Best Buy Margins To Remain Under Pressure

Best Buy (NYSE:BBY), the largest specialty retailer of consumer electronics in the U.S., reported surprisingly strong Q3 2015 earnings earlier this month. The company reported $9.4 billion in sales, up 5.4% sequentially and a roughly flat 0.6% year to year. The better than expected results were primarily driven by the lower than expected sales declines in the NPD-reported Consumer Electronics categories, higher than expected revenue in computing and tablets, higher mobile revenues due to better than expected results from new phone launches, as well as the better performance of the new credit card agreement, and greater pricing and promotional effectiveness. Offsetting this were increased investments in customer-facing initiatives. (Read Our Earnings Article)

The 60 basis points decline in the overall non-GAAP gross margins, from 23.7% in Q3 2014 to 23.1% in Q3 2015, was within company guidance. Best Buy’s GAAP gross margin declined from 23.1% in Q3 2014 to 22.7% in Q3 2015 primarily due to a mix shift into the lower margin gaming and computing categories, structural investments, increased promotional activity, price competitiveness (particularly in accessories), and a 20 basis point negative impact related to the less favorable economics of the new credit card agreement. These factors were partially offset by an improving mix of higher margin large screen televisions and the realization of the Renew Blue cost reductions and other supply chain cost containment initiatives.

We forecast Best Buy’s margins to continue declining, albeit at a lower rate compared to the past.

Our price estimate of $33 for Best Buy is at a an approximate 15% discount to the current market price.

See our full analysis for Best Buy

Competitive Environment Will Limit Margin Growth

Rising competition from online players such as Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY) is impacting Best Buy’s 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 more 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 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.

Higher Sales Of Lower Margin Products

Increasing sales of lower margin gaming and computing categories in both domestic and international segments puts pressure on Best Buy’s gross margin. Though the company expects an improvement in the year-over-year gross profit rate, it believes that internal factors like faster growing sales of lower margin products, higher growth in the low-margin online business and intensified investments in customer-facing initiatives will put pressure on its bottom line.

Accelerating growth in its online segment remains one of the main focus points for Best Buy, as it aims to update its website to get on par with Amazon and other competitors. As a percentage of total domestic revenue, online revenue increased 110 basis points to 7.5% in Q3 2015, versus 6.4% last year.

Cost Saving Initiatives 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. Meaningful progress against its RenewBlue initiative helped the company eliminate approximately $1 billion in costs through operational efficiencies, and lower domestic SG&A rate by approximately 170 basis points in Q3 2015 compared to two years ago. At the enterprise level, Best Buy’s non-GAAP (SG&A) expenses as a percentage of revenue declined to 20.2%, compared to 21.5% in Q3 2014. The decline was mainly due to its Renew Blue cost reduction initiatives and tighter expense management throughout the company.

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, the company plans to reduce its selling, general & administrative (SG&A) 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 [↩]