Best Buy Saying the Right Things, but Is It Enough?

 Best Buy's (BBY) first conference call following last month's abrupt departure of former CEO Brian Dunn had a refreshing feeling to it, as interim CEO Mike Mikan was blunt in addressing the structural and competitive pressures facing the company while acknowledging that more aggressive measures were needed to keep the brand relevant in the eyes of the consumers beyond the transformational strategies laid out in March. 

Few specifics about what additional measures would be taken were disclosed on the call (understandable, given that Mikan has only held the interim CEO tag for a few weeks), and management plans to unveil a more formal long-term strategy later this summer, but we were encouraged by directives like reducing square footage/smaller format stores, leveraging data and technology to better address consumers' needs and the in-store experience, and evolving its service offerings past technical support. Despite Mikan's straight talk about the potential for Best Buy's turnaround, we harbor concerns about the company's ability to make meaningful changes while the board undergoes its search for a permanent CEO (which may take between six and nine months to complete). Given that consumer electronics retail is a rapidly evolving business, delays in implementing measures to make Best Buy more relevant in the eyes of consumers could put the company in a deeper hole. Even though first-quarter domestic results were generally consistent with our expectations and management left its fiscal 2013  outlook unchanged (including adjusted earnings per share of $2.85-$3.25 including fiscal 2012 restructuring charges, or $3.50-$3.80 on an adjusted basis), we are planning a moderate reduction to our fair value estimate based on signs of increasing competition, weaker-than-anticipated international segment results, and a lack of visibility over later phases of Best Buy's turnaround efforts.

Best Buy's domestic fourth-quarter results were generally in line with our model, including a 3.7% decline in comparable-store sales, 30 basis points of gross margin pressure to 25.3% (driven primarily by a service revenue mix shift away from one-time transactions to ongoing tech-support memberships), and 100 basis points of operating margins contraction to 3.3% (4.8% excluding restructuring costs).  There were few notable changes in trends by product category, as tablets (including the launch of the new iPad), mobile phones, e-readers, and appliances offset softness in notebooks, gaming, digital imaging, and televisions. The international segment was another story, as macroeconomic pressures in Europe, a higher percentage of lower-margin smartphones in the mix, and weaker Five Star sales in China amid the expiration of government-sponsored programs to stimulate appliance sales brought results below our expectations. These pressures resulted in 10.5% reduction in comparable-store sales, 180 basis points of gross margin pressure to 24.2%, and a modest operating loss for the quarter.

Even though we agree with management that some of the international segment pressures will abate in the periods to come, management's fiscal 2013 outlook (including revenue between $50 billion and $51 billion, comparable-store sales declines of 2%-4%, a 4%-11% decrease in operating income dollars--after adjusting for restructuring costs, discontinued operations, and one-time items--and adjusted earnings of $3.50-$3.80 per share) now appears slightly aggressive amid increasing industry price competition, and we plan to adjust our model accordingly. 

In fact, while we view Best Buy's efforts to optimize its cost structure and trim the size of its store base, reconnect with consumers, and become more competitive in electronic and mobile commerce in a positive light, there were few details regarding what we view as Best Buy's largest competitive hurdle: the perception of pricing disparity between the retailer and players like  Amazon.com (AMZN) and  Costco Wholesale (COST). We've long held the stance that consumer electronics consumers will gravitate to the retailers with the lowest-prices regardless of the level of the in-store service offerings, but until we are convinced that Best Buy's turnaround efforts will be sufficient to drive enough price parity within the marketplace (and we suspect this will be a part of management's updated turnaround efforts later this summer), we will maintain our negative long-term outlook. Even if pricing parity is achieved, we have a hard time envisioning a scenario where Best Buy operating margins don't continue on a downward trend toward the 2%-3% range.

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