Best Buy Will Struggle to Defend Its Market Share

Although  Best Buy (BBY)  modestly exceeded comparable-store sales estimates for the third quarter (a gain of 0.3% compared with consensus expectations of a 0.7% decline), a 130-basis-point decline in domestic gross margins supports our view that the retailer will find it increasingly difficult to drive store traffic in a profitable manner over a longer horizon. Our due diligence had suggested that Best Buy was successful in driving consumers to stores over the Black Friday weekend (which was included in third-quarter results), which is supported by the positive comparable traffic gains for the period. However, we had been concerned about whether there would be enough full-price selling during the period to offset aggressive promotional activity, and the implied decline in the average transaction size and gross margin compression during the quarter suggests this was not the case. We plan to make some adjustments to our 2012 assumptions based on third-quarter results, including a mild reduction in top-line expectations and reduced gross margins but partially offset by more favorable selling, general, and administrative cost controls, which may push our fair value estimate down by a few dollars.

These changes are consistent with our long-term thesis, which suggests Best Buy will struggle to defend its market share and sustain store-level productivity amid an increasing competitive consumer electronics retail landscape featuring intensifying rivalry with mass merchants and online retailers and heightened price competition in the wireless and mobile computing categories.

We acknowledge that the company is taking several necessary steps to streamline its business and improve its competitive positioning in the consumer electronics retail category, including last month's strategic announcement to buy out Carphone Warehouse's interest in Best Buy Mobile (enabling a wider assortment of devices at Best Buy Mobile stores), reduced dependence on big-box store formats (evidenced by the commitment to reduce big-box square footage in the United States by 10% during the next three to five years and the closure of 11 U.K. big-box pilot stores), increased third-party relationships with mobile and connectivity specialists in emerging markets, and greater investment in its online sales channel. Still, we have concerns that consumers will gravitate to lower-cost rivals like  Amazon (AMZN),  Costco (COST), and  Wal-Mart (WMT) at a faster pace than these changes can take place, leaving Best Buy in a precarious position.

Other notable takeaways from the quarter included Best Buy Mobile's rebound from a disappointing second quarter with 9% comparable-store sales growth, aided by several high-profile handset launches in the latter part of the quarter. Still, this growth is not enough to shake our long-term fears about increasing price competition and continued retail development efforts by wireless providers. Appliances were the only other positive segment contributor domestically, with comps increasing 13.7%. Online sales accelerated on a quarter-over-quarter basis (up 20% versus 13% in the previous quarter), but according to our estimates, still fell short of broader consumer electronics e-commerce sales at major online merchants like Amazon.

With three quarters of the fiscal year in the books, management reiterated its full-year revenue guidance of $51 billion-$52.5 billion (an increase of 1.5%-4.4%, including 1.5%-2.0% from an extra week in the fiscal year) and flat to a 3% decline in comparable-store sales, which appears reasonable at the low end of the ranges.  Management also left its operating margin dollar expectations intact (anticipating a range between a 5% decline and 2% growth), as gross margin compression of 50 basis points (to around 24.7%) will be offset by lower SG&A spending than previously assumed. There was no change to the full-year adjusted earnings per share outlook of $3.35-$3.65, or a loss of $3.52-$3.17 after factoring the purchase of Carphone Warehouse's stake in Best Buy Mobile, impairment charges related to the write-down of Best Buy goodwill, and U.K. big-box store closures. Over the next five years, we expect that top-line growth trends will remain in the low-single-digit range, driven by low-single-digit comparable-store sales growth but tempered by a reduction in U.S. retail selling square footage, with consolidated operating margins contracting to around 3%.

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