Pick Up Some Best Buy (BBY) on Sale

Best Buy (BBY) reported fiscal first quarter results on Monday afternoon and the stock fell 6% after the disappointing news.  Top line growth was only 6.9% compared to Wall Street estimates of 8.4%.  Surprisingly, the company reported same store sales gained only 1.9%, which was far less than expected (estimated gains of 4.3%) as the conventional wisdom held that the consumer spending environment is much healthier now than it was then.  Furthermore, Best Buy brought in net income of $155 million or 36 cents per share versus $153 million and 36 cents per share last year.  Analysts had expected earnings per share of 50 cents per share, and management blamed 6 cents per share in restructuring charges accounting for part of the miss.

While the results were undoubtedly a disappointment compared to expectations, we see a number of reasons for optimism going forward.  First of all, the company continues to grab market share after its primary competitor, Circuit City, declared bankruptcy last year and drastically reduced operations.  In the quarter, the company continued to gain share, as they estimated a 1% increase from a year ago as it contends with online competition and increased competition from Walmart (WMT) as well as other big box stores.

There were bright spots as well, as sales of notebook computers and mobile phones were particularly strong.  The launch of Sprint’s (S) new HTC EVO 4G was well received, and the new iPhone should continue to generate demand in the coming weeks for their high margin mobile phone business.  Best Buy has greatly expanded the mobile phone side of their business and has opened up new stand alone Best Buy Mobile shops.  Aided by strong demand for phones, gross margin held up better than most analysts had predicted as well, coming in at 25.9% from 25.3% last year.

Although costs for things such as new store openings were higher than anticipated in the quarter, Best Buy stood by their original forecasts for sales, net income and expenses for the year.  Thus, management believes that better times are ahead through the balance of the year and the all important holiday season.  For the year, they forecast earnings of between $3.45 and $3.60 per share on revenue of $52 billion to $53 billion.  Traditionally speaking, the first quarter normally only accounts for 20% of annual revenue and less than 15% of net income, so a miss in the first quarter is far less detrimental than one around the holiday season.

Also, Best Buy has other initiatives geared toward raising sales in bringing in customer traffic.  For example, Best Buy will now offer shoppers a chance to sell back used video games for a gift card, taking direct aim at one of GameStop’s (GME) most profitable businesses.  In an effort to draw in game buyers, they have also deployed touch screen kiosks to allow customers to preorder and test new games.

Make no mistake, this quarter was a disappointment as management did not do a very good job of reigning in costs while sales were less than impressive.  However, the fact that the company has reaffirmed guidance gives us reason to believe it was a hiccup and not a particularly worrisome trend.  Expectations for sales may have been much better than at this time a year ago, but after today’s decline the stock is trading for just about the same price level as it was twelve months ago.  In that context, we believe BBY offers a compelling value with sales and expected full year profit showing nice growth.  Historically, Best Buy has traded for 10.8x to 23.1x times price-to-cash earnings, and the current multiple is near the low end of that range at 11.2x.  Furthermore, a current price-to-sales per share multiple of only .31x is well below the historically normal range of .36x and .71x.  Based on our methodology, Best Buy could feasibly trade in the mid $50’s before we would start to become concerned about their valuation getting overheated based on current fundamentals.  For this reason, we think that the market may be short sighted in sending Best Buy shares down this low, and it may not last very long.  After all Christmas will be here before you know it, and games, gadgets and gear are always near the top of consumers wish lists.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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