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Best Buy's Turnaround Remains Shaky

By Adam Levine-Weinberg - Jan 22, 2016 at 8:47AM

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Best Buy has taken investors on a roller-coaster ride in the last five years -- and it's not likely to end soon.

Investors betting on a turnaround at consumer electronics giant Best Buy (BBY 2.92%) have endured a lot of ups and downs in the past few years. Every big rally has been followed by a heartbreaking slump.

BBY Chart

Best Buy stock performance, data by YCharts.

Best Buy's recently released holiday update shows that the company's turnaround progress remains shaky. On the one hand, it has managed to stabilize its earnings by slashing costs and taking market share from weaker competitors.

On the other hand, consumer interest in the product categories it carries appears to be quite volatile. Best Buy's sales results are overly dependent on product cycles at tech companies like Apple (AAPL -0.26%), as well as other factors outside of management's control.

Holiday sales disappoint
In November, Best Buy forecasted that fourth-quarter revenue would be roughly flat in the U.S., while its adjusted operating margin would decline by 20 basis points to 35 basis points year over year due to a variety of factors. Meanwhile, international revenue was expected to plunge 30% due to store closures and economic weakness in Canada, with a 2%-3% operating margin.

In its holiday update issued last week, Best Buy maintained its forecast for the international segment. But within the U.S., sales missed expectations.

Best Buy's domestic sales declined slightly during the holiday season.

During the first nine weeks of Q4, domestic comparable-store sales fell 1.2% year over year. As a result, Best Buy now expects domestic revenue to decline about 1.5% for the quarter, compared to its previous guidance for flat revenue.

On a more positive note, the domestic operating margin decline will be only half as large as Best Buy had previously projected. That said, the domestic operating margin would be falling even more but for an unusually large profit-sharing payment from its extended service plan portfolio.

Buffeted by consumer trends
Digging deeper into the report, weak smartphone sales are driving Best Buy's Q4 revenue shortfall. Comp sales declined 7.2% in the computing and mobile phones category, excluding the accounting impact of a shift to installment billing for cell phone plans.

Relatively weak domestic demand for the iPhone 6s is hurting Best Buy. Image source: Apple.

A year ago, Apple's iPhone 6 and iPhone 6 Plus were taking the world by storm. However, Apple is seeing slower sales for its flagship phones in the U.S. now, as many iPhone users just upgraded a year ago. Best Buy doesn't seem capable of doing anything to insulate itself from consumer trends like this.

On the flip side, Best Buy has benefited immensely in the past few years from strong appliance demand. Home-improvement spending has soared in the past few years along with home values and broader economic growth. In Q3, domestic comp sales rose 16.4% in the appliances category, and this double-digit growth continued in the first two months of Q4.

Too much risk for the potential reward
Best Buy shares look quite cheap right now. The stock trades for roughly 10 times forward earnings. Furthermore, Best Buy has about $6 in net cash on its balance sheet that it could use for higher dividends or share buybacks.

Additionally, Apple is expected to release the iPhone 7 this fall, which could lead to another strong upgrade cycle and a rebound in sales. A new 9.7" iPad could be coming even sooner, giving Best Buy a shot in the arm this spring.

However, these positives are outweighed by the reality that these sales gains could be fleeting. Given the maturity of the U.S. smartphone and tablet markets, every strong Apple product cycle is likely to be followed by a downturn the following year. Also, profit margins on Apple device sales are notoriously thin.

The strong housing sector trends boosting appliance sales today could also reverse in the next few years, especially if interest rates move higher.

In short, Best Buy's sales and earnings appear to depend heavily on volatile factors outside of management's control. That's not a good situation for investors. There are better opportunities than Best Buy both inside and outside of the retail industry.

Adam Levine-Weinberg is long January 2017 $85 calls on Apple. The Motley Fool owns shares of and recommends 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.

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