Why Best Buy’s Gross Margin Will Continue Declining

The largest specialty retailer of consumer electronics in the U.S., Best Buy (NYSE:BBY), has witnessed eroding top line growth on account of growing competition from retail giants, including Amazon (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT). However, benefiting from its restructuring initiative, Best Buy’s financial performance improved in fiscal 2014. It witnessed 6.5% annual growth in revenue and reported positive net income of $532 million, compared to a net loss of $441 million in fiscal 2013.

Though Best Buy has come out with innovative schemes to re-accelerate its business, the move has impacted its gross margins. Its gross margins declined from 23.2% in fiscal 2012 to 22.8% in fiscal fiscal 2014. In Q1 2015, Best Buy’s gross margin declined by 75 basis points (to 22.4%) due to a number of factors, such as: 1) the less favorable ongoing economics of the new credit card agreement; 2)  the absence of proceeds from legal settlements in the quarter; 3) increased product warranty costs primarily relating to the mobile category; and, 4) structural investments in price competitiveness. Yet the operating expense burden decreased by 105 basis points, enabling a 30 basis-point increase in operating margin. (Read Our Q1’15 Earnings Article: Best Buy Suffers From Lower Electronics Sales, But Cost Savings Improve Profits)

Best Buy is still in the transitory phase, and thus its gross profit is expected to remain under pressure due to a number of factors.  These include not only competitive pricing, lower sales, and incremental investment in pricing and the Renew Blue SG&A program, but in additional expenses related to mobile warranty programs and the new credit card agreement. We forecast Best Buy’s gross margin to continue declining, albeit at a lower rate compared to the past.

Our price estimate of $26.38 for the company is almost in line with the current market price.

See our full analysis for Best Buy

Competitive Environment Will Limit Growth; Best Buy’s Price Matching Policy Impacts Its Bottom Line

Rising competition from online players such as Amazon and eBay is impacting Best Buy sales and profit margins. Potential customers use brick-and-mortar stores, such as Best Buy, to browse through products only to order them online at cheaper prices. This phenomena, referred to as Showrooming, is impacting brick-and-mortar sales and forcing stores to lower their margins to match the prices offered at online stores.

March 2013, Best Buy put in place a permanent “Low Price Guarantee” policy under which it will price match all local retail competitors and 19 major online competitors in all product categories and on nearly all in-stock products, whenever asked by a customer. The policy is an attempt by Best Buy to tackle the problem of Showrooming. It will focus on making its price more competitive though improved analytics over the next several quarters. Though lower prices enhance Best Buy’s competitiveness in the market, it puts pressure on its bottom line.

With the recent increase in gaming-console sales and expectations for strong software sales later this year, GameStop also poses as a serious threat to Best Buy. GameStop’s strength in hardware, software, and pre-owned games is a huge advantage with the popularity of the Xbox One and PlayStation 4. Best Buy devotes a significant portion of its big-box stores to game sales. ^[1]

Best Buy has been incurring higher promotional expenses to tackle rising competition in the market. Additionally, the company has stepped up investment to spur its online sales. (Read: Best Buy To Benefit From Increasing Online Sales) All these initiatives put pressure on Best Buy’s gross margin. Best Buy’s current gross margin (~22%) is significantly lower than that of Amazon (29%) and GameStop (31%). Thus, Amazon and GameStop are in a stronger position to further lower margins to increase their competitiveness in the market.

Cost Saving Initiative Can Offset Weaker Sales & Higher Costs Related To The Price Matching Policy

In a bid to remain price competitive, Best Buy is working on margin enhancement and cost reduction initiatives. It expects its cost cutting efforts to offset the weak sales and margin impact related to its price matching policy.

Best Buy aims to reduce its cost of goods sold by increasing its supply chain efficiency and modifying its return and replacement policy. Having exceeded its cost reduction target of $725 million in Q4 2014 (it delivered cost reductions of $765 million in the quarter), Best Buy has increased its Renew Blue cost reduction target to $1 billion. In Q1 2015, Best Buy eliminated an additional $95 million in annualized cost, taking the total Renew Blue cost reductions to $860 million. Excluding the impact of the increased mobile warranty expense, Best Buy’s cost savings and other operational improvements materially offset its price matching policy and other Renew Blue investments last quarter.

Best Buy has changed the space allocation in a number of its stores to enhance revenue and profit per square foot. It has allocated more space to smartphones, tablets and related accessories; while musical instruments are making the way for clearance items. The company is trying to improve its supply chain efficiency through freight consolidation and vendor rationalization, which helps lower shipping costs and increases purchasing power. Additionally, Best Buy plans to reduce its selling, general & administrative expenses by cutting redundant headcount and costs.

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1. 3 Reasons Best Buy Needs to Rethink Its Strategy, The Motley Fool, June 6, 2014 [↩]