Best Buy in the Crosshairs

19 Jun

I love a good growth company. Good growth businesses are even better when paired with long-tenured managers who own a significant amount of shares while presiding over a great track record of growing earnings and free cash flow and earning high returns on incremental capital. Furthermore, the situation is even better when the current stock quotation undervalues the business. These factors all may be characteristic of Best Buy (BBY) at its current price.

Best Buy announced quarterly earnings today that were 18% lower than the comparable period last year and shares are down nearly 6% on the day. Much of the decline in profits was due to a shift in revenue mix to lower-margin products such as flat-panel TVs, notebook computers, and gaming hardware. So is the selloff in the shares warranted? Are lower margins forever in Best Buy’s future? Those selling off shares today seem to think so.

The main concern swirling around Best Buy seems to be that of a sharp downturn in consumer spending. Though likely to slow a bit, betting against the consumer has not historically been a good gamble. In addition, Best Buy continues to take market share from competitors such as Circuit City (CC), which will help mitigate the pressure on its business in the event of a slowdown in consumer spending. But concerns about consumer spending represent short-term thinking. Investors in common stocks should typically think in longer time horizons. Are the company’s competitive advantages intact? Can Best Buy grow while continuing to earn good returns on total capital? Over the longer-term, it seems highly probable that Best Buy can continue to grow and prosper both domestically and internationally. For instance, Best Buy holds a potentially valuable option in its Chinese operation, where it now has just one store.

There is a longer-term risk to profitability: Wal-Mart (WMT). I believe Wal-Mart will continue to be a fierce competitor but probably only on the lower end. Its main advantage is obviously price. Yet Best Buy offers more qualitative advantages: clean stores, great selection, a cool environment, and great service, and often consumers go there first if it’s electronics they crave. The wider selection and more knowledgeable staff (rather than someone who also works in fabrics or grocery) give Best Buy an edge over Wal-Mart in its core customer base for years to come.

As for profitability, for the past ten years returns on total capital have been around 20% on average (due to a modest debt load, returns on average equity have averaged a couple of percentage points higher). The lowest-return years of the past ten were 2001 and 2002 (recessionary conditions) and returns in those years were still quite satisfactory at 17.1% and 17.8%, respectively. Sales have risen 13.7% annually while store base has grown only 12% over this same period. Management stated in today’s press release that new store openings continue to produce 20% returns. These are great numbers and are evidence of a competitive advantage.

The stock currently trades at 15 times forward earnings based on the low end of management’s updated guidance for 2007. This compares with the stock’s average P/E in the 18-20 times range over the past 15+ years. Debt represents about 9% of capital. Management has been buying back shares and increasing the dividend payment steadily since initiating payments in 2003. Chairman Richard Schulze still owns 15% of the company. Even while steadily expanding its store base (the company has ample room to grow) and investing in existing stores, the stock’s free cash flow yield is roughly 5% at today’s price levels. And the company has $2.8B in cash and short-term investments (13% of market value) on the balance sheet. Back out the cash ($5.70/share) from today’s price and the stock trades at 13.5 times forward earnings. Hardly expensive for a business generating such high returns on capital if the returns are sustainable.

At today’s price level (roughly $45/share), taking a small position is likely to yield good long-term returns. Yet the stock doesn’t look cheap enough yet to load up. Unless something has fundamentally impaired the business, if the stock price continues to fall, I may be inclined to provide some liquidity to panic sellers.

Full disclosure: Long shares of Wal-Mart at time of writing.


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