Best Buy: Do You Believe in the Business or Not?

Published 12/06/2022, 11:12 AM
Updated 07/09/2023, 06:31 AM
  • At 13x earnings, BBY is priced for minimal growth.
  • The company’s pre-pandemic performance suggests it can do better.
  • But analysts are skeptical, and with good reason: a number of risks loom.
  • Alongside its third quarter report two weeks ago, Best Buy (NYSE:BBY) issued guidance for the fourth quarter and full-year fiscal 2023 (ending January). The company expects same-store sales to decline by about 10% for both periods. Despite the seemingly ugly outlook, BBY stock would increase 13% on the day.

    Of course, in context, that outlook isn’t as ugly as the headline figure would suggest. Best Buy is coming off two stellar years, in each of which same-store sales increased about 10%. Those years benefited from trends created by the novel coronavirus pandemic; this year suffers from the demand pulled forward into those periods, along with the impact of rising inflation and lingering supply chain issues.

    The fact that a 10% decline in same-store sales is viewed as good thus makes some sense. But it’s still unusual. And that seeming contradiction — sales down double-digits, stock up double-digits — shows the complexity involved in valuing BBY at the moment. There are a ton of moving parts, a lot of uncertainty, and a business model that magnifies the impact of relatively small changes in customer behavior.

    Yet at this point, and after a post-earnings rally, the key question for BBY stock doesn’t necessarily relate to earnings multiples or the stock chart but simply how an investor views the business over the next few years.

    A Simple Valuation

    One aspect of BBY is relatively simple. Based on analyst consensus—which in turn is informed by the company’s guidance—BBY trades at a little under 13x earnings.

    That’s a multiple that prices in essentially zero growth from this point forward. (At an 8% discount rate, a company with perfect stable free cash flow should trade at about 12.5x free cash flow, and historically Best Buy’s earnings and cash flow have tracked rather closely.)

    And so, looking at valuation, the debate here is relatively simple. If Best Buy’s profits grow, bulls win. If profits decline, shorts—and there is about $580 million worth of short interest at the moment—prosper.

    The catch, however, is that choosing a side in that debate is far from simple.

    The Case for Best Buy

    Both the retail industry and the world should further return to normalcy in 2023, and in theory, that should be good news for Best Buy. There are inflationary and, possibly, recessionary risks looming, as management discussed on the third quarter conference call. But before the pandemic, it’s worth remembering that Best Buy was a pretty good business—and BBY was an impressive stock.

    In early 2014, BBY plunged amid disappointing results. The consensus at the time was that the electronics retailer was set to be yet another victim of (NASDAQ:AMZN). That proved not to be the case, however. Best Buy righted its ship, grew sales alongside steadily increased profit margins, and by the beginning of 2020, BBY had nearly quadrupled.

    The bull case is that Best Buy, once it works through the crosswinds created by the pandemic, can get back to that playbook. The idea that Amazon can put Best Buy out of business seems overwrought at this point. Direct competition is close to non-existent at this point; no company has the selection of big-ticket items that Best Buy does.

    In other words, Best Buy in 2024, in theory, should look like Best Buy in 2019. And that version of Best Buy was growing profit, buying back stock, and returning cash to shareholders via dividends. Simply put, it was a business worth owning.

    What Goes Wrong

    Interestingly, Wall Street is not on board with that story, however. The strong Q3 report (bear in mind that the company’s expectations for the fourth quarter are essentially unchanged) led to a series of increased price targets, but the average valuation from analysts still sits below Monday’s close of $84.32.

    One obvious problem is the macroeconomic cycle. Best Buy did grow nicely through the second half of the 2010s, but it had a (mostly) strong macro tailwind at its back. It was also benefiting from an easy comparison: adjusted operating margins in fiscal 2014 were just 2.8%, a figure which expanded steadily to 4.9% by FY20.

    By FY22, those margins had hit 6.0% amid strong demand. But this year is different. Best Buy is targeting a low 4% figure for the full year. Management said on the Q3 call that the promotional environment had intensified. And many consumers won’t be buying, no matter the promotion offered, given how many televisions, sound systems, and computers were purchased in 2020 and 2021.

    Again, it’s strange that BBY stock rallied after guiding for a 10% decline in same-store sales. But it’s a rally that only occurred because the environment is so difficult.

    The big risk here is that the environment doesn’t get better, and even Best Buy’s strong execution isn’t enough. A consumer stretched by inflation, and already loaded with goods, isn’t going to spend. And so, the worry here is not what same-store sales look like in calendar 2022 but what they’ll look like over the next two years. Investors really have to trust that demand will remain intact to even consider BBY here, as cheap as the valuation looks.

    Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.

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