Best Buy Looking to Lift Profitability

Best Buy (NYSE:BBY) is a specialty electronics retailer that competes with general retailers like Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) as well as other specialty retailers like GameStop (NYSE:GME) and Radio Shack (NYSE:RSH). Our price estimate for Best Buy stands at $38.48, which is about 20% above market price.

The company’s stock has struggled to gain ground since Best Buy’s earnings release in December 2010. Best Buy has faced limited demand for featured products like 3D TVs, and appears to have underestimated competition from players like Wal-Mart and Amazon (NASDAQ:AMZN). Beyond these challenges, we’ve also explored the developing trend of increased mobile internet usage, and the potential threat this poses to Best Buy’s key advantages (see our article Is Best Buy Losing its Edge?).

Despite these obstacles, we believe Best Buy can benefit from better management of its inventory in 2011 and can also take steps to mitigate the growth headwind created by competitors. What else is Best Buy doing?

Best Buy’s recent announcements indicate that the company is focusing efforts on more profitable stores, and closing those that are less profitable. The company is also looking to restructure its global operations to yield cost benefits.

Best Buy’s Steps and Cost Benefits

Best Buy recently announced its plans regarding store expansion, with emphasis placed on growth areas like Best Buy Mobile stores in the U.S. and Five Star stores in China. ^[1]

The Best Buy brand has struggled to gain traction in China and the company has decided to shift direction and close all its Best Buy brand stores in the region, as well as those in Turkey. Instead, it will push forward on operations of its Five Star stores, a local Chinese brand that Best Buy acquired some years ago.

The restructuring effort is expected to result in annual cost savings of about $60-70 million beginning in 2013. However, the initiative will cost the company roughly $245 million over next couple of years. ^[1]

How might this affect Best Buy’s stock value?

Slight Margin Improvements Could Add Some Value, But Not Much

If we assume that costs and savings from the restructuring are incremental to our base forecasts, it implies that Best Buy may witness slightly compressed margins over the next couple of years and improvements thereafter. How big could this be for the company? A back of the envelope calculation suggests that the cost savings could lift gross margins by barely 0.15%. So not a great deal of incremental value added. This calculation also assumes that all cost benefits are absorbed by the U.S. segment. Of course, in reality, this will be spread across all divisions, but the magnitude of the impact can be gauged by making this assumption to simplify calculations.

See our full analysis and $38.48 price estimate for Best Buy

When comparing Best Buy’s revenues ($50+ billion) to expected cost savings ($60-70 million) , one can understand why the upside benefit to overall company value might be limited.

Drag the trend line in the interactive chart above to see the affect of various U.S. store gross profit margin scenarios on Best Buy’s stock value.

1. Best Buy Shuts China Stores to Focus on More Profitable Brand, Bloomberg, Feb 22 2011 [↩] [↩]