Three Factors That Could Significantly Increase Our Valuation Of Best Buy

Most people had expected Best Buy to go down the same lane as RadioShack, which, after years of losses, filed for bankruptcy earlier this year. This belief caused Best Buy’s stock to fall to about $11 at the end of 2012 (a level not seen since 2002). But, thanks to the company’s turnaround strategy, called Renew Blue, it sharply recovered to more than $40 by the end of 2014. Investments in inventory availability, multi-channel execution and a more targeted marketing approach helped the company achieve top line growth and margin improvements. Best Buy’s stock price has risen by more than 40% in the last one year. In this article, we take a look at a scenarios which could lead to further upside and quantify the potential impact each of them could have on our current price estimate for Best Buy.

Our price estimate of $34 for Best Buy is at a marginal discount to the current market price.

See our full analysis for Best Buy

A Lower Decline In Margins As Best Buy Manages To Tackle Competition From Online Retailers (+10%)

A major shift in electronics purchases from offline to online was the cause of all the problems for brick-and-mortar retailers, especially in the consumer electronics industry. Not only did online retailers take market share away, but retail stores had become their showrooms. Consumers visited their stores to browse through products only to later order from an online seller of the same product (termed showrooming). Best Buy tackled this issue by providing customers a price match guarantee. They would price match all local retail competitors (including their online prices) and some major online retailers, including Amazon.com. This somewhat helped Best Buy regain sales, though they had to sacrifice margins in this attempt. Gross margins for Best Buy US decreased from 23.4% in 2012 to 22.4% in 2014.

While online retailers haven’t made a move yet (by lowering prices), price competition cannot be a sustainable way of gaining sales for Best Buy. As online retailers are substantially cost-advantaged compared to physical retailers, they would have much more room to lower prices than the latter. This forms the basis for our current forecast for Best Buy’s US gross profit margin, which we expect to further decline to 18% by the end of our forecast period as a result of the rising competition from online retailers.

However, Best Buy is looking to ease the downward pressure on margins. The company has set itself a target of approximately $400 million in cost reductions over the next three years. As these savings are expected to be driven by streamlined processes and operational efficiencies (which are structural in nature), they are not expected to begin until the latter half of fiscal 2016. If the company is able to achieve this target, cost reductions could help offset the margin loss faced due to price competition. In a scenario where Best Buy ‘s US gross profit margin falls only to 21% instead of 18%, there could be a 10% upside to our current price estimate.

Reduction In Capital Expenditure Due To Lower Investment On Technology (+10%)

Best Buy plans to continue investing in the transformation of its e-commerce technology platform, with support from its new technology development center in Seattle that it recently opened. Similar to general industry trends, Best Buy’s website traffic from mobile phones is growing faster than its traditional desktop traffic. Accordingly, the company is increasing investment in its mobile platform to provide streamlined access to essential product information during the discovery, research and check out process. Therefore, we forecast Best Buy’s capital expenditure as a percentage of gross profits to increase from the current level of 6.2% to 7.0% by the end of our forecast period.

In 2013, the company cut down its capital expenditure by 2 percentage points to 5.8% of its gross profits. However, investments in technology to improve its online presence increased capital expenditure as a percentage of gross profit to 6.2% in 2014. Given the online capabilities that Best Buy has already developed, it could bring its capital expenditure down once more in the long term. In a scenario where capital expenditure as a percentage of gross profits declines to 4.2% by the end of our forecast period, there could be a 10% upside to our current price estimate.

Stores-Within-A-Store Format Increase Revenue Generated Per Square Foot (+10%)

Best Buy’s stores-within-a-store format has been an important part of the company’s efforts to make better use of its store space. The company rents out spaces within its stores to popular brands, similar to brands occupying separate stores in malls. They have large product displays, dedicated checkout areas and trained employees of respective companies to guide customers. Best Buy’s current list of partners includes Samsung, Microsoft and Time Warner cable. This has played a key role in reshaping Best Buy’s image in the minds of customers. As gadgets grow from mere slabs of metal to components of one’s fashion statement, such as the Apple Watch, it is likely that consumers will increasingly feel the need for the stores within Best Buy stores as various manufacturers showcase their products. Not only does the rent paid by the partner act as an additional source of revenue for the company, but it also offers the possibility of driving traffic through the rest of the store.

We forecast the company’s average revenue per square foot in U.S. to marginally increase from $870 to about $900 by the end of our forecast period. While this is a conservative estimate of the benefits arising from the stores-within-a-store, it is quite possible that they could be significantly higher. Growth in the number of partners opening their stores within Best Buy could drive the metric further up. If the average revenue per square foot increases to about $1,000 instead of $900 by the end of our forecast period, there could be a 10% upside to our current price estimate for the company.

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– Margin Pressure?http://www.fool.com/investing/general/2014/07/02/can-rite-aid-and-walgreen-overcome-this-threat.aspx

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