Last fall, two major U.S. retailers, Best Buy (NYSE:BBY) and Target (NYSE:TGT), announced plans to match competitors' prices on many items during the holiday season. These price-matching policies were unusual in that they applied to online competitors such as Amazon.com (NASDAQ:AMZN), not just other bricks-and-mortar retailers. As such, these price-matching campaigns were clearly aimed to combat the "showrooming effect": when shoppers research high-priced items at stores like Best Buy and Target and then go online to find the best deal.
Surprisingly, this seemingly obvious move by Best Buy and Target to fight Amazon was criticized by many retail industry analysts. Some argued that the price-matching "process" would slow down checkout lines, angering other customers. Others stated that the policy could be difficult to implement since online prices change frequently. However, the most frequently heard concern was that offering to match prices would drive even more consumers to the Internet to find the best price, thereby devastating profit margins -- particularly for Best Buy. Indeed, a study by InvisibleHand (a firm that specializes in real-time retail price-checking) claimed that this effect would reduce Best Buy's fourth-quarter profit by $1.12 or more. This finding was supported by some equity analysts, including Michael Pachter of Wedbush.
I was very skeptical of these claims at the time. As I have pointed out on numerous occasions, Best Buy and Target have cost structures that are in the same ballpark as Amazon. Amazon's key advantages in underpricing these companies to date have been: 1) not collecting sales tax; and 2) accepting a significantly lower profit margin. The early results from price-matching show that the strategy has worked, particularly for Best Buy. In fact, price-matching was so successful over the holiday season that both Target and Best Buy have announced in recent months that they will match prices year-round.
Best Buy: A case study
Price-matching is probably more important to Best Buy than to Target. While Target has lost some momentum due to online competition, it has continued to grow revenue and earnings, whereas many investors have placed Best Buy on "death watch." Coming into the holiday quarter, Best Buy had seen comparable-store sales decline in nine of the previous 10 quarters. Clearly, something had to be done.
In its study last year, InvisibleHand projected that matching prices could boost revenue by $537 million over the prior-year quarter, but that gross profit would drop by $400 million. This implies that InvisibleHand expected Best Buy's domestic gross margin to drop by as much as 4% during the quarter.
In reality, the impact on both the top and bottom lines was much more limited. Price-matching helped offset the impact of declining categories (such as physical CDs and DVDs) by increasing or maintaining Best Buy's market share in stronger categories. Overall, Best Buy's domestic comparable-store sales increased by 0.9% for the quarter. Meanwhile, the effect on gross margin was negligible. In the U.S., Best Buy's adjusted gross margin declined just 10 basis points year over year, to 22.4%. Even if we exclude a profit-sharing payment that Best Buy received during the quarter, gross margin declined by only 40 basis points. The impact was thus (at most) 10% of the 400-basis-point drop expected by InvisibleHand.
While Best Buy's adjusted EPS fell from to $1.64 from $2.18 in the prior-year quarter, that drop can be almost entirely attributed to the 6.6% comparable-store sales decline in the international segment. In other words, the implementation of a price-matching policy was able to stop the loss of U.S. customers to Amazon and other online competitors, with a minimal impact on profitability.
Bears' predictions did not come true in large part because popular items generally do not require big discounts to sell. InvisibleHand's methodology was flawed, because it apparently averaged the discounts available on Amazon for all "overlapping" products, rather than adjusting for how popular each item is at Best Buy. However, many device manufacturers (most notably, Apple) have implemented so-called "unilateral pricing policies" that prevent retailers from discounting beyond a certain level. Companies producing popular devices seem particularly likely to implement these policies, meaning that severe price competition is most common on less-popular items. The result is that the margin hit from price-matching is much less than might otherwise be the case.
In spite of the success of holiday price-matching, Pachter (the analyst who vouched for the original InvisibleHand study) recently went on CNBC to criticize Best Buy once again. He compared the company to the Titanic, and reiterated that price-matching would destroy the company's profit and cut its free cash flow by nearly 60% this year.
While Best Buy's management has already cautioned that first-quarter results will be weak, I believe that Pachter is overstating Best Buy's troubles. Price-matching may have a bigger impact on profitability outside of the fourth quarter, because Best Buy has always discounted heavily in the holiday quarter. Nevertheless, price-matching is a necessary step to bolster Best Buy's market share, and combined with other cost-cutting plans, should improve profitability by 2015.
Fool contributor Adam Levine-Weinberg owns shares of Apple and is short shares of Amazon.com. The Motley Fool recommends Amazon.com and Apple. The Motley Fool owns shares of Amazon.com and Apple. 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.