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Best Buy (NYSE: BBY) is in Full Retreat

By Jim Fink on March 29, 2012

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When I was in business school, I interviewed for a job with a mutual fund company. After a few pleasantries, the interviewer asked me a simple question to see whether he could take me seriously as a potential equity analyst hire for his firm:

“If you could only look at one thing to determine if a retailer is performing well, what would it be?”

Apparently, retail stocks are among the easiest industries to analyze because their business models are relatively straightforward – compared to something wickedly complex like bank stocks – so if I couldn’t answer this question there was no point in continuing.

At the time, I was a financial novice and knew more about constitutional law than retailers, so I just blurted out a financial buzzword I had recently learned in my corporate finance class: “Return on invested capital (ROIC).” My answer was theoretically a good one – after all, profits are the name of the game in business and the more profit you can squeeze out of each dollar of capital invested is tremendously important. However, my answer was completely generic and vague, whereas he was looking for a retailer-specific answer that would reveal some industry knowledge on my part. After hearing my answer, the interviewer briefly frowned and said:

“Store openings. The more stores a retailing company opens, the more money it makes.”

We then talked for another 15 minutes on non-business-related subjects including the weather, sports, and what restaurants were good in the area. Needless to say, I didn’t get the job.

Best Buy Reports a Disastrous Quarter

What stirred this slightly-unpleasant memory of mine was the release of Best Buy’s (NYSE: BBY) fourth-quarter and full-year financial report. The consumer electronics retailer reported a miserable fourth-quarter loss of $4.89 per share and announced that it was restructuring. Specifically, the company will close 50 of its big-box stores this year (fiscal 2013) and plans to cut $800 million in expenses over the next three years, with $250 million in expense reductions (i.e., the easy, low-hanging cuts) happening this year. The breakdown of the total $800 million in three-year cost cuts is as follows:

  • Retail stores: $300 million 
  • Corporate and support structure: $300 million 
  • Cost of goods sold: $200 million. 

The $300 million in cost cuts from closing stores appears easily achievable – stop paying rent and salaries associated with those stores. I also understand where some of the cost cuts from the “corporate” category are coming from: the company will be firing 400 employees and using fewer outside consultants. But the rest of the cost cuts sound aspirational and a bit fuzzy like  “IT service savings,” “reduction of product transition costs,” and “supply chain efficiencies.”

I’ll believe it when I see it. Sounds a lot like the “fraud, waste, and abuse” that U.S. presidential candidates always promise to eliminate in order to shrink the budget deficit, but never actually accomplish.

Retrenchment Almost Never Succeeds

But fuzzy expense reductions aside, the main thing I take away from Best Buy’s restructuring announcement is that the company is closing stores, the exact opposite of what my disappointed business school interviewer told me was the sign of a healthy and profitable retailer! Closing stores is a sign of failure plain and simple – consumers don’t like what you are selling. Cost cutting may temporarily improve company profitability, but profitability derived from retrenchment is one-time and fleeting. Furthermore, cutting costs often means cutting customer services, which will make Best Buy even a less pleasant place to shop and the company will be entering into a negative feedback death spiral of cost cuts and increasing customer disenchantment. Only organic growth and the opening of new stores based on consumer delight generates the sustainable revenues needed for long-term financial success.

Is Best Buy the Next Sears?

Just look at the retail disaster known as Sears Holdings (NasdaqGS: SHLD) to see what happens when a retailer tries to cut its way into prosperity. supposed to do. Hedge fund manager Eddie Lampert merged Sears with Kmart in 2005 and engaged in financial engineering full of cost cuts and share repurchases to try to create a winning investment. The one thing Lampert never did was spend money on improving the core retailing experience in the stores themselves. The result has been six consecutive years of sales declines since the merger and cost cutting began and whispers of a potential bankruptcy.

I’m afraid that Sears’ dreadful fate awaits Best Buy given its new defeatist retrenchment philosophy.  Investors apparently agree with me, selling off the stock by 7 percent on the restructuring news. Elliott Gue, co-advisor of the Cocktail Stocks investment service, predicted today’s disaster for Best Buy a month ago when he wrote on Seeking Alpha that Best Buy’s stock was a candidate for a short sale:

Problems facing Best Buy are more secular than cyclical in nature as the company is facing increasingly intense competitive pressure from online retailers of electronic products such as Amazon.com. In addition, discounters like Target and Wal-Mart have also entered the market for electronic devices selling digital cameras, tablets and laptops, usually with aggressive pricing strategies that further undercut the profitability of Best Buy’s bread-and-butter business.

Consumers’ preference for Apple’s popular iPhone and iPad presents another challenge, as these products carry far lower profit margins for Best Buy than laptop PCs and digital cameras. Best Buy can’t compete with Apple’s unique store layout and enhanced customer service. Many customers’ first inclination is to go straight to the source for Apple products. The outright collapse in sales of video games and consoles is another major challenge for Best Buy.

Ugh. Perhaps Best Buy CEO Brian Dunn had no choice but to restructure – given the awful business brick-and-mortar consumer electronics has become. But sometimes the best restructuring is liquidation rather than prolonging the agony.

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  1. avatar
    Isabel J. Griffin Reply March 29, 2012 at 7:11 PM EDT

    For me online shopping is fine but brick and mortar stores “touch and feel
    experience” is not fully satisfied online. Plus there is degree of “what if the purchase is not satisfactory?” The inconvenience of boringly rewrapping the physical package to return online is another. There is still nothing like returning or exchanging an item directly to the store and speaking to a knowledgeable salesperson who in many cases can help influence the purchase to the customer’s satisfaction with additional information. That being said, ” I hope “Best Buy” does not go out of business. JG