Best Buy Suffers From A Perfect Storm Of Weaker Margins And Sales

Electronics retailing giant Best Buy (NYSE:BBY) announced its Q3 results on November 20. The results were disappointing as the company announced an unexpected net loss and weaker results than the company’s guidance in October. Management placed blame on the effect of product transitions especially related to the Windows 8 launch and the launch of several new smartphones and tablets. Customers delayed their purchases in anticipation of new products to be introduced.

The market has reacted negatively to the results. Shares of the Minneapolis based retailer dropped almost 15% on Tuesday, hitting a new 10-year-low before recovering slightly at midday. So far this year the stock is down by almost 50%, as the company struggles with declining sales at its big-box stores that some consumers are using as a showroom before they buy products elsewhere online. The shift in product mix from higher margin categories like TV’s and PC’s to smartphones and tablets has been another factor driving stock prices lower as gross margins have been impacted.

See our full analysis for Best Buy

Factors Impacting Gross Margins

A category that showed comparable sales growth was mobile phones where the growth rate was 32%, benefiting from the launch of several new smartphones. The growth rate was high partly due to a larger mix of higher price point smartphones. However, the category inherently generates lower gross margins. Profitability in the smartphone category is primarily driven by the money Best Buy receives from the carrier and from the attachment of accessories in services that go with it. The price point of the smartphone is almost irrelevant in the calculation of gross margins, because it’s a heavily subsidized product. So when looking at a gross margin rate, even with a higher value smartphone Best Buy is still getting the same amount from the carrier and the same attachment at the end of the day.

For TV’s, a less favorable product mix dominated by smaller screen sizes lowered margins. Lastly, gross margins were impacted by the impact of product transitions ahead of key new launches.

In the International segment of the business, gross profit rate declined by 2.8% in Q3. This was attributed predominantly to Europe, where gross profit margin was driven by an increased sales mix of lower-margin wholesale business and a price competitive environment for mobile phones, along with more expensive headsets.

Problems And Solutions

There are two major problems Best Buy is grappling with – negative comparable growth rate figures and declining margins.

We think that declining margins are here to stay for the foreseeable future since the biggest factor impacting gross margins is the product mix composition which is dictated by consumer preferences and is largely beyond Best Buy’s control. To improve comparable sales growth, Best Buy will do well to leverage its multi-channel approach where it can engage consumers across multiple platforms like brick-and-mortar stores and online. It is already investing in training personnel appropriately and paying higher compensation to associates which caused the SG&A to go up by 1% in the third quarter. However, we think it is a necessary investment to reap rewards in the future and the company should continue with its approach.

Best Buy also faced a decline in comparable sales in its services business which is driven primarily by the Geek Squad division. This was primarily due to lower sales volume of PC’s and TV’s which are devices that require assistance from Geek Squad personnel.

The retailer lowered the forecast of its annual free cash flow by $500 million, to a range of $850 million to $1.05 billion. It had forecast a range of $1.25 to $1.5 billion in late August. The company said the revised estimate reflects lower projected profit and potentially higher year-end inventory. For retailers, dwindling cash flow is a problem because it can scare suppliers, who may worry that they won’t get paid. But Best Buy said that suppliers haven’t changed terms and that there is a $2.5 billion credit line available to it which hasn’t been touched so far.

While CEO Hubert Joly mentioned broad strategic goals aimed at correcting the company’s problems, he provided mostly sparse details about how Best Buy will move beyond problem solving into more profound change.

Next Quarter

There are significant product introductions on the horizon in key categories for the holidays. These include phones, tablets, Windows 8 and gaming products. Best Buy can generate a lot of revenues from these because they have turned into major gift-giving categories and a lot of people would be looking to upgrade their systems or devices. Retailers can typically manage to generate 40% of their annual revenues in the holiday season itself.

The company also expects to reap benefits from the additional training it has provided to its employees and from the Price Match strategy it has put in place for the holiday season. Best Buy would essentially match the lower prices offered by an online retailer upon request by customers in the company’s brick-and-mortar stores.

There were no comments about Richard Schulze’s attempts to make a bid for the company  in order to take it private. However, with the company’s stock price plummeting and no clear turnaround strategy in place, he may anyways find it difficult to convince private equity players to invest in the company. With the future outlook hazy at this point, these players would find it difficult to devise an exit strategy.

We have a price estimate of around $25 for Best Buy which will be revised now that the third quarter earnings results are out.

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