about it off-air that their price matching is sketchy, because it doesn't include delivery, and it's not as convenient as Amazon. But the other one they did -- and, again, we were just talking about this upstairs -- is, they lowered some of their prices. It used to be, you'd need something -- batteries, a cable, a printer cable, whatever it is. You'd go to Best Buy, and the price would be 15 times higher than Amazon. It would be $40 vs. $2. They took a lot of those items and made them $6, $8, $10. Things like headphones, that are a commodity -- if you break your $12 headphones, you don't want to wait until two days from now to get them. But if you go to Best Buy and they're $35 like they are at the airport, then, well, you're going to wait and order them. They corrected a lot of that stuff. 

They also took salespeople off commission and changed the vibe in their store, where you could trust that the person who was pointing you toward a product might actually like that product, rather than getting a slightly higher commission on it. And they doubled down on service. Geek Squad, handling all this stuff. Yeah, you can buy your TV from Amazon. Are they going to mount it? I mean, yeah, Amazon sells that now, but it's still a lot easier to do that all in one.

Shen: Let's step back a little bit. To clarify, some of the initiatives that you mentioned, they're all part of a push that they branded as their Renew Blue campaign. This campaign launched in 2012 and ran for about four or five years. They wrapped that up last March.

Kline: It didn't have a timetable on it. It had goals. Yes, last year, they declared that they are no longer a turnaround.

Shen: Okay, or in that phase. That was the silver lining, if you've been following this story, because many of the Renew Blue initiatives pushed the company in the right direction. There was also cost-cutting measures and a realignment of a lot of their resources.

Kline: I think it's important, again, to bring up Sears. Sears has been aggressively cost-cutting. But if you cost-cut and don't add or change the experience, maybe you can shrink your way to some level of profitability. The reality is, Best Buy cost-cut, but they also did things like bring in Apple, Microsoft, Samsung store-within-a-store concepts. They gave you more reasons to go to their store while also meticulously cutting costs. Over $1 billion, I want to say $1.4 billion.

Shen: $1.4 billion, yeah. Wrapping up on some of the lead-up here, which I think is important context to understand this next phase now that the company's entering. That brings us to their current status and its outlook going forward, which they've, again, branded as their New Blue, pretty clever. Details for this 2020 roadmap were shared last fall. Can you give us a little bit of detail on what that looks like?

Kline: It's really building their place as a brand expert, as a place to go. It's doubling down on, yes, you could buy these products facelessly from a lot of other people, but you could come into Best Buy and get the full experience, and it's going to cost you the same amount. It's adding more store-within-a-store, other brands, and that. If you want to buy an Apple product, you're actually working with a salesman who knows the Apple products. It's not just someone who's picking it up off a shelf or can tell you what the pricing is. It's really enhancing that. It's also adding to the service model further with Geek Squad and home setup, and pricing some of those things a little bit differently so it's maybe a little less off-putting to people.

Shen: At this point, their comparable store sales have recovered to positive levels. Their operating margins are back to more sustainable levels, as well. Definitely in a stronger financial position. I was looking at the very long and detailed investor presentation that they shared about this New Blue initiative. Some of the things that jumped out to me, they're looking at underpenetrated or new product categories, things like appliances and mobile phones.

Kline: Smart homes.

Shen: A small market share or big opportunity, and they can really look into investing into that more. They're focusing on services a lot over hardware. They have numbers pitting services spending, in terms of consumer technology, as being 80% of where consumers are putting their money. So that's a really important part of their efforts going forward. 

Then, trying to differentiate, like you mentioned, in terms of that service level, with things like tech demos, having more knowledgeable employees in general, and the tech support after you've taken a product home -- for example, Geek Squad and home advisors.

Kline: I'll give you an example. We just got a smart thermostat in our second home. We didn't intend to get one, it was just what the guy had on his truck and he installed it. It took me three hours of reading and playing to download the app, get everything hooked up, and I can still only control half of the things I think I can control fully. I would have paid a slight premium for Best Buy to come out and set that up and teach me. Or I would happily go to a Best Buy in-store seminar to learn how to use it better, and maybe, while I'm there, I would buy a video game.

Shen: At least you have someone you can ask questions to.

Kline: Yeah. I think those markets -- which is sort of a parallel to the consumer electronic market -- the smart home market and smart home services market is going to explode. You and I might be able to figure out how to install a Ring doorbell ourselves. My mom can't. But my mom has an Amazon Echo in the center of her house, and it would be very useful for her to be able to say "lights on" when she comes home. I think Best Buy is going to be a popular gift starting this Christmas season, where you're seeing the gift of services for that type of stuff. That's what they're pivoting heavily into.

Shen: They're looking at the demographics in the categories that they can break their customers into and targeting them accordingly based on broad categories and trends -- like smart home, like cyber security, and also assured living, which is basically assistance for older consumers. Those are all things that they've focused on and looked at as part of this New Blue initiative. 

Just to give you an example, they're dedicating 1,500 employees to focus on smart home selling. They're also rolling out 300 of these in-home advisors, people who will come into the comfort of your own home, where they find that consumers are a little bit more open and comfortable, in terms of looking at new products and services, increase incremental spending. They want to be a technology consultant. Once they've established that relationship, these consumers see Best Buy as, there's a greater connection there.

Kline: It's sort of megaomnichannel. Every retailer talks about omnichannel, which is the idea that you're standing in a store and order on your smartphone, or you order on your smartphone and you pick up in the store. It's that it doesn't matter. Best Buy is moving to, they'll offer you sales, like, the actual sales help and pitch, wherever you are -- at your home, at your business. That takes it to a level. It's hard for a pure digital company to do that. Amazon does not have great customer service, if you've ever had to deal with it. They're great on returns, but there's no one to call at Amazon when you don't know how to use your smart refrigerator, or whatever it is.

Shen: Or you have a more technical problem with your product, or whatever that you bought. Sure.

Kline: Best Buy is really looking at being a true omnichannel. You can do it in the store; you can do it on a pre-recorded thing on the web; you can do it with an actual person; you can, before you even buy it, have someone consulting with you on it. It's going to be a really interesting model. What we don't know is -- we've talked about this before, too -- exactly what people want out of smart homes. Do you really want a refrigerator that tells you, "You have six eggs. They're fresh. That could make two omelets with the ingredients you have in here."

Shen: I think that would be pretty nifty.

Kline: I would have said no. But if you knew how many times a day I check my smart thermostat, [laughs] because it really is cool to see how you can tweak it, like, "I saved another $0.03 here because I moved it to 78 during this day part where I'm not home!" Or, "If I set it at 77, it only cycles on six times a day, as opposed to at 76 where it cycles on every 20 minutes." You really can learn some stuff.

Shen: That extra service, that high-touch service that they want to offer, they see that as a differentiator. Of course, returning to Amazon, which was mentioned in the question, Best Buy has also worked to consistently grow its online business. Their online revenue topped $5 billion recently, and that's double the level from where it was five years ago. So they're pushing in that realm. It's enjoying a double-digit annual growth rate, so that's not something they're neglecting. It is omnichannel.

Kline: They've also done a good job with their rewards program and integrating that into their website. Their website used to be a chore. You would go, and they have a feature where you can see if something is in the store. That would work OK for new inventory. But for things like open boxes and sales and discounts, it never worked that well. They've really done a good job. At my local Best Buy, I can literally see what they have in open box inventory on televisions and things like that. They've improved that. In general, they've improved their shipping. They're not Amazon. You're not getting everything in two days, unless it's a big ticket item, but it's improved quite a bit.

Shen: That's part of the New Blue initiative, as well. The company offers some additional guidance in terms of fiscal year 2021. They're targeting $43 billion revenue, about $2 billion of non-GAAP operating income, and ongoing operating margin around 4.5%. I think they've planned another $600 million of potential cost savings. 

Ultimately, I think, with that operating margin, for example, they're running into issues where that's down from where management had previously hoped to deliver. I think they previously envisioned 5% to 6%. But they realize now, a symptom of the increased investments in service offerings that they're trying to roll out to develop these deeper relationships with customers, it's a worthwhile trade-off. 

Some of the increased capital spending, the capital expenditures, will be going to things like supply chain investments, which will have benefits go toward both its online channel and also their brick-and-mortar business. 

Getting to Ryan's core question now, I'm curious, Dan, where do you stand on Best Buy as a long-term value play? Are you sold after doing this due diligence?

Kline: I am. I've been a fan for a few years. That said, I think Best Buy has been very good in that they're experimenting. They will walk away from things that don't work, they will double down on things that do work. This is a company that figured out, "This is where the bottom is. We can operate," they got smaller, they lost stores, they lost some people, "we can operate here if we're well-run." Now, it's build it back up. They got rid of the small mobile stores. They refocused and put everything back together in a different way. Most retailers are great at cutting; they're not good at cutting and also trying new things. 

Do I think Best Buy is going to be where it was before there was an internet? No. Do I think the company will mostly, steadily grow, with the occasional terrifying, "Christmas didn't go as well as we thought it would because people didn't buy 60 televisions."

Shen: A short-term hiccup.

Kline: Yeah. I don't think they're immune from that. Too much of their business is tied to technology answers that nobody gets 100% right, 3D televisions being a recent one, VR. There was a lot of thought that VR headsets were going to be a big deal last Christmas, and they were not.

Shen: For consumers, yeah. If you like what you've heard about New Blue, management's focus areas, some of these initiatives that they're rolling out, and the longer-term guidance that Best Buy has shared on things like revenue growth, profitability, e-commerce, there are still a few other things to consider. 

Shares of Best Buy are currently trading around $75, with a forward price to earnings multiple of about 15x. With annual earnings growth over the next five years at about 8.5%, that's a price-to-earnings-growth ratio of 1.7x. It's not quite the <1 level that typically indicates an undervalued stock, but we're talking about a more mature retail operation here. There are other parts to include in the equation. 

For one, the company pays a pretty generous dividend of 2.4%. Management has guided to sticking to a 35% to 45% payout ratio going forward, for its dividend payout. That payout ratio is the amount of net income being paid out to shareholders. In the past few years, Best Buy has stayed within that guided range. 

On top of that, though management is looking to increase its capital spend, they've also been active with their share repurchases. In the past three fiscal years, they bought back $3.7 billion of stock. That effectively reduced the outstanding share count by 20%, quite significant. 

While the ongoing repurchases are going to vary going forward, the company's balance sheet is very strong. They have $2 billion in net cash. Best Buy generated $1.4 billion of free cash flow last year. So financially, in that strong position where, you're right, they're kind of rightsizing the business, in terms of figuring out where things are. Not that they've closed a lot of locations.

Kline: No, but they've shrunk some locations. They did get rid of the mobile stores, which turned out to be very smart, because they were mostly mall-based, so they were dependent on traffic. And cellphones have largely become a commodity, so you don't really want smartphone-only stores. That no longer makes much sense. 

They're also really well-positioned to take advantage of the changes in retail. There are a lot of Toys R Us locations, there are a lot of Sears locations that are available. If you're a stable company with a good balance sheet, your ability to go to a mall operator, a Simon or whoever it is, and say, "I'm happy to go into your five new malls ... on these terms," they have the ability to do that because they're not going to go out of business in the next three years. JCPenney cannot make the same promise.

Shen: Yeah. I think they're considering all the factors going into this. Management has acknowledged that, with the online push, they're seeing a little bit of cannibalization of their brick-and-mortar business. But they're considering how these two things are synergistic and how they work together.

Kline: That's a whole show. How you're reporting a digital vs. a physical sale in an omnichannel world, in most cases, it's based on where you pay for it or where you pick it up. But there's no hard-and-fast rule on that.

Shen: And given some of the gray areas there ...

Kline: Yeah. The reality is, stores will become distribution warehouses. They are for Best Buy. In many cases, a store will be involved in a sale it's not going to be credited for. That's why, as we look at the next year, maybe two years, of earnings, before we figure out how to quantify these things, don't just look at same-store sales. If the whole company is increasing its sales, but same-store sales are down 1%, but digital sales went up 43%, that's probably still a win, because the stores are being utilized as part of that.

Shen: Wrapping up, with everything that we've discussed, I'll just say, I'm pretty impressed with how Best Buy has managed to regain its footing and bounce back at a time when storied national chains -- like Toys R Us, which you just mentioned -- are closing their doors. 

I personally have extra-high standards and expectations before buying into a brick-and-mortar retail business, so Best Buy isn't right for me. We can't really tell you, Ryan, specifically what to do here. But we can at least give you some signposts to watch as you track the progress that Best Buy is making. 

If they're able to accelerate same-store sales, if there's growth in some of those under-penetrated product categories that we mentioned, strong results from the services side of the business, such as in-home advisors, and the continuing growth of their online revenue. If they can do all of those things without wearing down their bottom line profits, that's a very good sign. Definitely some things to keep in mind. I'd say, it sounds like, Dan, you and I are both pretty impressed with this story.

Kline: Yeah. It's hard to underplay confidence in management. But I look at what Joly has done -- and, I assume his lieutenants are part of this, and all of the other management at the company.

Shen: Of course.

Kline: That makes me think, let's pretend smart home never moves much beyond a speaker that can tell you what the weather is. Maybe people just don't want this stuff. Or it becomes something built into high-end homes and not something the average person buys. I'm confident Joly will see that and pivot and move into wherever people are. That's not something I could say about a lot of retailers.

Shen: Yeah. They're at this point now where they're making this transition from a turnaround story to more of a low-growth, stable business where they're looking at opportunities. 

Thanks a lot, Ryan, for the question. Dan, any final thoughts from you before we roll off here?

Kline: I think we should go to Best Buy! [laughs] 

Shen: OK! Dan, thanks so much for flying in and joining us today!

Kline: Thanks for having me!

Shen: Fools, again, thank you so much for tuning in. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Daniel B. Kline owns shares of Apple and Microsoft. Vincent Shen owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, Apple, and Twitter. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.