Consumer electronics retailer Best Buy (NYSE:BBY) reported stellar holiday sales, with domestic comparable store sales growing by 3.4%, far better than the 0.9% decline during the 2013 holiday season. This performance was driven by strong demand for large televisions and smart phones, offsetting the weak demand for tablets.
The stock sank, though, due to disappointing guidance for 2015. The excitement around new products like the iPhone 6 and 4K TVs is unlikely to last, said CFO Sharon McCollam, and comparable-store sales growth for the first half of the upcoming fiscal year will be flat at best and a low-single digit decline at worst.
Given the tough outlook for the company, should Best Buy investors be worried?
The turnaround so far
Best Buy has made plenty of progress turning around its business since CEO Hubert Joly took over in 2012. The company has slashed costs, lowered prices to become more competitive, drove rapid online sales growth by shipping orders directly out of its stores, and sold off both its European and Chinese businesses. The focus now is clearly on the U.S. market, and with Best Buy being the only major nationwide consumer electronics retailer left standing, it has a meaningful advantage.
Today, Best Buy is leaner than it's ever been. During the trailing-twelve-month period, Best Buy spent just 19.2% of revenue on operating expenses, about three percentage points lower than 2011. Gross margin has also declined as Best Buy has become more price competitive, but profitability seems to have stabilized. Going forward, Best Buy's operating margins will likely be lower than in the past, but the company has proven that its profits aren't going to disappear.
The company has also been picking up market share. During the nine-week holiday period, The NPD Group reported that the consumer electronics industry declined by 3.7% compared to 2013. Best Buy's increased price competitiveness, while hurting profits in the short-term, is allowing the company to win a larger share of the market.
Also helping the cause is strong performance from the company's e-commerce business. During the holidays, online sales grew by 13.4%. This is slower than the 23.5% growth during the 2013 holiday season, which benefited from the full roll-out of the company's ship-from-store program, but it's impressive nonetheless.
In fact, Investors couldn't have really asked for a better holiday season from Best Buy. Sales grew, operating margin for the full fourth quarter is now expected to expand by nearly a percentage point compared to 2013, and online sales surged. Unfortunately, 2015 may not be so rosy.
The strong holiday season is not expected to carry over to the first half of 2015. Comparable-store sales could decline, according to management, and operating margins will be squeezed by both lower sales and the continued investments that Best Buy is making in its business.
With operating margins already in the low-single digits, the 30-50 basis point decline management is predicting for the first half of the year is a pretty big deal. One thing to point out, though, is that Best Buy has been extremely upfront about pointing out potential problems during its turnaround, and its guidance tends to err on the side of caution. The company has handily beat analyst earnings estimates for the past four quarters in a row, in each case by more than 20%, so I wouldn't be surprised if the results end up less dire than the guidance suggests.
Regardless, Best Buy is facing weak demand for consumer electronics, and until that changes, revenue and earnings will continue to feel pressure. The silver lining is that Best Buy is performing much better than smaller rivals like HHGregg and Conn's. HHGregg expects comparable-store sales to decline by 6% for its holiday quarter, and shares of Conn's recently imploded after profits fell off a cliff. Conn's problems have more to do with its loose credit policies than anything else, but it's clear that Best Buy's performance has been far better than its peers.
So, what should investors make of this? Best Buy currently trades for around $34 per share, putting the P/E ratio based on the average analyst estimate for fiscal 2014 (which ends in January) at just about 14. Best Buy certainly isn't cheap, but it's not all that expensive either. During the past twelve months, Best Buy has generated roughly $1 billion in free cash flow, according to S&P Capital IQ, putting the market capitalization at around 12 times this number.
Best Buy also has an extremely strong balance sheet. Going into the holidays, Best Buy was sitting on $3.1 billion in cash and just $1.6 billion in debt, giving the company plenty of breathing room if things take a turn for the worse. This cash balance will likely be far higher coming out of the holidays as well, if history is any indication.
As long as the consumer electronics industry remains weak, Best Buy's margins are likely going to be depressed. But even in this difficult environment, the company is generating plenty of profits, and any uptick in demand for consumer electronics will be a boon for the Best Buy. 2015 is shaping up to be a tough year for sure, but Best Buy has made the necessary changes over the past few years to weather nearly any storm. In this context, investors should ignore the market's overreaction.