S&P expects the retailer to benefit from strength in consumer-electronics spending and an ability to outmaneuver competitors
From Standard & Poor's Equity ResearchWhy do we have a "strong buy" on Best Buy (BBY)? We think that the healthy consumer-electronics cycle will continue to propel sales and earnings growth despite an expected slowdown in consumer spending. Second, we think that aggressive expansion and a continued focus on service levels will allow Best Buy to increase overall market share and build loyalty with consumers.
Finally, we think the company's valuation is compelling. Best Buy shares trade at a price-to-earnings (p-e) multiple below its peers and in line with the broader market, despite sporting greater growth potential and what we consider to be a stronger balance sheet. These factors help the stock earn Standard & Poor's highest investment ranking of 5 STARS (strong buy).
Best Buy is North America's largest specialty retailer of consumer electronics. As of Mar. 3 of this year, it operated 869 Best Buy stores (822 in the U.S. and 47 in Canada), 20 Magnolia Audio Video stores, 14 Pacific Sales showrooms, and 12 Geek Squad stores in the U.S. It also operates 121 Future Shop stores in Canada, 135 Five-Star stores in China, and one Best Buy China store.
Solid Sales Increase
U.S. Best Buy stores average approximately 41,300 square feet and offer merchandise in four product groups: consumer electronics, home-office, entertainment software, and appliances. Consumer electronics (45% of fiscal 2007 revenues) consists of video and audio products and services. Video products include televisions, digital cameras, DVD players, digital camcorders, and accessories. Audio products include MP3 players, home theater audio systems, mobile electronics, including car stereo and satellite radio products, and related accessories.
The home-office product group (30%) includes notebook and desktop computers, computer support services, telephones, networking equipment, and accessories. Entertainment software products (18%) include DVD movies, video game hardware and software, CDs, computer software and subscriptions. The appliances product group (7%) includes major appliances as well as vacuums, small electrics, housewares, and services.
The domestic consumer-electronics industry generated $145 billion in sales in 2006, according to the Consumer Electronics Assn. (CEA), a 15% increase from the $125.9 billion in 2005. Total industry sales are forecasted to increase 7% in 2007, to approximately $155 billion.
While the market remains fairly fragmented, the top three players have a nearly 50% share. Best Buy leads the way with an approximately 25% share, followed by Wal-Mart (WMT), with 15%, and Circuit City, (CC) with 9%. Competition is fierce, and we believe that retailers who differentiate themselves, either through service, marketing, or product mix, will benefit.
We expect further development and increased adoption of digital products to boost future sales of consumer electronics. At this point in the cycle, we continue to project declines in average selling prices (ASPs), which we think are hurting manufacturers but are helping to fuel demand and benefit retail sales. We do expect to see more rational behavior from vendors in calendar 2007, following drastic price declines in 2006, but still project ASP declines in flat-panel TVs of about 20%.
Longer term, we expect a growing convergence between computers, televisions, cameras, and telecommunications equipment. As to the impact of the Internet, the growing availability of entertainment for downloading from the home is likely to hurt long-term sales of CDs and DVDs at stores, in our view.
Strong Customer Service
Thanks in large part to a healthy consumer-electronics cycle, Best Buy recently posted revenue growth of 16.5% in fiscal 2007 ended February, including a same-store sales gain of 5.0%. Earnings per share increased 23%, to $2.79. While we expect growth to slow somewhat in fiscal 2008, we remain confident that strong product cycles will continue to drive impressive results at Best Buy.
Growth in advanced TVs is expected to slow from what we think was a high double-digit gain in fiscal 2007, but we still expect a fairly strong double-digit increase in fiscal 2008 as declining prices continue to fuel mass adoption and drive unit volume. In fiscal 2007, the strength in advanced TVs fueled a strong triple-digit increase in home theater installation services, and we think this higher-margin service benefited from successful promotion strategies and a sales staff catering to Best Buy's customer-centric core business strategy. Because of this detailed attention to customer service, which we think differentiates the company from other low-cost retailers, we believe Best Buy will continue to remain the retailer of choice when consumers are seeking to purchase a new TV or home theater system.
We expect several other categories to perform well in 2007. Following the launch of the Nintendo Wii and Sony (SNE) PlayStation 3 in late 2006, video game hardware and software should both increase impressively this year, in our view. In addition, the recent launch of Microsoft (MSFT) Vista should contribute to solid growth in sales of notebook computers and computer services. Lastly, we expect modest growth in MP3 players and digital cameras. Growth in the aforementioned products should help minimize the effects of projected declines in sales of CDs, DVDs, and desktop computers.
Competitors Are Ailing
We think recent layoffs and store closures at competing retailers provide Best Buy with a golden opportunity to gain additional market share in calendar 2007. Circuit City, the second-largest specialty retailer of consumer electronics, announced in late March that the company would lay off 3,400 store associates, 60% of whom are "customer facing." Also in March, competitors CompUSA and Tweeter Home Entertainment (TWTR) announced plans to close 126 and 49 stores, respectively, due to price erosion and competition.
While these store closures could lead to slightly softer sales and margin pressure for Best Buy in the early part of the year due to clearance sales at competitors, we think the longer-term sales benefit of industry rationalization should be rather pronounced for the company. In addition, we see the layoffs at Circuit City providing an opportunity for Best Buy to further differentiate itself from peers in terms of service quality.
Global expansion remains a priority for Best Buy, and we believe the company can continue to drive strong square footage growth over the next several years, including global gains of approximately 10% in fiscal 2008 (this would represent the highest square footage increase for the company in several years). In fiscal 2008, Best Buy plans to open 90 new Best Buy stores in the U.S., 12-14 new stores in Canada, about 22-26 new stores in China (including 2-3 Best Buy China stores and 20-23 Five-Star locations), and five new Pacific Sales stores. Company plans also call for testing the markets in Mexico and Turkey. While we were surprised by plans for the acceleration of store openings, we think Best Buy is trying to capitalize on the struggles of many of its competitors.
Apple Partnership Promising
Longer term, we believe the North American market can support anywhere between 1,200 and 1,500 Best Buy stores, so we think the company is somewhere between 60% and 75% of total store penetration, with 869 Best Buy locations in the U.S. and Canada as of Mar. 3, 2007.
Incremental growth drivers in the near term, by our analysis, include a partnership with Apple (AAPL: Strong Buy; $91) that will lead to the sale of Apple computers in approximately 200 Best Buy locations by this fall, and the expansion of Best Buy Mobile (wireless phones and services) to 150-200 additional stores. While nothing has been mentioned yet regarding the Apple TV or iPhone, we think a relationship beyond computers and iPods would be beneficial for both parties.
We project earnings per share of 53 cents for the coming May quarter (the company is scheduled to report on June 19) on sales growth of 12%, including 4.0% growth in comparable-store sales, a key retail metric that measures revenue growth at stores open at least a year. We expect gross margins to narrow approximately 70 basis points, due to declines in ASPs, the inclusion of Best Buy's significantly lower-margin Five-Star acquisition (which closed in June, 2006), and expected promotional activity in response to clearance sales at rival stores that are closing. We expect operating margins to narrow slightly as well, as projected gross margin declines are only partially offset by the leveraging of expenses over a greater sales base.
For the full year fiscal 2008, we expect Best Buy to post sales growth of about 10%, driven by an increase in square footage of approximately 10% and comp-store sales gains of 3%-4%. We project gross margins to decline 40 basis points, as further declines in ASPs and a competitive marketplace erode profits. However, we expect operating margins to widen by approximately 10 basis points as a projected same-store-sales increase leverages infrastructure and advertising expenses. After taxes at 36.0% and a 1% reduction in shares due to repurchases, we project EPS of $3.17. For fiscal 2009, we project sales to rise an additional 10%, driving EPS to $3.62.
Best Buy shares are essentially flat year to date, underperforming computer and electronics retail peers as well as the broader market. The shares recently traded at approximately 15.4 times our fiscal 2008 EPS estimate of $3.17, a 12% discount to their three-year historical average of 17.5 times, and in line with the S&P 500-stock index. We believe that Best Buy should trade at a modest premium to the broader market due to its above-average growth prospects and strong balance sheet. At a p-e-to-growth ratio of 1.1 times, the stock trades at about a 15% discount to the S&P 500.
We believe Best Buy has one of the stronger balance sheets in our specialty retail coverage universe, with over $3.7 billion in cash and short-term investments (as of Mar. 3, 2007). In fact, Best Buy's net cash position (cash plus short-term investments minus debt) equals approximately $6.50 per share. Excluding the net cash position, we note that Best Buy stock trades at just 13.2 times our fiscal 2008 EPS estimate.
Favorable Corporate Governance
Because we believe that Best Buy will be able to fund future growth and acquisitions entirely with operating cash flow, we expect management to use excess cash to ramp up share buybacks in the near term. A slight increase in dividend payouts may also occur within the next couple of quarters. Lastly, while we think that adding leverage could improve the company's capital structure, we do not fault the company for its conservatism.
Our discounted cash flow (DCF) valuation suggests an intrinsic value of $63 for Best Buy shares. This value, which is also our 12-month target price, is about 30% above the recent price, and approximately 20 times our fiscal 2008 EPS estimate.
In general, we view Best Buy's corporate governance favorably. Several of the practices we view positively are that the board is controlled by a majority of independent outsiders, the company does not have a poison pill, the fact that the nominating and compensation committees are entirely made up of independent outside directors, and that all stock-based incentive plans have been approved by shareholders. We also like that the company has reported "clean" earnings results (without one-time charges or gains) and has not had any recent restatements of its financial results. However, shareholders do not have cumulative voting rights, and the board is authorized to increase or decrease the size of the board without shareholder approval.
Risks to our recommendation and target price, in our view, include: a greater-than-anticipated slowdown in consumer spending; a weakening digital products cycle; execution risk related to international expansion and the integration of acquisitions; currency risk; and a shift in consumer tastes and preferences away from consumer electronics.