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Best Buy Bulls Just Got a Reality Check

By Adam Levine-Weinberg – Jan 21, 2014 at 1:30PM

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Best Buy bulls have recently valued the company as if it is primed for long-term growth. Last week, they got a costly reality check.

Nothing about electronics giant Best Buy's (BBY 0.15%) strategic situation changed very much last week. At the beginning of the week, it was a struggling company with stagnant sales facing robust competition from competitors like Wal-Mart and At the end of the week, that was still the case. However, you wouldn't know that from Best Buy's stock performance.

BBY Chart

Best Buy Price Chart, data by YCharts.

Best Buy stock plunged 35% in the span of two days last week after it gave an update on its holiday performance. This holiday update highlighted the depth of its challenges, but the only surprising thing about it was that so many investors were surprised! Before last week's plunge, Best Buy was being valued like a growth company, which it has not been for years. Best Buy's big drop merely corrected its valuation to a more defensible level.

Best Buy's bind
Best Buy has a relatively simple problem. First, while it was the go-to store for electronics just five or 10 years ago, has solidified its position as the go-to store for e-commerce. The ongoing shift of retail toward e-commerce devalues one of Best Buy's strongest competitive advantages: its brand name.

Best Buy has been hit hard by the growth of e-commerce.

Second, discounters like Wal-Mart, Target, and even Costco like using big-ticket electronics items as loss leaders during the holiday season. With the 2013 holiday season being particularly competitive, all of these stores could feel some pressure on their holiday quarter profit margins. However, electronics items are just a small part of their businesses, and these chains are consistently profitable throughout the year.

By contrast, Best Buy typically earns the majority of its annual profit in the fourth quarter. In fiscal year 2012, Best Buy posted adjusted EPS of $1.99 in Q4 -- 56% of its annual EPS of $3.54. In FY13, the company's Q4 EPS of $1.47 was 58% of its annual EPS of $2.54. As I pointed out two months ago, this heavy reliance on Q4 earnings made Best Buy particularly vulnerable to a holiday season price war.

A terrible quarter
Up until last week, Best Buy analysts and investors seemed to ignore this risk. At that time, analysts projected that the company would grow earnings ever so slightly this quarter. Investors rewarded this expected earnings growth with a generous earnings multiple that peaked at about 17 times forward earnings.

BBY PE Ratio (Forward 1y) Chart

BBY P/E Ratio (Forward 1y), data by YCharts.

As it turns out, both the earnings estimates and the valuation multiple were too optimistic. On Thursday, Best Buy announced that domestic comparable-store sales dropped 0.8% for the first nine weeks of Q4, comprising the key holiday selling period. Meanwhile, heavy "investments" in price competitiveness undermined Best Buy's profitability, leading to a drop of 175 to185 basis points in Q4 adjusted operating margin.

This means that Best Buy's adjusted operating margin will fall from 7.2% in Q4 of FY12 and 5.5% in Q4 of FY13 to around 3.7% this quarter. As a result, EPS will fall significantly from last year's mark of $1.54.

Going the wrong way
Best Buy's management noted hopefully last week that online sales are growing rapidly (up 23.5% in the nine-week holiday period) and that the company gained market share during the period. However, the heavy discounting seen throughout the electronics industry -- such as big Black Friday iPad sales at Wal-Mart and Target -- did not stimulate additional consumer spending. Instead, it just compressed margins.

Best Buy's Q4 results should clarify for investors the depth of Best Buy's dilemma. Even after slashing hundreds of millions of dollars in annual costs, Best Buy still cannot compete on price with Amazon, Wal-Mart, and other discounters without severely damaging its profit margin.

Best Buy's operating margin was 1.9% through the first three quarters of FY14, and its Q4 results suggest that its full-year operating margin will land around 2.5%. After accounting for interest and income tax, Best Buy's profit margin will be barely more than 1%. Best Buy may gain market share this way, but its victory will be Pyrrhic, because it won't be able to earn back its cost of capital.

Foolish bottom line
Throughout the holiday season, Best Buy executives have been fond of saying that "price competitiveness is table stakes." In other words, if Best Buy wants to be a winner in the U.S., it needs to prove to customers that its prices are just as good as Amazon's or Wal-Mart's.

If that's really the case, Best Buy should find another table with a lower ante. Best Buy would be better off gradually losing market share and downsizing in order to protect its profit margin than following its current strategy. A long-term market share battle plays right into the hands of Best Buy's better-capitalized competitors.

Fool contributor Adam Levine-Weinberg is short shares of The Motley Fool recommends and owns shares of and Costco Wholesale. 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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