Best Buy? Not So Much
Best Buy’s stock isn’t the best buy right now. In fact, I’d be more inclined to sell the stock than buy it after reviewing its recent quarter. With a rousing 14% rally greeting its third quarter earnings release I was eager to learn about how the company managed to be one of the few retailers to escape the clutches of Amazon.
Earnings skyrocketed an incredible 50% to 62c and are expected to jump 20% in the fourth quarter, a number that would have been higher if not for the Galaxy Note 7 recall, which has left some potential mobile customers waiting for a better, large-screen mobile phone.
Imagine my surprise when reading that Best Buy’s sales inched up just 1.4% and are flat for the first nine months of the year. Online sales, a category boosted by the company’s free two-day shipping, catapulted 24% but represents just 10% of total revenue, too little to move the needle on overall growth. Revenue for the critical fourth quarter, which makes up 35% of annual sales, is expected to decline slightly.
It appears that while Best Buy has been able to keep its head above the tsunami of Amazon, it was not making much progress bringing new customers to its stores.
I continued to dig on, searching for the catalyst that ignited Best Buy’s remarkable earnings growth. Gross profit margins were not responsible. These margins, which represent the profit left after deducting store expenses and the cost to purchase merchandise, rose a meager 4%. Certainly no double digit jumps in profits being driven by this line item.
The company did make some decent strides in controlling its SGA (sales, general and administrative) expenses. It has been diligent in the past two quarters in its hiring practices. In addition, vendors like AT&T and Verizon have set up mini-stores within its stores, staffing them with their own employees, lessening the load on Best Buy.
These expenses did not increase from last year’s third quarter which drove a big jump in the company’s operating profits. Typically administrative expenses rise in lock step with revenue which dilutes the earnings growth. This is just the second quarter that Best Buy has shown the ability to control SG&A, a positive omen for at least a few more quarters. I’ll give the company a gold star for discipline in spending in the face of tepid sales but I’m not convinced it will be enough to increase earnings growth.
When moving down the income statement I was surprised to see that almost half of Best Buy’s earnings improvement came from a combination of lower interest expense, a lower tax rate and a drop in shares outstanding. While all of these are perfectly legal and important drivers of earnings growth, they are less likely to fuel a longer tail of earnings growth.
Certainly a drop in interest expense is impressive. This expense dropped 20% due to a one time debt repayment in this year’s first quarter. This lower expense will continue to boost earnings for the next two quarters. After that the company would have to pay off another lump of debt or refinance at a lower interest rate to lower this expense.
The company has some leeway with its share buyback program to further boost earnings. Last February it announced a $1 billion buyback. To date it has used up a bit more than half of that. At current prices, the remaining $480 million could buy 10.5 million shares, which could increase earnings per share by 3%. Again, this is helpful but not enough to justify higher prices in the stock.
All of the analysis above would be a moot point if the stock offered a terrific value. However Best Buy now sells for a PE of 13 times its 2018 estimate, when earnings are expected to increase just 5%. It’s certainly possible that Best Buy’s revenue catches some momentum and fuels more investor enthusiasm but with the stock up 52% year to date, it looks like there are better buys in the market.
I’ve made several successful bearish bets for subscribers of Profit Catalyst. Best Buy is now officially in my inventory bin and I’ll be looking for the right spots to make some trades on it.