Market Getting Ahead of Itself With Best Buy Enthusiasm

Some of the outperformance can be chalked up to Best Buy Canada, where last year's brand consolidation efforts did not disrupt customer retention as much as anticipated, resulting in international segment revenue falling just 1%, versus management expectations for a 5%-10% decline. However, there were several other encouraging developments, including computing/mobile phone category comps increasing 0.3% despite softness reported by mass-merchant rivals, a 24% jump in online sales, and ongoing cost-containment efforts.

From a longer-term perspective, we believe the second-quarter results reveal several things. On the positive side, the sales trends support our view that Best Buy has improved its consumer relevancy through better category management (notably home theatre, appliances, and wearables), store-within-store partnerships with key vendors, a more efficient online experience with fulfillment/installation flexibility, and a head start in nascent product cycles, such as connected home and virtual reality.

However, domestic gross margin declines of 70 basis points--due in part to more aggressive pricing--indicate that the company still faces structural headwinds, most notably Amazon Prime, but also potentially increased direct sales activity from vendors over time, both of which play a part in our no-moat rating.

Based on the first-half results and optimism over back-half sales trends, we plan to ratchet our $30 fair value estimate up by a few dollars. While Best Buy remains a solid capital-allocation play, we're concerned that the market may be getting slightly ahead of itself regarding near-term expectations and not properly pricing in longer-term structural pressures.

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